The Coronavirus Pandemic of the past two years has changed how many view the traditional employer-employee relationship and has also helped make the workforce incredibly mobile nationwide. This increased mobility, together with the growing desire of many state and local governments to generate new or increased revenues, have combined to thrust the once dark and nebulous realm of state and local taxation back into the spotlight and consciousness of many business owners and their employees.
To see this, one must look no further than the taxation of the “Remote Employee.” It is now more common than ever to see employers with a headquarters in one state employing remote workers in multiple other states. And, as transactions and employees cross state lines, state and local tax laws—and income tax withholding requirements, in particular—can trigger unexpected consequences, and lines can get blurry fast. This is increasingly the case, as many states that voluntarily chose not to impose taxes related to remote workers during the Pandemic are bringing their grace period to a rapid close.
It is because of this that we wanted to devote some time to explore some basic multistate payroll tax concepts—specifically, how states tax the compensation of employees and how employer withholding and payroll tax requirements are determined. Our goal is to make the dark and nebulous a bit more understandable, through this discussion. As we explore these issues, we will need to watch for three recurring factors that will serve as guides, whether we are looking at things from the perspective of the employee or the employer: to wit, where the employee lives, where the employee works, and whether the employee or employer has nexus with the state(s) in which the employee lives and works.
Generally speaking, a state will impose its income tax upon the compensation of all taxpayers who are considered its “residents,” regardless of where that income was actually earned. Also, a state will typically tax the compensation of a nonresident if the income was earned within that nonresident state. So, for example, if a Virginia resident were to perform work in West Virginia, all the Virginia resident’s compensation would be taxable to Virginia—even the portion earned in West Virginia; however, the portion of the Virginia resident’s compensation that was earned in West Virginia would also be taxable to West Virginia. Now, you might say, “Wait, that sounds like double-taxation!” And, sadly, you would be correct. Fortunately, many states have laws in place that serve to mitigate or even eliminate this double-taxation on an employee’s wages through the use of state income tax credits. However, not all states have these credit provisions, and some of the states offer credits to residents but not to nonresidents, so this is something that remote employees should always be mindful of, before they change jobs or begin work in a new state. It is also worth noting that most states allow nonresident employees to allocate their compensation to each nonresident state based on a “working days” type formula, in which the numerator is “days worked in nonresident state ‘A’” and the denominator is “total days worked in all states.”
From our example above, it should be clear that the idea of “residence” is central to understanding how an employee’s wages are taxed—this is because it is how many states define nexus with an employee (more on what we mean by that later). As you might imagine, with 41 states imposing their own income tax laws, definitions of terms such as “residence” can (and do) vary quite a bit, depending on where you are. Most states determine the residency of a taxpayer based on two methods: the first of these is the number of days the taxpayer spends within the state and the second is a test related to where the taxpayer is “domiciled.” The first is a fairly straightforward mathematical calculation; however, the latter method is far more subjective, as it takes into account factors such as where the taxpayer lives, where their family lives, where they go to church, where they own property, or where their driver’s license is issued from. It is possible that a taxpayer may actually be a “resident” of more than one state, under such individual state laws, and, when that happens, things can get far more complicated.
The good news is, once remote employees have successfully identified the state(s) to which they will owe income taxes, they can plan to make estimated income tax payments, if their employer is not required to withhold state income taxes from their pay. Besides helping them avoid having a large tax balance owed when filing their return and preventing them from incurring large underpayment penalties and related interest, this simple step can also empower employees when they hold compensation-related conversations with a prospective employer.
The first, and most obvious, question to deal with when it comes to this issue is, “What is compensation?” This is because many payments made by an employer to or on behalf of an employee are not taxable for Federal or state income tax purposes, specifically because they are not considered “compensation.” Examples of such payments include nontaxable fringe benefits or expense reimbursements under an accountable plan—such as when an employer reimburses a remote employee’s telephone or internet expenses. However, once we have determined that a particular payment is, in fact, compensation for an employee’s services, we need to evaluate three other factors that might sound a little familiar at this point: where are the services performed, where does the employee live, and does the employer have nexus with either the state where the employee lives or the state in which the employee works?
In general, employers should withhold income tax from employee wages based on where their employees perform services. At first blush, this makes sense and may seem straightforward, based on our earlier discussion, since most states will tax the wages earned in-state by both a resident and a nonresident employee. However, when a remote employee lives and works in different states, the issue becomes more complicated, as the employer must also take into account the employee’s state of residence. This is because some states have reciprocity laws in place that formally govern which state has the right to tax the income of an employee who lives in one of the signatory states and works in the other. These reciprocity laws, in turn, determine which state an employer must withhold under. Generally, reciprocity agreements default to make the state of the employee’s residence the one to whom tax is owed and for whom tax should be withheld by an employer. If no reciprocity agreement exists between the states in question, the employer must look to the laws of each state.
At this point, you may be wondering, “But what about nexus—how does it play into all this?” Let’s start by defining the term. In the context of taxes, “nexus” is a word used to define a connection between two entities sufficient for one entity to impose a tax on another; thus, if an employer or an employee has nexus with a state, the state has the authority to impose its tax laws upon the individual. As it relates to withholding taxes from employee compensation, nexus can act something like a trump card, when it comes to reciprocity agreements between states, and it can guide what needs to be done absent a reciprocity agreement. For example, take the case of an employer who pays an employee for work performed in the employee’s nonresident state, and assumes the employee’s state of residence has a reciprocity agreement with the state in which the employee works (i.e., the nonresident state). In this case, the employer would normally be required under the reciprocity agreement to withhold income taxes for the employee’s state of residence, and it would be prohibited from withholding income tax from the state in which the employee actually performs services (despite the fact the employee may ultimately owe tax to that state). However, if the employer has no nexus with that employee’s state of residence, it will not be required to withhold income tax on the employee’s compensation! This is important for an employee to understand because, absent employer withholding, the employee would need to consider making estimated tax payments to the state in which he or she lives.
While we have focused on the state income tax payment and withholding requirements for remote workers, we’d be remiss if we didn’t also mention that state and local income taxes are only one of the types of payroll-related taxes employers need to be aware of and manage, with regard to their remote employees. Another major type of tax are state unemployment insurance taxes. As a general rule, state unemployment taxes are paid by employers and should be paid to the state where it is most likely the employee would seek employment or unemployment benefits. So, for example, if an employee lives and works from home in Virginia for a company located in Tennessee, the employer should typically pay unemployment benefits to the state of Virginia. But, of course, there are exceptions to this general rule.
In summary, a mobile workforce can bring with it efficiency to employers and flexibility for employees; but it can bring potential pitfalls for both, too. Determining where an employee will owe tax on their compensation and where an employer should withhold on their wages can become complicated and nuanced quickly, as the states vary in their imposition of income taxes, their definitions of terminology, and their application of their laws to those who live and work within their geographical borders. It is important to realize that, at the end of the day, it is up to each taxpayer—whether an employer or an employee—to determine whether or not they are required to pay or withhold tax in a jurisdiction. A little planning and forethought can alleviate a world of pain and frustration when it comes to taxes and potential penalties! At Brown Edwards, we can help you answer those questions, to see whether your remote-work policies are still viable and whether they may have some hidden tax exposure.