My mother-in-law lives with me, my wife, and my two children (one 3 years old, the other 1 year old). Last year, my wife stayed at home and took care of our kids with the help of her mother. I claimed my mother-in-law as a dependent on my tax return for last year. I always file a joint married tax return.

This year, my wife has started a new job to earn extra income and my two young children are being taken care of by my mother-in-law. My wife and I have agreed to pay her a salary for her services. Realizing that I may need to pay employer taxes and/or tax withholdings, I downloaded and skimmed through IRS Publications 926 and 503, but I am still a little confused. Based on my understanding of Publication 926, I am not required to pay any employment taxes nor withhold any taxes for my mother-in-law, since she is my wife's parent, does not meet the exception as defined in the publication, and we file jointly. Is my understanding correct?

Also, I would like to maximize the tax benefits I am eligible for by paying my mother-in-law for dependent care. Again based on my understanding, Publication 503 says that I can claim up to 35% of the salary I pay to my mother-in-law for the child and dependent care credit, but only if I do not exclude or deduct $3,000 or more of dependent care benefits. My employer offers an optional dependent care flexible spending account and I can contribute up to $5,000 a year to it and that amount is not considered in my tax withholdings. What makes the most sense, maximizing my dependent care benefit, receiving no benefit and taking the credit on my tax return, or perhaps contributing $2,999 towards my benefit and still claiming the credit? I have a feeling that the answer is the third option, but I just want to make sure.

Some other information that may help anyone to answer: my wife and I combined make $130,000 a year; we have agreed to pay my mother-in-law an annual salary of $16,200.

Thank you for reading this. I look forward to any answers I can get. I apologize if this was asked before (my forum search returned nothing relevant).