Important Concepts in Multi-State Payroll Tax Withholding
Some basic terms may have specialized meanings in the payroll tax withholding context. These special meanings are referred to as terms of art, and compliance efforts require employers to grasp them.
What is meant by the term “multi-state payroll”?
Three scenarios present themselves when you hear the term “multi-state payroll.”
- Scenario 1: Refers to the state withholding obligations that various state tax rules place upon an employer who locations in more than one state.
- Scenario 2: Refers to payroll withholding obligations that become complicated when an employer hires employees who work in one state but reside in another. Such employees routinely cross state borders to travel to their jobs, raising the specter of multiple states’ income tax withholding rules.
- Scenario 3: Grows more common post-COVID-19. Many universities hire employees for one of their locations, but those workers perform their duties remotely from home. That often means from home in another state. By 2025, a recent report predicted that remote employment would reach a threshold of 22% of American workers.
These three scenarios require employers to withhold state income tax under various withholding rules. And those state rules are fluid and change periodically.
Add to this the overarching federal law that says employees should not have to pay state income taxes twice on the same earnings. It is easy to see why tax withholding is a complex issue.
What is a state withholding tax?
Each state’s legislature has the right to define income tax withholding rules and collect income taxes on its residents and employers with a tax nexus to the state. The withholding rules include the following:
- Income tax rate, and
- Categories of employees for whom employers are required to withhold state income tax from their wages.
The rules further stipulate that the employer must:
- Deduct the required amount from the employees’ wages, and
- Collect and forward the tax dollars to the state accompanied by the employer’s state tax return.
What is a tax nexus?
A tax nexus refers to the legal relationship between a state taxing authority and a business. The U.S. Constitution’s Commerce Clause provides that before a state can levy a tax obligation on a business, a “substantial connection” or tax presence must exist. In the case of payroll taxes, the required tax relates to employment tax withholding on behalf of the business’s employees.
For income tax purposes, hiring a new employee may create a new tax nexus for an employer if the employee:
- Earns income from within another state that results from activity that is more than solicitation; and
- Owns property within the state.
When COVID-19 hit in 2020, some states relaxed their laws on what created a tax nexus as they tried to deal with temporary remote workers. Those temporary orders expired at the end of each state’s COVID-19 emergency period.
States took varying approaches to the issues raised by remote workers. Approaches include reciprocal tax agreements, apportionment rules, and credits for taxes paid to other states.
What is a reciprocal tax agreement?
A reciprocal tax agreement is an agreement between two or more states to simplify the administration of income tax withholding rules. Such agreements act by allowing employers to withhold only state income tax based on the state of residence.
Employers with employees in states without reciprocity agreements must consider each state’s state tax withholding rules. Proponents of model workforce legislation have introduced legislation every year since 2006. The model legislation would create a 30-day threshold before recognizing income to non-residents.
States may have reciprocity agreement states with one or more states as they see fit. At this time, 17 states have reciprocity tax agreements, such as:
- Arizona with California, Oregon, Virginia, and Indiana,
- Washington, DC with Maryland and Virginia,
- Wisconsin with Michigan, Kentucky, Indiana, and Illinois,
- Pennsylvania with Maryland, Virginia, West Virginia, New Jersey, Ohio, Indiana, and
- Montana with North Dakota.
You can view the full list here.
What is a state non-resident taxation policy?
State laws generally require employers to withhold state income tax on wages earned where the employee performs the work. Secondarily, states require income taxes withheld on wages based on where the employee resides.
States often have non-resident taxation policies to treat employees subject to multi-state withholding rules fairly. A non-resident taxation policy may mean:
- Non-resident and temporary work agreements,
- Tax credits for taxes paid to other states,
- Income sourcing rules, and
- State non-resident taxation thresholds.
A majority of U.S. states have adopted non-resident and temporary work agreements. As with other state tax rules, the terms of the non-resident and temporary work agreements vary by state. For example, non-resident taxation thresholds may stipulate how long an employee must work in a state before the withholding rules apply. A state threshold of 60-days is quite liberal, but other state taxation thresholds are as short as 14-days.
University employees may have to file non-resident tax returns if they:
- Work in-person at the university but live in a neighboring state without a reciprocity agreement,
- Work for the university and travel to another state for a period of time outside the non-resident tax threshold of the other state; and
- Work remotely for the university and live in a state without a reciprocity tax agreement.
What is an income sourcing rule?
Income sourcing rules are another method that states take to simplify the administration of multi-state income tax withholding rules. Income sourcing is also known as the “convenience of the employee rule.” Five states (Arkansas, Delaware, New York, Pennsylvania, and Nebraska) have adopted the income sourcing or convenience rule to source the income of non-residents who work for in-state employers but at a remote location outside the state.
This rule provides that the source of wages is the:
- Employee’s physical location if the non-resident employee works remotely for the employer’s necessity; and
- Employer’s physical location if the non-resident employee works remotely for their own convenience.
Connecticut also applies this rule but only if the non-resident employee’s state of residence has adopted the same rule. For practical purposes, this means Connecticut applies the rule to non-residents who reside in Arkansas, Delaware, NewStat York, Pennsylvania, and Nebraska.
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