After hours of research and soul-searching, you've decided that of all your childcare options, hiring a nanny is the best choice for your family. So you find a reputable nanny agency, go through an extensive screening and interviewing process to select just the perfect person to care for your child, and hire her. Suddenly, you're a household employer, with all the legal, tax, and insurance implications that brings. Now what?

Nannies as Employees

You may be thinking that all of this sounds overly complicated. Couldn't you just call your nanny an independent contractor and make life a lot easier? In most cases, the answer is no.

The question of whether a nanny is an employee or an independent contractor is one that can sometimes have gray areas, but in almost all cases under both federal and state law, nannies are employees.

There are several legal criteria used to determine a nanny's employment status:

  • Amount of control: Another factor for whether a person is an employee centers on the issue of control. If you exercise control over how the person does his or her job in your own home - and in almost every case you would exercise such control over how your nanny interacts with your child - then you likely have an employee, not an independent contractor.
  • Economic reality test: Is this the nanny's only job? Even if it's not, does she rely on this specific job for a considerable amount of her income? Is her financial livelihood entirely or largely dependent on this job? If the answer is yes to any of these questions, then she's almost certainly an employee.
  • Regular and substantial hours: The more regularly a nanny works for a family, the stronger the case that she is an employee. It is when her hours are minimal and/or fluctuate from week to week (or month to month) that she is more likely to be considered an independent contractor.

The important thing to remember is that it's the law that determines who is and who is not an employee. How the nanny refers to herself, how the family defines her status in an employment contract, or whether she is paid hourly or is salaried do not necessarily matter in determining her employee status.

Although there are limited exceptions to the employee definition for certain family members or if you take your child to another person's home for care, the general rule is that if you control how she performs her duties in your home, she is your employee and you are required to pay employment taxes for her work. Bear in mind that these tests can be applied to other household employees as well, such as elder care providers.

Sorry, Paying Taxes is Not Optional

So here's the part you were afraid of when you first thought about hiring a nanny: paying employment taxes. The bad news is that it's not optional. Now for the good news: there are legal and tax advantages to paying your nanny legally that can offset much of the added cost.

If eligible, you may be able to maximize your tax savings in a number of ways, including:

  • Saving taxes by putting up to $5,000 pre-tax per family per year into a Dependent Care Account to help pay for your nanny.
  • Eligibility for the federal Child and Dependent Care Tax Credit for a minimum tax credit of 20% for the first $3,000 in qualifying expenses for each of your first two children per year.

The bottom line is that if you maximize your tax savings, paying legally can amount to as little as 5 percent more than paying your nanny under the table, and you avoid the potentially devastating charges, penalties, and other costs of tax fraud.

But Who Really Gets Caught?

When people make the conscious decision to pay their nanny under the table, there are assuredly several factors that go into that decision. One is the aforementioned misperception that the cost differential will be too much of a burden to bear. Another is difficulty believing that they'd ever get caught.

Yet people get caught every day. And you don't have to be a judicial or political appointee to feel the sting. Sometimes, it's nothing but a simple mistake that leads to someone being caught, but it's never a simple thing to make it right.

Many people believe that as long as a nanny doesn't turn her employer in herself, the employer will never get caught hiring someone illegally. Recent history, and the criminal courts, are littered with people laboring under this misconception.

Oftentimes, when someone is caught, it's unintentional. Say your household employee files for unemployment, social security, disability, or workers compensation benefits. Oops! You've just gotten caught not paying her employment taxes.

Or it could be entirely intentional: your employee quits or you fire her, and she turns you in - or tries to blackmail you. Or a disgruntled neighbor reports you.

Under any of these scenarios, the result is the same: you get caught and face considerable consequences. And what are the consequences of paying illegally? They can include:

  • paying all back taxes, penalties, and interest
  • charges of perjury and tax fraud
  • up to $250,000 in fines and up to 5 years imprisonment