The increased number of employees working remotely has caused a host of problems for employers – and employees – during the throes of the pandemic. Now that remote work is looking more and more like the new normal, it’s more important than ever that employers and employees understand what states require and what options are available. Why? Because failing to properly comply with state withholding rules exposes an employer to assessments for tax, interest and penalties (which may exceed 30 percent of the amount of tax not properly withheld). Equally important, compliance errors can also tarnish an employer’s reputation and cause employee relations issues. So it’s very important to get it right.
This post will focus on an employer’s general withholding rules and the most salient exceptions. As you will see, even the most traditional scenarios contain a degree of administrative complexity. Future posts will discuss collateral issues that flow from employees working remotely in a state that is different from the state in which their office is located and how an employer may turn the potential risks into opportunities.
In general, an employer is required to withhold income tax and remit it to the state (and local, if applicable, which adds an additional dimension) jurisdiction in which the employee performs the work. Before remote work became the new normal, it was easy for employers to comply. For instance, where an employee commuted from her home in Rhode Island to an office in Boston, the employer withheld state tax only for Massachusetts – Boston does not impose a personal income tax. The employee would file her Rhode Island income tax return and claim a credit for any personal income tax her employer withheld and remitted to Massachusetts. Because Rhode Island’s personal income tax rates range from 3.75 percent to 5.99 percent and Massachusetts imposes its personal income tax at a flat 5 percent, the employee may have to pay additional Rhode Island personal income tax if her Rhode Island tax rate is greater than the 5 percent withheld for Massachusetts.
Exception No. 1: Reciprocal Agreements
The first exception to the general rule is when the state in which the employee works and the employee’s state of residence have entered into a reciprocal agreement. In such a case, the employer withholds in the employee’s state of residence. For instance, New Jersey and Pennsylvania have a reciprocal agreement pursuant to which a Pennsylvania employer who employs a New Jersey resident withholds New Jersey tax – and not Pennsylvania tax. A reciprocal agreement, therefore, eliminates the employee’s hassle of filing a credit for taxes paid to another state but requires the employer to withhold in the employee’s state of residence. In our previous example, if Massachusetts and Rhode Island had a reciprocal agreement, the employer would withhold Rhode Island tax and the employee would not have to claim a credit on its Rhode Island return for taxes paid to Massachusetts. Massachusetts, however, does not have a reciprocal agreement with Rhode Island.
Exception No. 2: ‘Convenience’ States
Connecticut, Delaware, Nebraska, New Jersey, New York and Pennsylvania impose what is referred to as the convenience of the employer rule for withholding. Under this rule, the employer is only required to withhold in the state in which it requires the employee to work. Stated differently, these states require the employer to withhold in the home office state unless the employer requires the employee to work from a location in a different state.
Exception No. 3: the Massachusetts ‘Tax Man’ Maneuver
During the pandemic, Massachusetts adopted a rule that did what another Beatles song accused the British government of doing: “If you try to walk, I’ll tax your feet.” Not wanting to lose tax revenue on nonresidents who were no longer coming into the commonwealth, Massachusetts adopted a rule that required employers to continue to withhold Massachusetts tax from employees working from home in other states. In response, New Hampshire asked the Supreme Court of the United States (SCOTUS) to rule on this seemingly unconstitutional (the Commerce Clause prohibits a state from taxing income beyond its borders) maneuver. SCOTUS, however, declined to hear the case, so this issue remains undecided. That said, it would not be surprising if an individual (or class) brought a similar suit.
- The rules are complex, vary from state to state, do not always make sense and may even be unconstitutional – and local taxes impose an additional layer of complexity.
- An employer is subject to significant financial and reputational risk, particularly considering that it is merely performing the role of tax collector for the state or local jurisdiction.
Future posts will discuss ways to manage these risks and turn them into opportunities. In the meantime, let’s hope that states don’t keep employers “waiting here,” but instead, “come together … right now!”