Managing payroll tax withholding is an inescapable responsibility for all businesses worldwide. Additionally, how a business runs its payroll is governed by each state’s local rules and regulations. With all kinds of deductions and withholding taxes to think about for each employee in various states, multistate payroll tax withholding compliance is becoming more complex and time-consuming.
Mobile workers have also become an important and growing part of the modern workforce. The more employees move around, the more multistate payroll tax withholding complexities arise, making it necessary for employers to effectively manage them. Failing to do so can result in serious consequences and expensive penalties.
Elements of Multistate Payroll Tax Withholding Compliance
Multistate compliance requires managing sets of state and local laws, regulations, and deadlines since it usually involves situations where employees live in one state but work in another state or multiple states throughout the course of the year.
The most common reasons multistate payroll tax situations occur when:
- Employers operate multiple business locations in different states;
- Businesses are located near the border between two or more states, so employees commute in from other states;
- Employees are working from home in other towns, counties or states; or
- Employees are traveling to nonresident states for temporary work assignments or working while also on personal travel.
Despite its complexity, employers can effectively handle multistate payroll tax compliance, provided they understand some of the key concepts of the multistate payroll tax, such as nexus, reciprocity agreements, and nonresident taxation policies.
Tax Nexus
A tax nexus is a threshold established by each state that determines at what point an out-of-state business must register, collect and pay certain state taxes. As such, a tax nexus is an important but complex element of multistate payroll tax compliance.
Tax nexus can refer to different types of taxes:
- Sales tax;
- Income tax;
- SUTA; or
- Workers’ compensation tax.
Typically, the tax nexus threshold is reached when a business has a physical presence within a state. After a 2018 Supreme Court ruling in South Dakota v. Wayfair, sales tax nexus can also be reached based on e-commerce sales activity as well. The threshold for nexus can be reached based on the total amount of revenue generated or the number of transactions. While this ruling does not directly affect multistate payroll tax compliance, it is still an important detail for companies conducting business across multiple states.
Also, during the COVID-19 public health crisis, many state tax agencies have issued guidance waiving nexus during the emergency period if it would have been established by the presence of resident employees working temporarily from home solely due to the pandemic. Most state guidance goes on to say nexus might be established in the future if the remote work continues beyond the emergency period.
Reciprocity Agreement
Some states have a reciprocal agreement with one another to ensure employees who live and work in different states are not subject to double tax withholding. The main purpose of a reciprocal agreement is to make things administratively easier for both the employee and the employer, as they represent an exception to the general rule of withholding tax for the work states and allow the tax to only be withheld for the state of residence instead of the work state.
If an employee works in multiple states that do not have a reciprocity agreement with the employee’s state of residence, then the laws and requirements of both states must be considered. Consequently, employers might need to withhold state income tax for both the work state and the state of residency.
Not every state maintains a reciprocity agreement. Seventeen states, including the District of Columbia, have active reciprocity agreements as of July 2022:
- Arizona – Form WEC;
- District of Columbia – Form D-4A;
- Illinois – Form IL-W-5-NR;
- Indiana – Form WH-47;
- Iowa – Form 44-016;
- Kentucky- Form 42A809;
- Maryland – Form MW507;
- Michigan – Form MI-W4;
- Minnesota – Form MWR;
- Montana – Form MT-R;
- New Jersey – Form NJ-165;
- North Dakota – Form NDW-R;
- Ohio – Form IT-4NR;
- Pennsylvania – Form REV-419;
- Virginia – Form VA-4;
- West Virginia – Form WV/IT-104R;
- Wisconsin – Form W-220;
To ensure multistate tax withholding compliance, it is important to note that agreements cannot apply to all neighboring states. For example, Illinois has a reciprocity agreement in place with neighboring states Iowa, Kentucky, Michigan and Wisconsin, but not with Indiana or Missouri.
Nonresident Taxation Policies
In addition to determining whether a company has nexus and if the states in which the employee is working and living have reciprocity agreements, the nonresident certificate is another important element of multistate payroll tax compliance.
Some states do not require an employer to withhold tax from employee wages until an employee has met a certain threshold number of days worked or an amount of wages earned for services performed in the state. At the same time, it is important to note that states have inconsistent and differing requirements when it comes to nonresident taxation policies.
Ensuring Effective Multistate Payroll Tax Withholding Compliance
Processing multistate tax withholding is usually a complex procedure as employers must pay employees and withhold and contribute to state taxes for multiple states. Also, the increasing number of employees working from home in the post-pandemic landscape creates additional obligations for employers.
There are many elements to take into account when managing multistate payroll tax compliance, such as a tax nexus and a reciprocity agreement. However, employers can take appropriate steps in advance to keep up with multistate payroll tax withholding regulations or changes to deadlines to avoid critical payroll mistakes. In addition to this, employers with multistate obligations can benefit from using a proven tax withholding solution to meet deadlines and regulations in a variety of jurisdictions while devoting significantly less internal resources.
