Multi-State Payroll Tax Compliance for Universities
What Universities Should Know about Multi-State Payroll Tax Compliance
The COVID-19 pandemic transformed the way employees in higher education work in the U.S. Almost immediately, universities and colleges embraced remote and at-home workers. They did so to protect the health of their workers, while the pandemic threatened to disrupt the classroom.
In the years since the start of the pandemic, the remote work movement has continued to grow. In its wake, universities and colleges face complications regarding compliance with multi-state income tax withholding obligations. Some employers may not recognize the pitfalls.
For instance, higher education employers may have vastly different state income tax withholding obligations depending on a university’s geographic location and its employees’ states of residence. Employees who cross state borders to perform their jobs raise even more complications.
Proper treatment of multi-state payroll taxes requires employers to understand several complex legal concepts, as described below.
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.
Factors Impacting Multi-State Tax Withholding in Higher Education
Several factors impact multi-state tax withholding rules in the higher education sector. Higher education payroll departments should answer the following questions before hiring each non-resident employee.
Are payroll taxes based on where an employee lives or works?
An employer bases the payroll taxes for each employee on the rules set by each state. In most cases, the employer bases payroll taxes on the state’s laws where the employee works and the business maintains a nexus with the state. Some states, however, require taxes paid on all income earned by their residents whether they earn that income in the resident state or as a non-resident in another state. These issues complicate the payroll withholding question. They require an in-depth working knowledge of various state employment tax rules.
What if there is no reciprocity agreement between the states?
If no reciprocity agreement exists between the resident and non-resident states, employers may need to withhold taxes for both the state of residence and the state in which the employee performs the work. Prudent practice requires employers to check before payroll withholding with their state tax authority.
How do taxes work if the employee lives in a different state?
If the employee lives in a different state, employers generally withhold payroll taxes based on the state where the employee performs the work. However, if the employee’s state of residence requires taxes withheld on all income no matter where derived, then the employer may have to withhold taxes for both states. The employee may also live in a state with a reciprocity agreement. In that case, the employer will withhold according to the terms of the reciprocity agreement. Such agreements often permit the employer to withhold payroll tax only from the employee’s home state.
What if an employee crosses state lines while working?
If an employee lives in one state and crosses state lines to perform work of a substantial nature, then the employer must withhold taxes according to the rules of both the state of residence and the state where the employee performs the work.
What if an employee works in multiple states?
The employer will deduct payroll taxes for the employee’s state of residence and for each state in which the employee worked. The employer must keep abreast of each state’s payroll withholding rules. Some states may have reciprocity agreements. Some resident states may provide a tax credit for the non-resident state’s payroll taxes. On the other hand, some states enter into apportionment agreements, or temporary work rules.
How does payroll work for remote employees?
Payroll for remote employees throws a wrinkle into the general payroll work equation. This is especially true given the popularity of remote work post-COVID-19. Remote workers fall into the category of multi-state payroll obligations with the same payroll agreements between states such as reciprocity agreements, non-resident and temporary work agreements, non-resident tax credits, and non-resident work thresholds.
What happens when an employee moves to another state?
Employees who move to another state create new payroll obligations for the employer. This is true no matter why the employee moves to the new state. It is most likely that the employer will have to withhold payroll taxes for both states on the same income. Some states may have reciprocity agreements. Others may require payroll withholding for both the resident and non-resident states. This is another example of an employer’s need to understand and follow each state’s payroll withholding rules. The employer may also have to register with the new state as a business entity doing business within that state. This may mean the employer must comply with the new state’s labor law rules, such as the minimum wage, overtime, payday rules, etc.
Simplify Multi-state Taxation with a PEO
There’s an easy way for universities to simplify the administration of the multi-state taxation minefield. They can hire a Professional Employer Organization (PEO).
PEOs provide comprehensive HR outsourcing solutions. For example, a PEO calculates the employment taxes and files the forms on your behalf under the PEO’s Federal Employer Identification Number (FEIN).
With a PEO, the university is free to hire employees anywhere in the country because a PEO eliminates employer worries about the:
- Complex and constantly changing laws;
- The hiring of new employees in a new tax nexus; and
- Registering yet another state withholding account.
Taking the Next Step
If you face the payroll tax issues that come with remote workers, multi-state employees, and employees who move to new states, you should consider outsourcing your payroll obligations to a PEO. The PEO becomes your HR outsourcing partner.
The PEO takes on due diligence research to understand the complex payroll tax withholding rules. It relieves the payroll tax filing obligations from an overburdened HR staff. In practical terms, a PEO contract shifts a portion of the taxation obligation from your shoulders to the PEO and limits your risk.
A comprehensive HR outsourcing partner takes duties off your plate and frees you and your staff to do what you do best: help your university thrive.