Although the COVID-19 pandemic opened up the possibility of working from almost anywhere for many, remote work has been accompanied by new worries for businesses and employees surrounding tax compliance.
The crux of the issue is that each U.S. state has its own rules regarding how income for remote workers and the businesses that employ them are taxed.
Companies that have employees residing and working in a state different from where the business is physically located are sometimes faced with unexpected state and local taxes. Meanwhile, remote workers who moved to low-tax states could find themselves being taxed on the same income twice.
Double taxation for some employees
In general, income is taxed by the state where the employee works or is physically located when earning their income. But in the remote setup, these state income tax rules have become notoriously tricky owing to a lack of uniformity in how that rule of thumb is applied.
Broadly speaking, at the time of publication, state income taxes for remote employees fall into 1 of 3 categories:
- States with the convenience rule
In a bid to balance budgets deeply impacted by the Covid-19 pandemic, some states are not ready to let go of tax on income once earned within their borders. They have resorted to taxing out-of-state employees based on the unchanged location of the business.
These states tax remote employees on the basis of the location of their employer’s office — even if the resident has temporarily moved out of state for their convenience and physically doesn’t work in the state.
In many cases, the convenience rule also strips employees of their eligibility for tax credits in their home state. That means subjecting employees to double taxation as two states try to tax the same income.
States that have enacted the so-called “convenience rule:
Connecticut, Delaware, Massachusetts, Nebraska, New York, Pennsylvania.
- States with reciprocal agreements
Some states in the mid-Atlantic and Midwest have implemented tax agreements with neighboring states to minimize duplicate taxes.
For example: Virginia and the District of Columbia have reciprocal tax deals. Employees who live in Virginia but work in Washington, D.C., file taxes in the state where they reside without worrying about paying taxes or filing in Washington, D.C.
Reciprocal agreements apply in:
District of Columbia, Arizona, Illinois, Indiana, Iowa, Kentucky, Maryland, Michigan, Minnesota, Montana, New Jersey, North Dakota, Ohio, Pennsylvania, Virginia, West Virginia, Wisconsin.
- States waiving income tax on temporary residents
Some 15 U.S. states, such as Alabama and Georgia, for the time being have decided not to tax employees who moved in temporarily during the COVID-19 crisis.
State income taxes for employers with remote work setups
Employers may also face any of these six unanticipated state taxes stemming from remote work.
Withholding wrinkles:
Many states, but not all, have issued guidance regarding income tax withholding requirements for businesses. But the approaches from states that have provided guidance are not necessarily clear. If requirements overlap, this may trigger income tax withholding from multiple states for a single employee, increasing the employer’s withholding obligations.
Employee-tracking systems:
Companies now must develop systems to track where their employees are, in addition to grapple with new state tax rules. Although many companies already had established practices for travelling employees, devising and implementing a process for tracking an entire workforce is a new challenge.
Additional corporate taxes:
Employers may face additional taxes due to the nexus created by out-of-state employees. While working outside the state or states where the employer operates, the employee ends up creating a physical nexus, obligating the employer to comply with the tax regimes of corresponding states. For example, businesses could be subject to additional state income taxes, franchise taxes, gross receipts taxes and sales and use taxes.
Labor and employment laws:
Out-of-state employers may have to comply with labor and employment laws in the state where a remote employee works. This potentially affects workers’ compensation insurance, wages and hours, and unemployment insurance.
Compliance burdens:
As employers tried to trim real estate costs amid remote work, new tax requirements stemming from newly out-of-state workers may also have increased their tax compliance costs. With companies likely to face taxes from other states, as well due to the nexus created by remote employees, tax preparation and filing have become more complicated with changes to business income taxes, sales and use taxes and payroll withholding taxes.
Business registrations:
The presence of new remote workers may require employers to obtain a certificate of authority to legally conduct business in states where they previously had no operations or employees working.
