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State Income Taxes in a Remote World

Services: Tax

By: Donna Holm

With the recent passing of the American Rescue Plan, states have received some much-needed help from the Federal government to aid in jump-starting small business and enabling expansion initiatives. Many business owners have also realized that while some state funds have been made available to retain employees and stay afloat, they are forced to understand a complex set of rules within already confusing state laws, especially regarding state conformity to Federal legislation and the existence of a remote workforce.

Since each state operates under its own set of rules, businesses are forced to assess their state tax compliance in a more comprehensive manner than ever before. For example, the Federal change to allow deductions for expenses paid with PPP money helped many businesses, until the owners realized that their state may not have conformed to this change, and a large state tax bill followed.

The first step in understanding the state tax environment is to understand nexus. The concept of nexus has always plagued business owners, particularly in the sales tax arena. Nexus is the minimum level of activity or connection to be subject to tax, whether sales tax, income tax, or both, in the context of physical presence in a state or an economic presence in a state.  States are assessing their ability to meet their budgets, and as a result new guidance continues to be issued, often broadening their tax base. Business owners need to watch carefully to be able to pivot and implement changes quickly should the need arise.

One area that is unprecedented is the evaluation regarding a remote workforce. Some business owners have taken advantage of the move to remote to reduce office space overhead, or have even permanently closed some locations. Employees may be working at home, they may have relocated closer to other family, or have just taken advantage of the ability to work anywhere as long as a good internet connection is available. Employers need to contemplate state tax exposure as this temporary phenomenon may have morphed into a permanent way of life for some businesses.

A new remote workforce presents challenges. The general rule is that employers should be withholding state income taxes in the state where the employee performs the work. This is an easy determination when workers are present in the employer’s offices. With a remote workforce, assuming business as usual may be a mistake. States are enacting legislation that directly affect employees working remotely in another state where the employer does not have a physical location. Some states have provided temporary relief for pandemic-related cross-border employees. For those states that have not addressed this issue, or where guidance is lacking, companies need to evaluate where their workers are, and perform a self-audit as to the issues created by their remote workforce. The presence of employees in some states will trigger nexus. For example, if an employee travels to Michigan to work in a cabin even one day this summer, the employee would be subject to  Michigan state income tax. In addition to nexus issues, payroll withholding issues may emerge. Employees may seek guidance as to the filing of nonresident/part-year resident tax returns in light of being under-withheld. Employees should also be proactive in advising employers as to where their work is being performed so that employers may match their withholding tax accordingly. Also important to note is that many local governments also impose an income tax on employees that may require withholding tax revisions.

Noncompliance is widespread and most companies are not even aware of the challenges. Employers should survey their workforces to make a determination as to their risk of exposure. Consult with a tax advisor familiar with these type of issues to create a plan for compliance and avoid penalties down the road.