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My mother-in-law lives with my wife and me and baby sits our 5 month old baby. I pay her every week and I was wondering what makes the most financial sense for tax report/breaks/etc?

I believe I can claim her as a dependent in my house (along with my son), but I was wondering if it is wise to start a 'business' so that I can get some tax advantages or should I just keep paying her as is, document it, and take care of taxes at the end of the year as usual?

I have no idea what I'm talking about or how to proceed, I just feel like there are some potential benefits in this but I'm not sure.

What makes the most sense?

  • Is this in the US? Who's considering starting a business - you or your mother in law? – littleadv Aug 18 '13 at 0:09
  • @littleadv This is in the US, and I'm the one considering starting a business, but I don't know if that makes any sense at all. – hax0r_n_code Aug 18 '13 at 0:14
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Are you working for a company that offers a Dependent Care Account? You may be able to withhold up to $5000/yr pre tax for care for you child.

If you cover more than half her expenses, she is your dependent. You can't "double dip." If she is your dependent, she cannot be the care provider for purposes of the DCAS, see Pub 503 top of p7 "Payments to Relatives or Dependents."

How do you think a business would change your situation? The DCA is a small tax break, if you have no business now, this break isn't something that should drive this.

  • I just feel like there is something I'm not doing or should be doing since I'm just paying her out of my pocket to watch my son every week. But maybe not. – hax0r_n_code Aug 18 '13 at 0:18
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    @inquisitor yeah... You should also look for a tax break to buy the diapers. Why would you buy that out of your pocket as well? – littleadv Aug 18 '13 at 0:22
  • @littleadv I never knew that there is a tax break for diapers! Thanks for the advice. – hax0r_n_code Aug 18 '13 at 0:26
  • I doubt that creating a business just for the sake of DCA will go smoothly with the IRS. Lack of business purpose etc.... – littleadv Aug 18 '13 at 0:32
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You should check several things:

  1. Schedule H - while your mother-in-law is family and in fact lives with you, paying her may require you to file schedule H with your tax return.
  2. Dependent Care Credit - depending on your and your spouse's employment and income, you may be eligible for this credit. Check the details in the link.
  3. Cafeteria plans - As Joe has mentioned, you may have a benefit from your employer that allows paying for dependent care from pre -tax money. I'm not sure, though, if paying to your own family member is allowed under such plans.

How your business can deduct your child care expenses is beyond me. If your mother-in-law starts a business as a neighborhood babysitter, she might get some deductions for her related expenses though.

  • I just read the links that you provided and now I'm wondering which is better: 1.) Claim mother-in-law as a dependent or 2.) Get the dependent care credit? I can't get both because they can't be the same person (according to the IRS link you posted.) – hax0r_n_code Aug 18 '13 at 0:38
  • Do the math, make a decision. Dependent exemption is $3700, child care credit is up to $3000 - if you can get the maximum credit, it will be much better than getting the exemption ($3700*your marginal tax rate - assuming you pay 25% marginal tax rate, $3700 exemption gives you $925 tax benefit on Federal forms). – littleadv Aug 18 '13 at 0:38
  • I had no issue using the DCA when we paid my MIL to watch my daughter after school. It's been a few years now, but we also didn't have to worry about the 'nanny tax' which of course was paid when we had an actual nanny. BTW - Exemption is now $3900 (for 2013) – JoeTaxpayer Aug 18 '13 at 1:45
  • I just edited my answer. A dependent relative cannot be the provider for purposes of the DCA. Although as I noted, a non-dependent certainly can per my experience. – JoeTaxpayer Aug 18 '13 at 14:51
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You said your mother-in-law lives with you. Does she pay rent, or are you splitting the cost of housing? That would also have to figured into the equation.

If you had a business you would now have to declare the expense on your business taxes. This would also then be income for her, which she would have to account for on her taxes. Remember there are both state and federal taxes involved.

Regarding expenses like diapers. If the MIL had the business she could deduct them as a business expense. If you have the business it would greatly complicate the taxes. Your business would be essentially covering your personal expenses. If your MIL was not a business the cost of diapers would be paid by you regardless of the working situation of you and your spouse.

To claim the tax credit:

You must report the name, address, and taxpayer identification number (either the social security number, or the employer identification number) of the care provider on your return. If the care provider is a tax-exempt organization, you need only report the name and address on your return. You can use Form W-10 (PDF), Dependent Care Provider's Identification and Certification, to request this information from the care provider. If you do not provide information regarding the care provider, you may still be eligible for the credit if you can show that you exercised due diligence in attempting to provide the required information.

The IRS will be looking for an income tax form from your MIL that claims the income.

Getting too cute with the babysitting situation, by starting a business just for the purpose of saving money on taxes could invite an audit. Also it is not as if you just claim 3000 and you are good to go. You can only claim a percentage of the expenses based on the household AGI, the more the make the more you have to have in expenses to get the full 3000 credit, which mil cause more taxes for your MIL. Plus the whole issue with having to pay social security and other taxes on a household employee.

It might be best to skip the risk of the audit. Claiming your MIL as a dependent might just be easier.

  • Thank you for the post! My MIL does not pay any rent. She just lives with us and I only pay her to baby sit my son. So I'm going to really think about your comments and consider just claiming her as a dependent. – hax0r_n_code Aug 18 '13 at 14:25

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