Nexus, the required level of connection between a business and a state or locality before taxes may be imposed, is an important but complex consideration for payroll taxes and wage and hour laws, a payroll educator and a payroll association official said June 3.
Generally, nexus is established by having a business presence in a state, such as an office, store, factory, or even by an employee entering into a state, Jim Medlock, CPP, a payroll compliance educator with Medlock and Associates, said at the American Payroll Association’s virtual Congress.
For state income tax withholding, nexus determines whether an employer is required to withhold tax for a given state, said Laura Lough, director of publications for the American Payroll Association.
The general rule for state withholding is that tax should be withheld where the employee works, Lough said. If an employee lives in one state and works in another, the employer is responsible for withholding tax for both states if it has nexus in both states, but the work state takes priority, with many states allowing employees credits for taxes withheld in other states, she said.
Employers should familiarize themselves with each state’s definition of residency, Medlock said. State definitions primarily use either domicile or a threshold of a number of days spend in the state, he said. Indicators of domicile states may use to determine residency include property ownership, bank accounts, driver’s licenses, or voting registration, Medlock said.
“The two states that we see most frequently that there are issues with” are California and New York’s definitions, Medlock said.
Reciprocal Agreements, Other Exceptions
An exception to the general rule of withholding tax for the work state is reciprocal agreements, which allow tax to only be withheld for the state of residence instead of the work state, Lough said. A total of 17 jurisdictions, including the District of Columbia, have at least one reciprocity agreement, she said.
Generally, the employee must submit a certificate of nonresidence in the work state to benefit from reciprocal agreements, and the employer must only report wages to the state of residence using Boxes 16 and 17 of Form W-2, Wage and Tax Statement, Lough said.
If an employee lives in one state and works in another where a reciprocal agreement does not apply, the employer must ensure that the employee’s state of residence is correctly determined, Medlock said. Most states require withholding from nonresidents from work performed in that state, he said.
When employees work in multiple states that do not have reciprocity with the employee’s state of residence, the wages must be allocated to each state and tax withheld from the wages earned in each state, and possibly the state of residence as well, Medlock said. There are exceptions to this for workers in the transportation sector, such as railroad workers and truck drivers, he said.
Some states also have laws exempting disaster-relief workers from taxes if they are only in the state to perform disaster-related work during an official disaster period, Medlock said.
The federal Military Spouses Residency Relief Act allows spouses of military servicemembers to travel with the servicemember to the state where the servicemember is stationed, keep their residence in their home state, and claim exemption from income tax in the state where they work, generally by filing a form, Medlock said. The law was amended at the end of 2018 by the Veterans Benefits and Transitions Act (Pub. L. 115-407), which allows the spouse to assume the servicemember’s state of residence for tax purposes upon marriage.
Payroll departments also may withhold taxes where they do not have nexus as a courtesy, but registering to withhold may trigger inquiries about non-payroll taxes from jurisdictions, Lough said.
An employer may have nexus with a state containing a locality but not the locality itself, and in this case is still subject to state tax laws, Lough said. States with local taxes generally have laws authorizing localities to impose the taxes.
The state tax exceptions for military spouses and disaster-relief workers also apply to local taxes, Lough said.
Employers should consider if employees live and work in different localities and determine if reciprocal agreements apply, Lough said.
Unemployment Tax, Wage and Hour
The nexus rules for income taxes “do not apply for state unemployment taxes,” Medlock said.
When an employee works in multiple states, the state to which the employee’s wages are reported for unemployment insurance is determined using the state where an employee’s work is localized, meaning that work performed in other states is incidental; using the employee’s base of operations; or using the location of the employee’s direction and control, Medlock said. In very rare cases where none of those factors apply, the employee’s state of residence may be used, he said.
There also are many reciprocal agreements for unemployment insurance coverage, which allow employers to choose which state’s law covers an employee working in multiple states, Medlock said.
With regard to wage and hour laws, there is no minimum time that an employee must work in a state before its laws apply, and the more favorable to the employee of state law or the Fair Labor Standards Act must be applied, Lough said.