Telework Creates Tax Headaches When Employees Cross State Lines

To attract and maintain the best talent, telework has become an option in many industries. But expanding the number of states where employees are present will complicate the state and local tax compliance burden.

It’s essential to understand the tax implications of having telework employees across multiple jurisdictions, and complying from the outset is always less costly. This eliminates the need for expensive audit defense down the road and protects against harsh and aggressive state tax penalties.

Companies should be aware of nexus, payroll taxes, business income taxes, sales taxes, and all other tax-related complexities when considering how and where to offer telework as an employee benefit.

Nexus

Nexus simply means there is enough connection between a taxing jurisdiction and the business it seeks to tax to successfully impose its tax. State governments purport that a business of any significant size should be filing income tax returns in any state where customers are present, so having a certain volume of sales in the state should result in nexus.

If employees are physically present, few exceptions to nexus establishment have been made. One such exception relates to Public Law 86-272, which restricts a state from imposing an income tax if the only business activity of the nonresident within the state consists of the solicitation of orders for sales of tangible personal property.

If a telework employee is responsible for only solicitation for sales of tangible personal property, the state may be prohibited from imposing its income tax, even with the employee’s physical presence. Public Law 86-272 overrides any state position on nexus in this instance. The Multistate Tax Commission has provided guidance on how this protection should be applied.

Payroll Taxes

Payroll taxes apply to telework employees regardless whether the business is protected from other taxes. At a minimum, state unemployment tax and income tax withholding will be imposed. Each state has its own taxing structure, which can include additional payroll-related taxes such as state disability, employment training, and local income taxes.

To comply with state income tax withholding requirements, the employer will need the ability to track where employees are working. Income tax withholding generally follows the employee’s physical location. Withholding may be required in numerous states for traveling employees, which could result in multiple state income tax returns.

A few states, including New York, employ a convenience of the employer rule. For New York-based employers, the state requires income tax to be withheld from employee wages unless the employee is working for a bona fide office of the employer in another state. This applies regardless of what state the employee is working in and can result in double taxation depending on whether the employee can receive an offsetting credit in their resident state.

State unemployment tax must be paid to only one state, even though employees may perform services in more than one state. The Federal Unemployment Tax Act provides guidelines for reporting wages for employees who work in multiple states during a calendar year.

The Department of Labor developed tests all states must follow to determine the proper state for reporting. The following is applied in chronological order:

• If the employee performs services in only one state, or most services are performed in the state with only incidental services performed outside the state, the wages should be reported to the localized state.
• If the employee performs services in more than one state and isn’t localized to a single state, the state operating as the base of operations will apply as long as some services are performed in the state with the base of operations.
• If the employee performs services in more than one state, not localized to a single state, and there is no base of operations, the state where the employee is directed or controlled from will control. This also assumes some services are performed in the state where directed or controlled.
• If none of the above apply, the state of the employee’s residence will have jurisdiction.

Business Income Tax

States generally impose income tax on businesses that employ persons within their state but could provide other exemptions unique to their state—for example, if the employee is only performing back-office type functions that don’t contribute to establishing or maintaining a market within the state.

The state may define nexus as “doing business,” and further define “doing business” as actively engaging in any transaction for the purpose of financial or pecuniary gain or profit. If the employee is only conducting back-office tasks and no solicitation or income-producing activities are performed, the business arguably isn’t pursuing a “financial or pecuniary gain or profit” within the state.

However, having a filing requirement doesn’t always result in tax being due. Only an apportioned amount of income is subject to tax. To determine the apportioned income, an apportionment factor must be calculated.

Though the factor historically was based on property, payroll, and sales, states have shifted to a heavier-weighted sales factor or even to using a sales factor exclusively. As a result, if the business doesn’t have sales sourced to the state, it may not have any income tax due, even if many employees are located there.

Sales Tax Collection

A handful of states such as Hawaii and New Mexico also subject most services to sales tax. Economic nexus was firmly established through the US Supreme Court decision on Wayfair, and every state has clearly communicated certain thresholds for determining nexus (unlike the income tax area).

However, physical presence still creates nexus, even if sales volume is below the economic nexus threshold amounts. In other words, the thresholds aren’t safe harbors. An employee located within the state, or even periodic travel to a state, will create nexus.

Everything Else

The volume of state and local taxes enacted throughout the US causes additional complexity in navigating this area. Some states, including Ohio and Washington, impose gross receipts taxes, which generally have set nexus thresholds like the sales tax. These taxes can’t be collected from customers as a separate line item.

Net worth, business license, and minimum taxes may also apply in any given jurisdiction. All other applicable taxes should be identified, ideally before hiring a telework employee.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Catherine Shaw is state and local tax partner at Cherry Bekaert.

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