Updated: May 7, 2021
As the COVID-19 global health event continues, employees across the country are still working at home and will likely keep doing so for the foreseeable future. If you have employees who live in a different state from where your business is located, this can create additional tax and payroll challenges.
Here's what you should know about managing payroll taxes for employees working out of state, with insights from ADP's recent webinar, Strategies for Surviving Year-End Reporting.
State income tax withholding
When it comes to tax withholding, payroll primarily follows the rules of the state where the work is performed. If employees who live out of state come to your business for work, payroll would follow the withholding rules for the state where your business is located. These employees may owe income tax to their state of residence. Employers often withhold partial amounts for the residence state in addition to the worked-in state, or in some cases the employees handle that themselves when they file their personal income tax returns.
There is an exception when two states have a reciprocity agreement wherein the governments agree that residents only owe income tax to the states where they live, not where they work. If this applies to your workers, you should already be withholding taxes for the state where your employees live. Without a reciprocity agreement, taxes may need to be withheld in both the state in which work is performed as well as the residence state. Check with your state Tax or Revenue Department for details.
Income tax rules for working out of state
If your employees work from home in a different state for number of days that exceeds the established threshold for that state, the employer must generally recognize the change and begin to submit taxes to the state where the employee is working, not where the business is located. This threshold varies by state — for instance, in New York it's 14 days, but in Illinois it's 30. Other states have an income threshold, or a combination of time and income.
Another factor some state governments consider is whether the employee is working from home for their convenience or as a necessity for their job. If it's for the employee's convenience, then tax withholding should be sourced for the state where the business is located. If working from home is a job necessity, then payroll is sourced through the employee's state of residence. But state laws and rules vary considerably on the specifics.
Before COVID-19, employers could avoid managing payroll taxes for employees working out of state by having everyone work on site. Now, safety precautions and stay-at-home orders may have forced your organization to account for a multi-state workforce, especially since the pandemic has pushed many employees beyond the temporary thresholds for working from home.
If your business suddenly has employees performing significant out-of-state work due to COVID-19, you may need to register your business with these states to withhold taxes for these employees.
What complicates this matter is that state governments have taken different approaches to the crisis. Some have offered temporary guidance. Alabama and Georgia announced that they would not enforce their payroll withholding requirements for employees who are temporarily working from home in their states due to government-mandated stay-at-home orders.
As another example, Pennsylvania announced that if an employee is working from home temporarily due to COVID-19, the state will not consider that as a change to the sourcing of the employee's compensation. For non-residents who were working in Pennsylvania before the pandemic, their compensation would remain Pennsylvania sourced income for all tax purposes. For Pennsylvania residents who were working out-of-state before the pandemic, their compensation would remain sourced to the other state and they would still be able to claim a resident credit for tax paid to the other state on the compensation.
However, these rules may not apply depending on whether the states involved have a reciprocal tax agreement. Pennsylvania has reciprocal tax agreements with Indiana, Maryland, New Jersey, Ohio, Virginia and West Virginia.
In addition, some states like Connecticut have ruled that employees working from home due to COVID-19 is a necessity for work, while others, like New York, have ruled that it is for the employee's convenience. These conflicting rulings mean your business could be in a situation where you need to collect withholding on behalf of two states for an employee working from home.
Another related problem deals with tax "nexus", which is the concept that where a business has an established presence in a state, it may be required to pay sales, income and other business taxes for that state. In some states, having employees working in the state is enough to establish nexus, which could lead to further tax compliance requirements for your business.
Again, some states have issued guidance to address the effect of COVID-19 and people temporarily working from home. Pennsylvania, for example, will not seek to impose Corporate Income Tax or Sales Tax nexus solely on the basis of this temporary activity. However, this guidance is only in effect until the June 30, 2021, or 90 days after the emergency in Pennsylvania is lifted. In some cases, employers may need to assess whether remote workers are likely to return. If remote work locations are likely to persist, employers may need to consult with Legal and Tax advisors and register with any states in which a legal presence has been or will be established.
Even with extra guidance, employers must navigate a wide range of possible laws and payroll requirements, especially if they have employees living in several states. To improve the situation, the federal government is considering legislation that would establish a uniform rule for employees working from home due to COVID-19.
The Mobile Workforce State Income Tax Simplification Act would standardize rules for tax withholding for cross-border employees. For instance, the act would set up a uniform threshold of 30 days of at-home work before withholding laws would apply. The HEROES Act and HEALS Act proposals both contain provisions for this issue as well, but Congress is still debating these bills.
Unless state laws are changed and/or the federal government standardizes the rules, employers need to understand and comply with their regional requirements around managing payroll taxes for employees working out of state. Organizations will also need to understand the possible nexus impact on their business. To accomplish these objectives, consider speaking with a legal and payroll expert who is on top of the latest state laws. They can help you update your payroll system to manage the new requirements as your employees continue working from home.