Managing Out-of-State Employee Taxes: The Payroll Tax Conundrum

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The rise of remote work means employees could be anywhere, including out of state. Each state has different tax rules regarding payroll withholding for out-of-state employees. Here's what to know about managing out-of-state employees, and how the use of payroll software and consultants may help.

Even as the global health crisis becomes less of a concern and more employees return to the office, remote work remains popular and in-demand. In fact, 45% of employees say they plan to work remotely part- or full-time, and 90% of these remote workers want to continue this arrangement in some way going forward, according to a recent Gallup survey.

If some of your employees work remotely, they could be working from anywhere, including out of state, which can create new out-of-state employee taxes and payroll challenges that your system must figure out. Here's what you should know about managing payroll taxes in this new 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, it's possible that the employee could also owe income tax to their state of residence. In this case, employers may withhold partial amounts for both the residence state and the worked-in state. In other cases, employees may figure this out themselves through their personal tax returns.

Some neighboring states have reciprocity agreements for taxes. In these situations, the governments agree that workers only owe taxes for the state where they live, not where they work. This simplifies payroll, as you only need to withhold for one state. For example, Pennsylvania has reciprocal tax agreements with Indiana, Maryland, New Jersey, Ohio, Virginia and West Virginia.

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.

Income tax rules for working out of state

Figuring out tax withholding for out-of-state employees is more important than ever, given the increase in remote work. Since your employees could live and work from anywhere, you may need to figure out the payroll rules for any state in the country, not just those within commuting distance.

Another issue for payroll is the increase in hybrid work models, where employees work some days at home, some days at the office and some days while travelling, including for their personal enjoyment in a new area. 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. Other states base this on an income earned threshold or use a combination of time and income.

Ask remote employees to track where exactly they are doing their work. If they're taking extended trips to other parts of the country, they could cross these thresholds without knowing. Your payroll would need to adjust, or it would run into compliance issues. 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%.

State governments also consider whether an employee is working from home for their convenience or if it's a necessity for their job, as when no office is provided. If it's for the employee's convenience, generally tax withholding should be for the state where the business is located. If it's a necessity, then tax withholding should be for the employee's state of residence. However, the laws and specifics for this practice vary from state to state.

In the past, employers could try to avoid out-of-state employee taxes by mandating that everyone work in person at the office. However, since the start of the global health crisis, employees have gotten used to remote work, and many are unwilling to return to the office full-time. Sixty-four percent of employees said they would consider changing jobs if they were forced to return to the office full-time, according to an April 2022 ADP survey. The extra payroll work could be a worthwhile trade-off to prevent turnover.

Learn more in our on-demand webcast:

Multistate compliance considerations for a remote/hybrid workforce

Evolving laws for remote workers

When the global health crisis began, forcing many employees to work from home for pandemic safety, state governments passed a number of temporary measures to simplify the burden for out-of-state employee taxes. For example, Alabama and Georgia said they would not enforce tax withholding for employees temporarily working from home due to government mandated stay-at-home orders.

However, these measures for the most part have since expired. Now employers with remote workers must continue to follow the existing payroll withholding rules for state governments. In the cases of Alabama and Georgia, once again remote employees working from home need to submit payroll taxes to these states.

State governments are trying to replace tax revenue lost from commuters who now work remotely elsewhere. For example, New York and Massachusetts have both been pushing to collect from local businesses with remote workers in neighboring states. This can create another situation where your payroll must collect on behalf of two states.

Others have passed laws to deal with the greater number of remote workers who cross state lines. On March 2, 2022, Utah passed a bill creating more specific rules for workers living temporarily in the state for work or vacation. They created a threshold of 20 days of living there before an employee needs to submit payroll taxes. The bill does have some exceptions, including cases where the employee came from a state with no income tax or a similar exclusion for Utah residents.

In tracking the various state laws, reciprocity agreements and changes in this new environment, payroll can become complicated quickly, especially as your workers spread to different areas. Specialized software can help you track each of these elements automatically so that your business can avoid getting into compliance trouble with out-of-state employee taxes.

Employer tax responsibilities

Having employees working remotely in other states can create new tax responsibilities for your business. First, to withhold state taxes on behalf of these employees, you may need to register your business with these states to do so. The more states your employees work from, the more registrations you'll need.

Another major concern relates to tax "nexus," which is the concept of a business having an established presence in a state. If you have nexus, your business may need to pay sales, income or other business taxes to the state. You may also need to register for state and local licenses and business permits as well. In some states, simply having one employee working there could be enough to trigger these rules. It doesn't matter if you don't have an office or any other physical presence in the area.

While states temporarily eased nexus requirements during the global health crisis, they are once again back in force. For this reason, you should carefully track where your employees plan to work and determine whether operating in those locales will trigger new tax responsibilities. If an employee wants to work remotely from a new state, consult your legal and tax team before approving to make sure it won't lead to unintended consequences.

New federal legislation

In this environment, employers may need to navigate a wide range of laws and payroll requirements for their employees in different states. This can become complicated quickly, as there are so many rules to track, and they keep changing.

To ease the burden, the federal government is considering new legislation called the Mobile Workforce State Income Tax Simplification Act. This act would standardize payroll rules across states. For example, it would set a uniform threshold of 30 days of at-home work before withholding laws would apply.

Congress debated this law in 2021 but did not pass it, despite bi-partisan support. If a law like this does pass, it could make life easier for employers tracking remote employees.

Payroll compliance

Until the federal government standardizes payroll rules, employees will be responsible for handling the various regional requirements around out-of-state payroll withholding. This includes watching out for the possible "nexus" impact on their business.

ADP created new technology to meet these challenges. ADP Mobile gives remote workers a self-service tool for time-tracking and accessing their payroll documents from anywhere, so they don't have to rely on an in-person HR department. Small business owners could also use Roll by ADP, a payroll app that automatically tracks and updates employee payroll in different situations.

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.

For more information on payroll taxes and other tax/legal issues, launch this on-demand webcast anytime: Strategies for Surviving Year-end Reporting.