What are the tax ramifications of having employees in multiple states?

October 6, 2022

Ephraim Fishman, CPA

By Ephraim Fishman, CPA


Remote and hybrid work options have become more accepted and many employees are insisting on this option. Remote work has many benefits for companies, including access to a wider pool of employee talent, reduced employee turnover, and cost savings. Many workers who were forced to work from home for the first time due to the pandemic, found this setup to be advantageous and want to continue working remotely. Now that this has become the new normal, businesses need to understand the tax ramifications of having employees based in multiple states and to prepare for the risks associated with having employees rendering services from various jurisdictions.


Payroll Taxes


If employees work from home in another state, where does a company withhold taxes? As a rule, employees pay taxes to the state in which the work is performed, which is known as the physical presence rule. For example, if a company’s head office is in State A but remote employee works at home in State B, under the physical presence rule, a company is required to withhold state taxes in State B, even if they don’t have a physical office there. Adding multiple remote locations expands the number of states where the business must collect and remit payroll taxes. Companies need to track their employee locations to properly manage their payroll tax responsibilities However, some states that border each other have entered into reciprocal agreements that allows an employee who lives in one state but works in a neighboring state, to have their withholding tax paid to the work state. In certain states the law is different and remote employees may encounter double taxation — being subject to income tax in both the state they reside and the state in which their employer operates.


Other Tax Compliance Issues


If a company has employees working in a state other than the state in which the corporation was formed, the company has employees in a “foreign” state. Depending on the type of business, what the remote employee is doing, how many remote workers are in a state, and how long they will be doing that work in the foreign state, a company may need to qualify in that state. Foreign qualification is the process of applying for authority to do business in a state other than the one in which the corporation or limited liability company was formed. Once qualified, the company may have other compliance obligations such as having to designate and maintain a registered agent, the requirement to file returns in that state because of nexus, or to file an annual report. The term tax nexus is used to describe a situation when a business has a tax presence or is doing business in a state other than its primary physical location. Physical presence is generally a strong enough connection with a state to establish an income tax compliance obligation. An in-state remote employee gives rise to state income tax nexus and the possibility of tax exposure. Depending on a state’s apportionment formula, remote employees may create a sizable income tax debt in states where a business did not previously operate. Depending on what your remote out-of-state employees are doing, your business may become subject to that state’s income tax laws.


Employee Classification


To reduce payroll taxes and other labor costs, it’s common for employers to want to classify remote workers as independent contractors. However, it’s wrong to assume that a remote worker is an independent contractor simply because they work out of state or have some autonomy because they work from home. To determine whether a remote worker is an employee or independent contractor, that worker’s daily activities are just one of the many factors to consider. It is important to understand the employee/employer relationship and whether the services the worker provides are integral to the employer’s business and the amount of judgment and initiative the worker exhibits. Evaluating whether a worker is an independent contractor is a complicated and nuanced process. Different states use different tests in determining who is an independent contractor and who is an employee.


Workers’ Compensation and Unemployment Insurance


Most states require that businesses provide workers’ compensation coverage for employees, but state laws differ on what constitutes a work-related injury. This becomes further complicated when an employee is working remotely from home in a different state from where the employer is located. In addition, companies are generally required to pay premiums for state unemployment insurance. So, if your workplace is situated in State A but employees work from home in State B, the company might be required to register with the state unemployment office of State B.


Hybrid Employees


Things get more complex if an employee only works a few days at home (out-of-state) and the remainder at the office. All the above discussed issues including withholding tax, worker’s compensation and unemployment insurance become more complicated when a hybrid employee works both in the office and at home.


Credits and Incentives


In many situations, state and local tax credits and incentives are predicated on maintaining a minimum number of in-state employees or by increasing the hiring of local individuals. Should employment levels shift with workers moving to other locations so they can work from home, businesses may find themselves losing their incentive qualifications. It is important for companies receiving state and local tax credits and incentives to continue to monitor employee work locations.


As evidenced above, there are many issues that arise when having remote or hybrid employees. Please consult with your LMC professional should any questions arise.


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