Out-of-State Employees: Navigating Payroll Tax Pitfalls and Compliance Considerations
Navigating payroll for out-of-state employees in a hybrid work environment requires careful attention to state income tax withholding, worker classification and employer tax responsibilities. Understanding reciprocity agreements, nexus thresholds and state-specific rules is essential to avoid penalties and maintain compliance.
When this article was first published in 2020, remote work was the reality for many businesses. Today, fully remote operations have taken a backseat to hybrid models, meaning organizations must be more diligent than ever in collecting, reporting and withholding taxes for out-of-state employees.
According to a recent Gallup poll, 51% of remote-capable companies use a hybrid work model, while just 28% are fully remote and 21% are entirely on-site. 2024 ADP research confirms what many businesses already know: Hybrid workers tend to be more productive and engaged.
As companies shift their focus to hybrid work, however, potential payroll pitfalls emerge. Fully remote and hybrid out-of-state companies require a different approach to tax withholding and compliance. Failure to remit and report the taxes correctly can lead to regulatory headaches that impact business revenue and reputation.
Here's what you need to know about managing out-of-state work taxes in a hybrid first environment.
State income tax withholding
State income tax withholding follows a few different rules: First, payroll is primarily based on the rules of the state where the work is performed. If an employee lives out of state but comes to work in person, payroll withholding generally follows the rules of where your business is located.
However, employees may be required to pay income tax in both states. This is known as double taxation, and is not ideal for businesses or employees. On the employee side, it means additional money withheld from their paycheck. On the business side, it increases the risk of noncompliance if taxes from both states are not correctly calculated and applied.
Some neighboring states have tax reciprocity agreements. In these situations, the governments agree that workers only owe taxes for the state where they live, not where they work. For example, Illinois has reciprocal agreements with Iowa, Kentucky, Michigan and Wisconsin, while Montana has an agreement with North Dakota, and New Jersey has one with Pennsylvania.
If there is no reciprocity agreement, then your payroll may need to withhold taxes for both the employee's worked-in and residence state. Check with your state's tax or revenue department for specifics and to verify whether a reciprocity agreement exists.
Learn more: Understanding the labor law landscape: Implications and considerations
Income tax rules for out-of-state employee taxes
If workers are fully remote, they'll typically pay income tax where they live.
With hybrid models becoming more common, however, out-of-state employees may spend some days at home, some days in the office, and some working on the road. This is especially common in states with cities located near their borders, such as New York City and Newark, New Jersey.
States have different thresholds for the number of days an employee can work there before an employer must start submitting taxes to the state. For instance, in New York it's 14 days, but in Illinois it's 30 days. Other states base this on an income-earned threshold or use a combination of time and income.
For example, if you don't realize that you're supposed to file and submit payroll taxes for an employee living in New York, the state could charge a failure to file penalty of 5% per month on the unpaid taxes, up to an additional 25%.
Classification considerations for remote workers
Whether or not your business is responsible for paying out-of-state taxes also depends on worker classification. While full- and part-time employees, also called W-2 employees, have state and federal taxes withheld, 1099 contractors do not. Misclassification, however, can be expensive.
If you're not sure how to classify an employee, the IRS offers three common law rules:
Behavioral: If employers control what work is done and how it is performed, workers are likely W-2 employees.
Financial:
If the company reimburses expenses or provides tools and supplies, W-2 is usually the proper classification.
Type of relationship:
If workers have access to benefits such as a pension, insurance or paid time off, they likely should be classified as W-2 employees.
Employer tax responsibilities
Having employees working remotely in other states can create new tax responsibilities for your business. To withhold state taxes on behalf of these employees, you may need to register your business in those states. The more states your employees work from, the more registrations you may need.
Your business may also be subject to a state "nexus" for sales tax. A nexus is established when business operations in a state exceed a specific dollar amount or transaction threshold. Once this threshold is met, businesses must collect and remit state sales tax, even if they have only a small physical presence.
For example, Texas has a nexus threshold of $500,000 in sales with no transaction minimum, while Missouri's threshold is $100,000 in sales with no transaction minimum. In neighboring Arkansas, however, a nexus is established at $100,000 in sales or 200 transactions.
Changing landscape: Keeping pace with the rules around out-of-state work taxes
Until the federal government standardizes payroll rules, employees will be responsible for handling the various regional requirements around out-of-state payroll withholding.
For more support with these objectives, consider speaking with a legal and payroll expert who is familiar with the latest state laws. They can help keep your business compliant with critical requirements as you continue to manage the new environment of remote work.
To get more practical insights on labor laws and workplace compliance for HR and payroll professionals, launch this on-demand webcast, Understanding the labor law landscape: Implications and considerations.
