Challenges of Payroll Tax Withholding For Remote Employees

January 26, 2023 by Rudy Mahanta, CPP

employer reviewing tax withholding for remote employees

Managing employee tax withholding has always been challenging for many employers, but the COVID-19 pandemic and the resulting increase in remote work has introduced new tax nexus considerations and further complicated the process. Each state has its own rules on whether and how telecommuters create a tax nexus for their employers, leading to differing and evolving local tax regulations. For example, some states treat telecommuters as creating a tax nexus, while others have issued guidance stating that a nexus cannot be established solely by employees telecommuting from within the state due to COVID-19. The complexity and variance from state to state means that employers need the right combination of people, processes, and technologies to overcome the challenges of payroll tax withholding for remote employees across all locations.

The acceleration of remote work has also changed tax withholding for employees and employers. Generally, taxes should be withheld for the state where services are performed, but this becomes more complicated when an employee works in multiple states or telecommutes. Instead of a uniform federal standard, employers must follow a patchwork of local tax regulations set by states and cities, which can be modified regularly or in response to emergencies like COVID-19.

Understanding the Concept of Tax Nexus and Its Impact on Remote Work

The intersection of tax withholding, remote work, and local tax rules can be seen in the dispute between Massachusetts and New Hampshire in 2020 over nonresident taxation. Massachusetts issued guidance stating that income earned by nonresidents who had worked in Massachusetts before the COVID-19 emergency declaration, but were now telecommuting from another state, would be treated as Massachusetts-source income subject to state taxes. This meant that New Hampshire residents who performed their work entirely in New Hampshire, instead of commuting to Massachusetts, would still have Massachusetts taxes withheld. New Hampshire, which has no state income tax, sued Massachusetts, disputing the constitutionality of this type of withholding of income taxes from nonresidents. The U.S. Supreme Court ultimately denied a review of New Hampshire’s lawsuit, meaning that it passed on the opportunity to review the broader issue of whether a state can impose its personal income tax on a nonresident telecommuting employee.

The Importance of Reciprocity Agreements in State Tax Withholding for Remote Employees

Many states have ended COVID-related nexus and withholding relief. New York, which has a significant influence on nonresident taxation, considers days telecommuted to be days worked in New York unless the employer has a “bona fide” location set up in the remote worker’s locality. New York also has a “convenience rule,” under which New York state tax withholding for remote employees must be withheld if an employee works outside New York for their convenience rather than due to employer necessity. In other words, their job could be done in the employer’s state and thus creates a tax nexus. Five other states have similar convenience rules: Arkansas, Connecticut, Delaware, Nebraska, and Pennsylvania. These rules create tax withholding complexity for employers and employees in these states, partly due to the lack of reciprocity agreements between states. Without reciprocity, more complex work is required to determine the correct withholding and file the appropriate tax returns. COVID-19 emergency declarations have further complicated these tasks.

Determining Residency Status: Key to Understanding California State Tax Withholding for Remote Employees

In California, a permanent resident will be subject to the state’s income tax. Part-time residents or nonresidents will also be taxed on California-based income. If you can prove that you are no longer a resident of California, you will be taxed as a part-time resident for only the months you were still living in the state. However, if your move was temporary, you will still be taxed as a full-time resident. Employers face the challenge of determining where a tax nexus exists and what emergency-related exemptions and reciprocity agreements apply. A tax nexus is a state’s determination that an organization has a presence in the jurisdiction. Pre-COVID-19, many states regarded remote workers as a nexus for employers based in different states. COVID-19 work-from-home orders generally stated that temporary telecommuters would not create a tax nexus where one would not otherwise exist. California has taken this approach, but other states have gone in different directions. Reciprocity agreements allow employees who live and work in different states to avoid tax withholding in the work state as long as all states involved maintain reciprocity.

Currently, there are 16 states including District of Columbia with reciprocal tax agreements in place:

  • Arizona
  • Illinois
  • Indiana
  • Iowa
  • Kentucky
  • Maryland
  • Michigan
  • Minnesota
  • Montana
  • New Jersey
  • North Dakota
  • Ohio
  • Pennsylvania
  • Virginia
  • West Virginia
  • Wisconsin
  • District of Columbia

Simplifying the Process: Tips for Managing Payroll and Taxes for Remote Employees

A sales tax nexus refers to a connection a business has to a state. It often occurs when a company has a physical presence or an economic relationship in a state. Employers may be required to report taxable employee benefits, such as bonuses and stipends, for remote workers and withhold income taxes for the respective states. Several states, including Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington, and Wyoming, do not require income tax withholding. States with no income tax, such as Texas and Washington, are popular for remote workers, but they may be responsible for other taxes or mandatory employee benefits. Remote employees are employees who work outside of the office setting and are on a company’s payroll, while independent contractors are self-employed and responsible for managing their own taxes. Employers are responsible for withholding federal income taxes, FICA taxes (Social Security and Medicare), and federal unemployment taxes (FUTA) for remote employees. Confusion may arise when it comes to withholding state income taxes, as each state has different rules and regulations. It is important for employers to stay up to date on all tax laws and requirements for remote employees.

Experian Employer Services offers a solution for automating the tax withholding process for remote employees, providing all necessary tax forms based on their work and home addresses. This solution also integrates with Workday, ServiceNow, and Cornerstone to streamline the onboarding and payroll process for remote employees. It helps both employees and employers avoid tax time surprises and manage the growth of telecommuting. Experian Employer Services’ Tax Withholding Services can assist companies in determining the proper state tax withholding for remote and on-site employees.

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