The COVID-19 pandemic has forced many businesses to close physical offices and transition their workforce to a remote work format. The arrangement is lasting longer than many initially expected, and plans for returning to offices commonly involve limited, phased, or cyclical attendance. Below is a review of critical state and federal tax concerns, as well as payroll considerations for businesses with remote employees.
Employee-Related Tax Obligations
It is important to understand your workforce makeup. Do you have full-time employees, independent contractors, or a combination of both? Tax and withholding consequences come into play with respect to full-time employees. As an employer, you must follow federal and state guidelines for classifying workers or risk facing penalties.
Individuals who are employees generally have fewer reporting and compliance burdens than independent contractors. Employees typically rely on the employer to withhold income taxes from employment compensation, whereas independent contractors are responsible for correctly reporting all taxes on payments received from their customers and other payors.
State tax laws imposing reporting and withholding obligations on employers vary depending on the remote employees’ locations. Employers must be aware of the different administrative requirements for each state and locality where they maintain a workforce.
Withholding Standard Processes Vary by Location
While remote workers are not new, the pandemic led to a significant increase in the remote workforce over the last year. Consider how many more people are now working from home, a relative’s house, or the beach than they were a year ago. These arrangements may continue well beyond the pandemic.
Withholding involves deducting income and payroll taxes from your employees’ compensation before payment to employees. Employees may adjust income taxes withheld from compensation by providing their employers with an employee withholding certificate. The most common state tax withheld from compensation is income tax.
The various locations involved may complicate the withholding requirements. The state where an employee principally lives generally has primary taxation authority over the individual’s income. However, for state taxes, withholding from employment income is typically based on where employees actually work. Thus, if an employee lives in one state but principally works in another, the employee is generally subject to withholding rules of the principal work state. However, the employee can typically take a credit for taxes paid to the principal work state against the employee’s tax liability owed to the home state. Complications can arise when reciprocal agreements exist between the two states for withholding. The sudden shift in employees’ principal work states caused by the pandemic may require employers to process and implement new withholding certificates.
Income Tax Withholding for Remote Workers
Having remote workers who live out-of-state can create a complex payroll situation for both employers and employees. As discussed above, remote workers generally owe taxes to the state from which they work, regardless of their employer’s location. However, some jurisdictions use the “Convenience of the Employer” test, under which the compensation is sourced to the employer’s location where the employee “is based” unless the arrangement is for the employer’s necessity, not the employee’s convenience. These states include Connecticut, Delaware, Nebraska, New York and Pennsylvania.
If an employee had principally worked in a state other than their home state prior to the pandemic but is now working from their home state due to the pandemic, there is no change to withholding from employment income if the states have a reciprocal agreement. Such an agreement allows the home state to have tax authority regarding withholding. If an employee is working in a state other than their principal state of residence or their principal work state, and they reach that state’s threshold number of work days if such a threshold has been adopted for withholding, that state’s withholding requirements are generally activated.
Nexus Implications for Income Tax Withholding
Employers must understand the nexus implications of income tax withholding from employment income to avoid state penalties for insufficient deposits of withheld taxes. The legal threshold for withholding obligations may differ from the threshold for employer taxability. Employers must perform withholding for employees in states where the employee’s activities create nexus for the business, or where the business otherwise has nexus. Employers generally do not need to withhold for employees in a state in which the employee’s activities do not create nexus and the business doesn’t otherwise have nexus. Employers that voluntarily transmit amounts withheld from employment income to a state, such as by withholding on behalf of employees when not otherwise required to do so, may create inadvertently nexus for the employer.
Employees teleworking from a state where the employer otherwise does not have nexus may create nexus with that state. However, some jurisdictions (including District of Columbia, Georgia, Indiana, Iowa, Massachusetts, Mississippi, New Jersey, North Dakota, Pennsylvania, and South Carolina) have waived nexus for businesses with remote employees during the pandemic or active official stay-at-home orders. Under this guidance, employees working from those jurisdictions will not be deemed to create nexus for their employers in these states.
Entity Level Tax Liability Issues
As previously mentioned, remote employees could create nexus for entities in new states. Nexus is the minimum connection that a business must have with jurisdiction in order for that jurisdiction to require the business to pay tax. Businesses that responded to COVID-19 by moving employees out of physical business locations and into remote work situations may have inadvertently created tax consequences for themselves. Measures taken by businesses to keep their workforce safe and adhere to government closure orders may have created nexus in these new states, which can bring additional state tax filing and payment obligations. Corporate tax departments should consider these “new” filing states when determining where their companies now have nexus and where they should be filing.
States’ Nexus Policies Require Careful Attention
Some states have issued guidance indicating that a temporary presence of teleworking employees due to the pandemic will not create nexus. Other states have announced that they will not change nexus standards regarding teleworking, or they may have not addressed it. In the absence of affirmative guidance indicating an exception to a state’s nexus position due to teleworking, businesses should assume that pre-pandemic nexus standards are unchanged. In states that have provided nexus exceptions, keep in mind that these exceptions were in response to the pandemic and were presumably intended to be temporary in nature. Businesses should be aware that if teleworking becomes the new normal, these temporary nexus waivers should not be relied upon to provide long-term protection.
Local Jurisdictions and Gross Receipts Taxes Complicate Nexus
As a further complicating matter, nexus rules for local taxing jurisdictions may differ from state thresholds. Some examples include Colorado home-rule jurisdictions and Louisiana parishes. In addition, employees working in certain localities could create sales tax collection responsibilities for their employers since those employees will generally be deemed to create nexus for the employer. Remote employees could also trigger liability for other non-income taxes such as gross receipts taxes.
Remote Work May Impact Apportionment of Corporate Income
In addition to triggering nexus in new states, telework arrangements made affect how employers calculate state income tax liability. When a company does business in more than one state, apportionment is the process for determining how much of the company’s income a state can subject to tax. Stated another way, apportionment is the mechanism by which a multistate company divides up its taxable income across the states in which it is doing business. A state is generally prohibited by the US Constitution from taxing 100% of a business’ income if that business is being done across many states. Every state income tax scheme has an apportionment methodology, and some have several different ways of apportioning income depending on the type of business. To further complicate matters, these formulas can and do vary from state to state.
While there is variation, these formulas typically look to three different factors:
- Where a company’s revenues are generated (i.e, to whom are you selling), typically referred to as the receipts factor.
- Where the Company’s real and tangible property is located (property factor).
- Where the Company’s workforce is located (payroll factor).
Many states look only to the receipts in determining apportionment. This approach requires the taxpayer to apportion its income based on where its receipts come from. Other states employ a three-factor apportionment formula that incorporates all three elements. A corporation doing business in a state that uses payroll as an element of its apportionment formula must consider the location of its workforce in determining how much of its income that state can tax. The shift in worker locations triggered by the pandemic can change the location of payroll and impact the apportionment calculation.
For instance, the movement of a company’s employees can impact where the payroll is located or where the receipts are deemed to be generated. Likewise, movement by a company’s customers of its employees into other states can change where the company’s receipts are generated and impact the company’s apportionment calculation. These are just a few examples of new COVID-induced considerations for a company whose workforce and receipts may have been stable in a pre-COVID environment. Companies must stay abreast of how states require apportionment to be calculated and keep in mind how changes in the location of their workforce and customers can change how they apportion income across all the states in which they operate.
If you have specific questions on the tax implications for your business, please contact our State and Local Tax team to evaluate your situation via our contact us form.