Navigating the Tax Complexities of Hiring Out-of-State Employees

Written by David Newman, JD LMC Tax & Legal Manager

As remote work continues to reshape the modern workforce, many businesses are hiring employees who live outside the state where the company is based. While this approach provides access to a broader talent pool and increased flexibility, it also introduces a variety of tax and compliance obligations that should be carefully considered.

State Registration Requirements

One of the first issues that arises when hiring an out-of-state employee is the need to register your business in that employee’s state. In many cases, this requires registering as a foreign entity with the Secretary of State, obtaining a state tax identification number, and enrolling with the appropriate agencies for payroll-related taxes such as state unemployment insurance. Failure to properly register can result in penalties and administrative challenges.

Payroll Tax Withholding Obligations

In addition to registration requirements, employers must address payroll tax withholding obligations. Generally, employers are required to withhold state income taxes based on the employee’s work location, which for remote workers is typically their state of residence. This means the employer must comply with that state’s withholding rules and may also need to account for local income taxes imposed by cities or municipalities. While some states have reciprocal agreements that simplify withholding requirements, these agreements are limited and must be reviewed on a case-by-case basis.

Income Tax Nexus

Hiring an employee in another state can also create income tax nexus for the business. Nexus refers to the level of connection that subjects a business to a state’s taxing authority, and even a single employee working remotely may be sufficient to establish that connection. As a result, the business may be required to file income or franchise tax returns in that state, apportion a portion of its income to the state, and pay tax on that apportioned income. This can increase both tax exposure and compliance responsibilities. It should be noted that that the taxes paid to the other state may be able to be used as a credit when filing in the employer’s home state.

Sales Tax Nexus Considerations

Similarly, the presence of an employee in another state may create sales tax nexus. When sales tax nexus is established, the business may be required to register for sales tax purposes, collect sales tax from customers in that state, and remit it to the appropriate taxing authority. Notably, the existence of a physical presence, such as an employee, can trigger nexus regardless of whether the business meets economic nexus thresholds based on sales volume or number of transactions.

Employment Law and Compliance Issues

Beyond tax considerations, employers must also comply with the employment laws of the state in which the employee resides. These laws can govern areas such as minimum wage, overtime, paid sick leave, family leave, and other workplace protections. In addition, employers are generally required to maintain workers’ compensation insurance that covers employees in the applicable state and to comply with state-specific new hire reporting requirements.

Other Considerations

There are also a number of additional considerations that businesses should keep in mind. These may include the need to obtain state or local business licenses, potential exposure to gross receipts or other state-specific taxes, and an increased likelihood of being subject to audits in multiple jurisdictions. As a business expands its geographic footprint, administrative complexity and compliance costs often increase.

Summary

In summary, while hiring out-of-state employees can offer significant business advantages, it also introduces a range of tax and regulatory obligations that require careful planning and ongoing attention. Each new state in which an employee is located can create new filing requirements and potential tax liabilities.

If your business is considering expanding its workforce across state lines, or if you already employ remote workers in multiple states, LMC Advisors can assist with evaluating nexus exposure, managing registrations, and supporting compliance with applicable tax and employment requirements.