Paying on a Net Basis is not as Convenient as You Think
The Whitaker family was a few months removed from the birth of their first child when Mrs. Whitaker decided she wanted to return to work. The family weighed their child care options and determined a nanny would be the best fit for their new daughter. Even though they were first-time household employers, Mr. Whitaker felt comfortable handling the hiring and employment process without the aid of an agency or a tax professional.
After interviewing several candidates, the Whitakers found a nanny they really liked who had experience working with young children and lived within 10 minutes of their Massachusetts home. When it came time to discuss her pay and how taxes would work, the nanny mentioned she had never had taxes withheld before and was used to taking home a certain amount of money each week. Not wanting to let a minor detail result in losing their favorite candidate, the family hired the nanny after agreeing to pay her $500 per week on a Net Pay basis. The Whitakers didn't really understand what that meant financially or administratively, but figured since they were hiring the nanny in October, they could figure everything out when it was time to file their personal taxes.
Payroll is calculated, tracked and reported to the IRS and state tax agencies on a Gross Pay basis (before taxes). In the eyes of the law, there is no such thing as a Net Pay compensation agreement.
Instead, families should negotiate a household employee's pay in terms of gross wages and then withhold the following taxes:
- Social Security tax - 6.2% of gross wages
- Medicare tax - 1.45% of gross wages
- Federal income taxes - determined by the employee's allowances on Form W-4
- State income taxes - determined by the employee's selections on their state withholding form if the family lives in a state with income taxes
Employees fill out Form W-4 and their state withholding form to elect the withholding status that most accurately reflects their life situation. This allows them to pre-pay income taxes each pay period at a rate that will approximately cover their end-of-year income tax liability. It is the employee's obligation to make the appropriate elections on Form W-4 and weigh the other factors that might influence their tax liability (i.e. other income, investment dividends, deductions, tax credits, etc.).
If an employee's elections cause taxes to be under-withheld, they have to make a tax payment at year-end. On the other hand, if their taxes were over-withheld, they will get a tax refund at year-end. Either way, it has no impact whatsoever on the employer because their obligation is simply to withhold the appropriate amount of taxes from their employee's gross pay.
The income tax withholding process is based on tax tables set by the IRS and the state - and they change every year. This makes working backwards from Net Pay to Gross Pay (also called "grossing up") a potential administrative nightmare for families and extremely prone to error.
When it came time for the Whitakers to file their nanny taxes for the first time - and file their personal income taxes - they discovered their willingness to gross up for their nanny's taxes actually caused them to pay more than they should.
The nanny elected to choose Single with 0 Allowances on her federal W-4. This election meant her gross wages were reported by the Whitakers as $668 per week in order to give her the $500 take-home pay she requested. Additionally, the family's employer taxes totaled $61 per week, making the total cost (before tax breaks) $729 per week for the 12 weeks of the calendar year the nanny worked for them.
However, since the Whitaker's nanny was single and had no children, the federal W-4 worksheet recommends she claim Single with 2 Allowances to better fit her life situation. If the nanny had filled the W-4 out this way, the Whitakers would only have reported $637 per week in gross wages to get the nanny to take home $500. The employer taxes in this case would be another $58 per week - taking the family's total cost (before tax breaks) down to $695 each week.
This $34 weekly difference amounted to $408 over the course of three months and would be $1,768 in additional taxes if applied to a full year.
The Whitakers were happy to pay this additional amount thinking they were helping the nanny cover her tax obligation. However, when the nanny filed her tax return, she got a large refund because, at Single with 0 allowances, the IRS determined she had too much in income taxes "withheld" from her pay. The family was confused and felt that since they covered her income taxes, they should be entitled to some or all of the nanny's tax refund.
A neighbor of the Whitakers suggested they call HomePay for advice because we handled their household employment taxes. When the family called, we explained the inherent issues with grossing up a net pay. Not wanting to run into this situation again, the family signed up for our service. Unfortunately, when we reviewed their tax returns, we found numerous errors in their "gross up" calculations due to changing tax tables during the year. This led to miscalculations, which required us to amend each return they filed.
Once they understood the situation, the Whitakers felt that the nanny had taken advantage of their generosity. They had agreed to cover her taxes, but they did not agree to overpay her taxes so she could get a large bonus at the end of the year. The family strongly hinted to the nanny that the tax refund money belonged to them, but the nanny did not take the hint and never offered to reimburse them. This caused friction and distrust between the two parties and led to the nanny's termination within the next three months.
How the Whole Thing Could Have Been Avoided
A little knowledge by all parties at the beginning of the relationship would have prevented all the mistakes and distrust. Knowing what they know now, the Whitakers understand to always offer a gross wage to any future nanny. HomePay has an Employee Paycheck Calculator that can be easily utilized to convert a Net Pay to a Gross Wage. Little details like this can help you steer clear of financial and legal issues that could potentially make or break an employment relationship. And if you run across something out of the ordinary, just give us a call. Timely professional advice can save thousands of dollars and dozens of hours of tedious work for busy families.