Payroll Brass Tax: Payroll Tax Compliance for Multistate Employees

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Mike Mahoney: Welcome to the second installment of Payroll Brass Tax. I’m your host, Mike Mahoney, a shareholder out of Ogletree’s Morristown, New Jersey, and New York City offices, and joining me today is Stephen Kenney, an associate out of our Dallas, Texas, office.
Today we’ve got a special topic that’s probably near and dear to many of our clients’ hearts, as we’re going to be talking about multi-jurisdictional tax issues for either hybrid or remote working employees. With that, let’s get this kicked off. Stephen, when thinking about multistate work arrangements, what payroll tax issues do employers need to keep in mind?

Stephen Kenney: So really here, employers have to manage the varying state and local income tax withholding rules, so they have to determine the where and the when. So, where do unemployment insurance contributions need to be made? Where do income tax withholding remittances need to be made and when do they need to be made based on travel schedules or based on the assignments of individual employees?
Employers also have to navigate state-specific benefit programs, and these complexities increase when employees live and work in different states or they travel to multiple states due to their duties and responsibilities, and it requires employers to carefully track the employees’ whereabouts and able to be in compliance with each jurisdiction’s requirements.

Mike Mahoney: With respect to the income tax piece of that, when does an employer have an income tax withholding obligation for a non-resident working within a state?

Stephen Kenney: So, here we have the classic lawyer answer of, well, it depends. So, generally, the location where services are performed is the driving factor in determining whether an employer has an income tax withholding obligation, but of course, there are exceptions. There are certain exceptions for bilateral reciprocal agreements between states, though those are dependent upon the work state and the resident state.
Other states implement a convenience-of-the-employer rule to determine non-resident income tax withholding, and really, each state is permitted to set its own threshold as to when an employer has a non-resident withholding obligation, which creates even more complexity. Much of the complexity that employers face is complying with non-resident withholding rules, but there’s a lack of uniform thresholds throughout the country. The majority of states have no thresholds. That is, residents that work within a state are subject to withholding in the same way that they are in a resident state. So, that would be day one within the state, first dollar earned within the state is subject to non-resident income tax withholding.
Other states do have days or dollar thresholds that a non-resident must exceed in order to trigger an employer withholding obligation, and then certain states do not have an income tax, so there is no employer withholding obligation regardless of the length of time the non-resident is spending within that state or the amount of wages earned in the jurisdiction, but yet there still may be a withholding obligation for the resident state while that non-resident is working in a state that doesn’t have income tax withholding. In essence, it becomes a state-by-state analysis to apply the non-resident income tax withholding rules to wages earned by non-residents while they’re working in the non-resident state, but then also taking into account the withholding requirements of the resident state.

Mike Mahoney: You touched on a couple different topics there, and I’m going to come back to some of them, but I think my first question is if an employee works a hybrid schedule, one where they’re working within one jurisdiction at an office location and some other period of time from a different jurisdiction from their home, what are the employer’s income tax withholding obligations in that hybrid scenario?

Stephen Kenney: So, when an employee splits time between two jurisdictions, so for example, they might have an office in one state and their home might be in another, so they’re spending some of the time working from the office, some of their time they’re working from their home remotely, the employer is required to withhold income tax for each one of those states based on the wages earned in each location.
So, you have to allocate wages between those two states unless there is some other arrangement between those two states. The employer has to accurately track workdays and has to accurately track the locations to ensure proper withholding and reporting. But in certain locations in the country, you have states that understand that employees regularly cross state lines, and in those situations, you often end up with those states that are bordering each other entering into a reciprocal income tax agreement with each other.

Mike Mahoney: Talking about that for a second, reciprocal income tax agreements, can you shed some light on what those are and how they impact an employer’s income tax withholding obligation?

Stephen Kenney: Yeah, so reciprocal agreements between states allow employees to pay income tax only to their state of residence, even if they’re working in a neighboring state. Employers in states with such agreements only have to withhold taxes for the employee’s home state, which simplifies compliance and avoids double taxation.
These agreements are not universal, though, and must be verified by each state payer. For instance, a classic example is Pennsylvania and New Jersey. They both had to enter into the agreement independently. Pennsylvania couldn’t obligate New Jersey to enter the reciprocal agreement, New Jersey couldn’t obligate Pennsylvania, but they had to enter into it independently, and now they have a reciprocal arrangement that allows the residents of each respective state to only be taxed by their resident state.

Mike Mahoney: Thanks, Stephen. I want to circle back to one other of the exceptions to the general state income tax withholding rule. You mentioned this phrase convenience of the employer. Can you provide some insight on how that impacts an employer’s obligation to withhold income tax?

Stephen Kenney: So, under the convenience of the employer rule, also known as simply a convenience rule, when income is paid to non-residents for work performed outside of a certain state, it is subject to tax in the employer’s location if the employee is working remotely for his or her convenience. So, this rule applies in certain states and requires employers to withhold income tax for the state where the employer is located if the employee works remotely for their own convenience and not out of the necessity of the employer. So, to simplify it, essentially it treats the employee’s remote work location as if it were an extension of the employer’s office, regardless of whether the employer requires or benefits from the employee working remotely.
So, states such as New York, Pennsylvania, Delaware, and Nebraska enforce this rule and it can potentially result in double taxation for remote employees if not handled properly, because you could have a remote employee that’s subject to the resident income tax withholding requirement, but they’re also still subject to that non-resident income tax withholding requirement in New York, for example, because their home office that they’re attached to is in New York and they are working for their own convenience from a remote location, which, in New York’s opinion, is that employee is benefiting from that relationship, the employer is not necessarily benefiting from that arrangement, and so the convenience of the employer rule is in play subjecting that employee’s wages to New York income taxes.
I mentioned New York, because New York’s convenience of the employer rule is the most robust. The New York State Department of Taxation and Finance has released a number of primary, secondary and other factors that it uses to determine if an employee’s home office is considered a bona fide employer office, and that determination dictates whether the out-of-state remote work arrangement is for the employer’s convenience or the employee’s convenience. If it is determined that it is for the employer’s convenience, then the wages paid to the remote employee are not subject to New York State income tax.

Mike Mahoney: I can speak from experience that New York does enforce that rule pretty strictly on its employment tax audits, but I want to pivot a little bit. We’ve been talking about the income tax obligations an employer has, but how do multi-jurisdictional employees impact an employer’s contribution requirements for state benefit programs like unemployment insurance or state disability insurance?

Stephen Kenney: So, a multi-jurisdictional employee can complicate unemployment insurance contributions and other social taxes, because generally employers pay state unemployment tax to the state where the employee principally works, but specific rules apply when work is performed in multiple states, and that requires careful analysis of each situation.

Mike Mahoney: If an employee works in multiple jurisdictions, how does an employer determine the single jurisdiction where state benefit contributions should be made?

Stephen Kenney: Yeah, so unemployment insurance is a jointly run federal and state program, so there is a uniform four-factor test that applies to all the states that determines which state’s unemployment insurance law covers the multistate employees. The four factors used in this test are: number one, localization of service; number two, base of operations; number three, place of direction or control; and number four, residence of the employee. The factors are applied in a cascading manner, so if the first factor is determinative, then there is no need to consider the additional factors. If the second factor is determinative, then there is no need to consider the third and fourth factors, and so on and so forth.
So first, let me get into localization of services a little bit. So, service is considered localized and covered in a particular state if it is performed entirely within that state, where it is performed both within and without the state, but the service performed outside the state is incidental to the individual service performed within the state. Service can be considered incidental, for example, if it is temporary or transitory in nature or consists of isolated transactions.
The second is base of operations. So, if an employee service is not localized in any state, and I will say that typically localization is determinative, but if it’s not, then we go into base of operations. How we look at base of operations is does the individual perform some service in the state in which the base of operations is located. The individual’s base of operations should not be confused with the place from which the services are directed or controlled, that’s factor number three, but instead the base of operations is the place or fixed center from which the employee starts work and to which the employee customarily returns in order to receive instructions from the employer or communications from customers, or to perform any other functions necessary to exercise the employee’s trade or profession.
The base of operations may be the employee’s business office, which may be located at the employee’s residence or the contract of employment may specify a particular place at which the employee is to receive directions and instructions. This test may be most applicable to people in the sales professions.
The third factor that we consider is place of direction and control. So, we consider this factor if an employee does not have a base of operations, and localization is also not determinative. The place from which the individual service is directed or controlled is the place at which the basic authority exists and from general control emanates. So, it’s not necessarily are they returning back to this place, but do they perform some services in the state from where general control emanates. Perhaps their manager is located in that state, and that manager is providing direction and control or general oversight to the employee’s services.
Then, finally, factor number four is the employee’s residence. So, if coverage cannot be determined based upon the previous factors, then it’s necessary to apply the test of residence. Residence is a factor in determining coverage only when the employee’s service is not localized in any state, and the employee performs no service in the state in which the base of operations or place of direction and control are located. It’s typically easy to figure out what the employee’s residence is; they provided it to the employer at the time of hire. It’s just that we can’t rush to factor number four; we have to consider the first three factors before considering the employee’s residence.

Mike Mahoney: Thanks, Stephen. One other issue that some clients encounter relates to employees working from jurisdictions where that business does not have current operations. Sometimes I jokingly say employees may have done this either by asking for permission first or asking for forgiveness later. In those situations, can you discuss an employer’s registration obligations in order to be compliant with employment tax requirements?

Stephen Kenney: Yeah, I think you’re right there, Mike. Asking for forgiveness is typically how I hear this come up as well. So, if you have an employee that works from a state where the employer has no prior operations, the employee’s presence in that state has now created nexus, the minimum contacts between the employer and the state taxing authorities for income tax withholding purposes, and also the State Department of Labor equivalent for unemployment insurance purposes. So, that means the employer is going to need to register with the state’s tax authority and also their labor agency, and that registration includes obtaining tax IDs and also complying with the local employment laws to fulfill the payroll tax obligations.
There’s also a requirement to register with the Secretary of State in order to be authorized to do business in the state, because having a remote worker within the state generally does not fall under an exception to doing business within the state for Secretary of State registration purposes. So, since the employee’s physical location typically drives these registration requirements, it’s crucial that employers are aware of their remote employees’ work locations and track them accordingly.

Mike Mahoney: Thanks, Stephen. And with that, I think we’re going to conclude this installment of Payroll Brass Tax. We look forward to joining you next month on another hot topic of issues that we frequently advise clients on. Until then, stay well.

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