In this article, tax professionals can take a deep dive into how states are taxing companies whose employees work in different states. Be sure to share this information with your tax clients.
There’s a good chance you’re reading this from home. Congratulations, you’re practicing social distancing! But, while you’re putting six feet of distance between yourself and other human beings, you and your employer might also be in closer contact with state and local tax regimes than you realize.
Corporate income tax nexus and apportionment
Many businesses are cautious about offering telework as an option precisely because it exposes them to taxation in states where they might otherwise have insufficient contacts — the technical term is “nexus” — to be taxable. The COVID-19 pandemic, however, suddenly made that the preferable choice for many businesses across the country.
When businesses engage in economic activity in multiple states, it is necessary to determine which states have a right to tax them and how much of the business’s net income those states can claim. This is where nexus and apportionment come in, and both are affected by telework.
Nexus tells us whether a business has sufficient presence in a state for that state to tax any of its activity. Apportionment determines the division of that income to yield the appropriate share for a given state to tax. Without some standards for nexus and apportionment, there would be nothing to prevent states from taxing businesses that have no connection to that state, or from taxing the entirety of a business’s income even though it is also taxed in other states on much or all of that income as well.
Under federal law, nexus cannot attach to a corporation just because it solicits sales in a state. There must be some further economic activity, like having property in the state or having employees work there. While many companies meet these thresholds in most or all states, there are plenty that do not — or at least did not until now. Even a single employee working from home in a state in which the company previously lacked nexus can be enough to qualify the company as taxable in that state.
Meanwhile, states determine the share of a company’s net income that is subject to their corporate income tax through an apportionment formula, which, in its traditional form, takes payroll, property, and sales into account, though many states now just focus on sales under what is known as single sales factor apportionment. In a three-factor state where the amount of payroll in a state (as a share of activity in all states) helps determine how much income is taxable, employees working from home can increase apportionment.
Even in single sales factor states, however, telework can make a big difference. Imagine a company that has extensive sales in a state but lacks nexus with that state because it does not have its own sales team there, does not service its goods there, and ships the goods into the state via a common carrier (or has customers come to them) rather than handling their own distribution. That company has no corporate income tax liability in the state into which it is selling—but suddenly, if even one employee is working remotely there, the state could begin taxing them, taking all of those sales into account in determining the share of net income to tax.
These issues are likely to be most significant along state borders, but any business allowing telework could be affected, particularly if employees decide to move across the country to be with family during the pandemic.
Given the incredible complexity to which this gives rise, and the degree to which this additional tax nexus was generated by matters outside of businesses’ control, it could be appropriate for states to disregard pandemic-related telework in determining nexus and apportionment. And for Congress to consider a temporary nationwide provision, under its authority to regulate commerce, deeming all such telework to take place at an employee’s normal place of work for nexus and apportionment purposes.
Employers withhold taxes on behalf of their employees with each paycheck, and typically they withhold for the state in which the work is performed even if the employee lives in another state. That employee, meanwhile, gets to take a credit against any income taxes paid in the jurisdiction in which they worked against their liability in the jurisdiction where they reside. (Some neighboring jurisdictions have reciprocity agreements that eliminates the need to file with multiple jurisdictions.)
Suddenly, however, many of these employees live and work in the same state — and it’s not the state in which their company has offices. These businesses should now begin withholding in the states where their employees work, even if just temporarily, which can be a costly compliance measure for businesses not already accustomed to having a workforce spread out over many states.
Tax liability in multiple states or municipalities
Employees themselves may owe taxes in additional states if they use this time to telework from a state other than the one in which they usually reside. Someone who lives in a state other than the one in which they typically work already has obligations to their home state, but in the midst of a pandemic, some employees will find comfort, convenience, or outright necessity in moving in with relatives or otherwise relocating. This can trigger obligations to file in those states as well, again with credits to avoid double taxation.
The obligations associated with working, even temporarily, in another state have long been a point of contention. Federal legislation long pending in Congress, called the Mobile Workforce State Income Tax Simplification Act, would establish a uniform 30-day threshold before employees are required to comply with the income taxes of a state other than their state of residence. This would eliminate the current system where many employees must file an income tax return in every state in which they travel for work, even if only for a day. (Compliance with this requirement tends to be low, though it is much higher, and much more extensively enforced, for extended periods and higher earners.)
But for now, that’s not the law — and many employees may be working in another state for extended periods anyway. They must be aware of the requirements that come with that remote work.
While most such considerations will be state-related, municipal income taxes come into play as well, and here some workers could benefit. Some Ohio municipalities, for instance, deny residents a credit for municipal income taxes paid at their place of employment, so living and working in one location could eliminate that double taxation, at least temporarily.
Sales tax obligations
Until recently, sales tax collections and reporting obligations required that the seller have physical nexus in the state into which a sale was made, but this no longer held true after the U.S. Supreme Court’s South Dakota v. Wayfair decision in 2018. Still, states must meet certain constitutional standards in imposing obligations on remote sellers, and every state but Kansas which has imposed a remote seller obligation has paired it with a safe harbor for companies with a relatively modest volume of sales into the state, exempting them from the obligation.
If, however, a company has a physical presence in a given state, they are not considered a remote seller and may not be able to take advantage of the safe harbor or other provisions designed to simplify the process for remote sellers. The presence of a single employee in the state can be enough to establish physical presence, rendering the seller in-state. This could be particularly burdensome in states like Louisiana which have an incredibly complex locally administered sales tax regime with a standalone “simplified” statewide system for remote sellers.
During the present crisis, remote work has become a necessity for many people. The tax implications, however, are very real and potentially quite complex. States and the federal government have a role here in eliminating needless complexity and would do well to treat temporary pandemic-related telework as if the employee’s place of business had not changed.
Editor’s note: This article was originally published by the Tax Foundation.