For a number of years I worked as an offsite employee for a New Jersey company. I was in New York, and later in Florida. I never had a desk at the company so I worked from home. This telecommuting arrangement is not unusual these days because technology makes it possible to collaborate and be part of a team that’s far away.
What does this arrangement mean for the income tax withholding responsibilities for the employer? What does it mean for employees who are in this situation?
Income tax withholding
Generally, the employer must withhold income tax in the state where work is performed—there is an exception that is explained later. If an employee who resides in another state works exclusively in that state—different from the employer’s state—then taxes are usually withheld only in the employee’s state. In this situation, the employer is in State A and the employee lives in State B and does all the work for the employer in home State B, so the employer should withhold State B tax for the employee, assuming State B has an income tax. I say “usually” because there are exceptions that permit the employer not to withhold state income taxes in the employees’ state.
If the employee resides in the employer’s state, tax for that state must be withheld even though the employee works exclusively in another state. And there may be additional withholding obligations in the state in which the employee works.
Already confused? If an employee works a few days in each location, things become even more complex, if that is possible. The employer must withhold income taxes in each state where the employee works. However, where there is a tax differential—one state has higher income taxes than another—the employer may have multiple withholding responsibilities.
For example, let’s say that a worker lives in a high tax state and works there part of the time but also works in the employer’s state, which is a lower tax state. The employee’s state is treated as the primary taxing state while the state of residence is the secondary taxing state. In this situation, the employer should withhold in the employer’s state, and in the secondary state, to account for the difference in withholding amounts.
For withholding purposes, a state’s tax treatment of certain fringe benefits may further muddy the withholding tax waters. For example, while employee contributions to a health savings account (HSA) are tax deductible for federal income tax purposes and as pre-tax contributions in most states, New Jersey treats them as taxable (they do not reduce taxable compensation). Similarly, employer contributions to HAS’s are tax free (not taxable compensation) for federal income tax purposes—but taxable for California income tax purposes.
I said earlier that withholding is usually done for the state in which the work is performed. But there’s an exception: For an employee who works at an employer’s location but lives in another state that has a reciprocal tax agreement, withholding can be made for the employee’s state of residence rather than in the employer’s state.
An employer must register with the department of revenue, taxation or finance (depending on the terminology used in a state) where withholding will be remitted. If an employee works in a state where there is no state income tax, then no withholding (or registration) is necessary there.
An employee files a resident state income tax return in the state where he or she resides. A nonresident return is filed for the state in which an employee works; tax is paid only on earnings in this other state. The employee’s state of residence usually offers a tax credit for taxes paid to nonresident states, so, in theory, the employee only pays income tax once on his or her earnings.
Recently the U.S. Supreme Court struck down Maryland’s tax regime in which a credit for state income taxes paid out of state was allowed against state income taxes but not for county income taxes. The court viewed this as being unconstitutional and imposing a double tax. Other states with special rules that have the impact of causing income to be taxed twice may now be viewed as unconstitutional—and employees who have been paying a double tax should file for refunds.
Employers with remote employees should rely on outside payroll companies or other tax experts due to the complexity of payroll withholding for remote staff. These experts can help employers not only do withholding correctly, but also determine how remote workers impact an employer’s state unemployment insurance.
Employees who work remotely should consult their own tax advisor to hone their state income tax withholding.
Barbara Weltman is an attorney, prolific author (with such titles as J.K. Lasser’s Small Business Taxes, J.K. Lasser’s Guide to Self-Employment and Smooth Failing) as well as a trusted professional advocate for small businesses and entrepreneurs. She is also the publisher of Idea of the Day® and a monthly e-newsletter called Big Ideas for Small Business®. She hosts Build Your Business Radio and has been included in the List of 100 Small Business Influencers for three years in a row. Follow her on Twitter @BarbaraWeltman