By: Jamie Baker, CPA
Key Takeaways:
• The COVID-19 pandemic significantly increased remote work, which many employees prefer to continue. This shift has allowed employers to save on office costs and hire qualified workers from diverse locations.
• Remote work introduces complexities in state tax rules. Employers must navigate varying income tax withholding requirements and potential sales tax nexus issues when employees work from different states.
• Employers should understand state and municipal tax rules, ensure payroll providers are knowledgeable about multi-state tax obligations, and consider the implications of sales tax nexus to avoid compliance issues.
The concept of remote work used to be rare in the American workplace. That changed with the COVID-19 pandemic when millions of Americans had to quickly shift to working from home.
When it was time to go back to the workplace, many employers found their employees preferred working from home at least a few days a week, if not full time. Moreover, employers realized having a remote workforce could result in significant savings, as large offices were exchanged for smaller, less expensive workspaces.
One benefit of transitioning to a remote workforce stands out above all others for many employers – the ability to hire qualified employees who live far from the employers’ locations. With persistent labor shortages in nearly every industry, the ability to offer remote work as an incentive is a recruiting advantage.
Uncoordinated State Tax Rules
But complications come with that ability, as employers find they must deal with a morass of uncoordinated rules about withholding income taxes from remote employees’ pay. Additionally, employers often find that having an employee living in another state triggers sales tax and income tax nexus for the company.
Understanding the complex rules around income tax withholding requires an awareness of a couple of key concepts:
- Home state withholding. When you have remote employees who work from their homes in other states, income tax withholding applies to the state where the work is being performed. That means income taxes must be withheld according to the rules of the employee’s home state, and the employer must file the necessary returns and forward the payments to that state. In this scenario, the employee is typically not required to file a non-resident tax return in the state in which the company is located. That’s how it happens when things are simple. But these things are not always simple.
- “Convenience of the employer” rule. Five states – Arkansas, Delaware, Nebraska, New York and Pennsylvania – have what is called a convenience of the employer rule, meaning the state may impose tax withholding on an employee that is employed by a company in that state but who works from home in another state. In this instance, the employee has income taxes withheld by two states. An additional three states – Connecticut, Massachusetts and New Jersey – have modified convenience of the employer rules. In all of these states, employees who are subject to withholding from two states are likely to get a tax credit from their home states for the taxes withheld from their employer’s state, but in some cases the credit will not cover the entire amount withheld. There are exceptions to these rules, which is why they are called “convenience of the employer” rules. If an employee works remotely for reasons that benefit the employer – i.e., the employer does not provide a physical office, or an employee manages a remote territory and must live there – multi-state withholding does not apply.
Reciprocal Agreements Among States
Throughout the country there are groups of states that have “reciprocal agreements,” stating clearly that employers in one state need only withhold state income taxes for the home states of their employees, regardless of where the work is performed. . This is a very taxpayer-friendly rule that ensures that employees who live in a one state, but work in another, do not have to file non-resident income tax returns in the state where their employers are located, and are not potentially subject to double taxation.
Employers who have workers living in a reciprocity state must have the employees fill out a form stating that they are a non-resident of the state in which the company is located, and therefore exempt from that state’s income tax due to a reciprocity agreement.
Illinois has reciprocity with four other states – Iowa, Kentucky, Michigan and Wisconsin.
Exceptions to Reciprocity
It’s important to note that reciprocity agreements apply only to state tax withholding. They do not apply to any municipal tax withholding for which an employee may be obligated. For instance, the city of Detroit has its own income tax, so if a Detroit resident worked from home for a company located in Illinois, the company would have to withhold those income tax amounts, and the employee would need to file a Detroit tax return.
Municipal-level and county-level taxes are becoming increasingly common, and localities are aggressive in pursuing the tax withholding they have coming. They are highly connected to their state revenue departments, and they will generally know when a company has nexus in their jurisdiction.
Nexus – Income and Sales Tax
In addition to income taxes, sales tax nexus can become an issue for companies that have remote employees in other states. What determines nexus for each state varies.
In general, having an employee in another state can create income tax nexus for the company, and an income tax filing obligation in addition to withholding for the employee.
The actual tax liability depends on multiple factors. Some states have factor-based nexus thresholds that may be based on a certain level of payroll in the state, a certain level of property in the state or a certain level of sales within the state. Under Public Law 86-272, part of the Interstate Income Act of 1959, a company is protected from nexus if its employee in another state is only involved in solicitation of sales, but does not accept sales orders.
Sales tax nexus is similar, in that having employees in a state typically creates a “physical presence,” which in turn makes a company liable for sales taxes on sales made within that state. In other words, if a company based in Illinois has even a single employee in North Carolina, all of the company’s shipments to North Carolina would be subject to sales taxes.
The actual laws surrounding income tax and sales tax nexus are much more complicated, and when you consider that there are more than 11,000 sales and use tax jurisdictions in the U.S., in addition to the state and municipal income tax jurisdictions, the massive web of complex regulations becomes clear.
What Employers Should Do
Before jumping into the trend of hiring remote employees, employers should consider the implications and potential unseen costs of doing so. Among the factors to be considered are:
- Where is the employee located, and what are the rules for that state? Understanding the nuances, laws, and regulations of each state where remote employees work is critical.
- Understand municipal level withholding requirements, as well as state.
- Even if an employee is in a state that doesn’t have an income tax, such as Texas or Florida, more often than not the employer will have some type of tax liability related to Unemployment Insurance.
- Ensure that your payroll provider is up to date on multi-state employment taxation. Most of the major providers are on top of this, but smaller providers may not be aware of complications that can arise. For instance, you may have an employee in another state who leaves the company. Does the payroll company do the due diligence to close the withholding account? If not, your company will have to keep filing withholding reports for that state.
- Understand sales tax nexus and the implications it creates for your company. This is often overlooked by companies that hire remote employees.
In Summary
As certain megatrends in the business world continue to play out, the complications of remote employment taxes will only grow. Now that the concept of remote work has become ubiquitous, more companies and workers will have to deal with employment tax implications. And as consolidation in many industries creates increasingly more multi-state entities, companies and payroll providers also will have complicated withholding and nexus issues.
It’s time for companies to take a look at how their employee landscape has changed post-pandemic to make sure they do not run afoul of state payroll tax rules and income tax nexus rules.
If you would like to discuss your company’s remote hiring practices and tax liabilities in employees’ home states, contact your KRD tax advisor.
