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Without a doubt by issuing a 1099, (whether it should be a W-1 or not is immaterial), her BIL is going to take a tax deduction or credit for what he pays your wife. That's taxable income to you. IF he issues the 1099, your move is to file it on Schedule C as a business, not a hobby. A hobby is something the IRS forces on you when you lose money at a business, not something you voluntarily do if you sell something or perform a service. Since when is baby sitting a hobby?

Anyway your wife is in the child care business and can write off more than she makes by allocating portions of the home, plus outside travel expenses, etc. for starters get IRS Publication 587 ( regarding providing child care. Instead of paying tax on it, REDUCE your taxes due to it. If you reduce your net to $433 or lower there's no SE taxes.

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