A tale of two day-care workers: how work arrangements affect taxes
Besides marital status and family makeup, one of the things that most impacts a tax return is the taxpayer’s occupation and work arrangement. It can set a taxpayer on one of two very different paths that can affect what out-of-pocket expenses they can deduct, the paperwork process they follow and even the way they travel, eat and entertain themselves and others. All these differences come down to whether the taxpayer is employed, earning a salary or hourly wages; or self-employed, working as a freelancer, contractor or small business owner.
To help understand the differences, Nathan Rigney, senior tax research analyst at The Tax Institute at H&R Block, suggested looking at two taxpayers who both work in child care. The first works for a day care center as an employee. The second runs her own in-home day care for a few families as a sole proprietor.
The day care center employee will owe federal income tax and half of the Social Security and Medicare taxes due on his income. If he lives in a state with an income tax, he will also owe the state.
The day care center employee will fill out a W-4 when he first starts his job, which will help the employer calculate how much tax to withhold from each paycheck. The day care center will withhold and pay these taxes on the taxpayer’s behalf, which means the taxpayer will not have any additional reporting requirements or face penalties or interest if his withholding covers his tax liability.
Just like the day care center employee, the in-home day care provider will owe federal and state income tax if she lives in a state with an income tax. However, she will also owe the entire amount of Social Security and Medicare taxes, known as the self-employment tax.
None of these taxes will be withheld from the income the in-home day care provider receives. But because the income tax system is pay-as-you-go, she should pay quarterly estimated taxes in April, June, September and January. If she does not make quarterly payments and pays her entire tax liability in April with her tax return, she could still face an underpayment penalty on top of her tax bill.
The day care center employee will use his W-2 from his employer to fill out his income tax return. If he only has wages, no dependents and uses the single filing status, he may be able to use the shortest and simplest tax form: the 1040EZ.
The in-home day care provider will file also file an income tax return but will not have a W-2 to report income. Instead, the provider will have to keep records of all payments received so she can report all income she has earned on Schedule C of the most complex individual tax return: the 1040. In addition to her records of all payments received, she should also keep organized and detailed records of her expenses.
Deducting business expenses
The in-home day care provider needs those detailed records of her payments and expenses because she can deduct all her expenses, as long as they are ordinary and necessary for the type of work she does. For example, this could include art supplies, food, diapers, wipes or other expenses incurred for the kids.
She can also make general self-employment deductions like half of the self-employment tax, health insurance costs and retirement contributions she pays.
The day care center employee may also have out-of-pocket costs for work expenses. But he may only deduct these expenses if the employer declines to reimburse him for the expense and if the cost, along with any other miscellaneous itemized deductions, exceeds 2 percent of his adjusted gross income. Even then, he must itemize to deduct the unreimbursed expense.
If his employer offers benefits, like a tax-deferred retirement plan or flexible spending account (FSA), he can take advantage of those but will have those contributions excluded from his income rather than taking them as business deductions.
Keeping a home office
If the in-home day care provider is licensed, she can deduct costs associated with her home “office” because she uses her home as her main place of business. And because her business is a day care facility, she does not have to meet the “exclusivity” test that other home offices must meet. This means she can use her living room and kitchen for business and personal use, but still claim those areas as her home office.
The day care center employee cannot deduct any costs associated with a home office unless it is associated with another business that requires him to work from his home. Because he is an employee, he can only deduct home office expenses if the home office is for the convenience of the employer.
“Being an employee can come with fewer burdens, but fewer tax benefits. Being self-employed means you can take advantage of additional tax benefits, but all the burdens of being an employer fall on you as well,” said Rigney. “Taxpayers should be familiar with these burdens and benefits before making any changes to their work arrangements.”
Taxpayers should talk to a qualified tax professional about their specific tax situation.
Learn how H&R Block is supporting small businesses through the Stand for Small coalition to help them navigate the COVID-19 crisis.
Data from a H&R Block study show small business owners could be operating with greater financial risks as they head into the holidays. Read more.
Learn the three steps small businesses owners can take to create business resilience right now.
Learn more about how Block Advisors helps small business owners leverage the tax benefits of the American Rescue Plan.