Hybrid work: A new frontier for state and local taxes

The hybrid workforce model many business and professional services firms have maintained or adopted post-pandemic creates significant complexities for state and local taxes. Because business and professional services firms offer employees the ability to work from various locations, it has become increasingly important for companies to meticulously track work locations for accurate and opportunistic tax reporting.

The hybrid work environment

New workforce models emerging from the pandemic include fully remote arrangements as well as the more popular hybrid model, which allows employees to work on-site in an office or other business location part of the time and remotely the rest of the time. Both models have helped businesses cast a wider net in the hunt for talent, but many companies are unaware of the potential tax consequences.

First, employees working from different locations can complicate the determination of where services are performed and customer benefits are received. In addition, hybrid work models require careful analysis to ensure compliance with unique and inconsistent state and local tax laws, from payroll taxes to income taxes. Finally, the rapid adoption of virtual work technologies requires updated methodologies to reflect the new work dynamics.

Not only does the hybrid model create nexus in multiple states, but it necessitates a reevaluation of income tax revenue sourcing methodologies for service providers because states use different methods to determine where revenue is sourced. While most states favor market-based sourcing, there are a handful of states that utilize cost-of-performance sourcing. Analyzing these methodologies offers benefits such as ensuring tax compliance, optimizing tax liabilities and leveraging tax benefits aligned with the geographic distribution of services.

Market-based sourcing

Market-based sourcing assigns revenue to the location where the customer receives the benefit of the service. This method is increasingly popular among states, as it more accurately reflects the customer base for the taxpayer’s services.

Key factors in market-based sourcing include the customer’s location and the state where the benefit of the service is received, which may vary according to local regulations. States use market-based sourcing to establish a tax obligation for out-of-state service providers based on revenue thresholds.

With a hybrid workforce, employees may be working from various locations, such as their homes, different offices, or even hotel rooms. This geographical dispersion can complicate the determination of where customers are located and where they are benefiting from the services provided. Advanced technology to track employee locations and activities may help determine where the benefit of the service is located.

Cost-of-performance sourcing

Cost-of-performance sourcing assigns revenue to the location where the service provider incurs the costs to perform the service. Key factors include the state where the service is performed and the costs incurred to perform the service, which can be complex if services are performed in multiple states. Some states require the majority of the service to be performed in the state to source any revenue there. With a hybrid workforce, costs may be distributed across multiple states, each with its own sourcing rules, thereby complicating the revenue allocation process.

Payroll is often the largest cost in cost-of-performance sourcing. If employees are working remotely from various locations, the business needs to track and allocate payroll costs accurately to the states where the work is performed.

Payroll taxes

Payroll tax complexities have also escalated because of hybrid workforces. Employers must navigate multistate tax compliance, understand residency rules and manage withholding requirements with heightened precision. Some states have “convenience of the employer” regulations that can further complicate employer compliance. These can widen the gap between an employer’s responsibility and the employee’s personal tax obligations.

The intricacies of apportioning payroll taxes are compounded when employees split their time between remote locations and a traditional office setting. This complexity can create pitfalls in tax compliance, and a robust system is necessary to track and report employee locations accurately.

Sales tax opportunities

Service providers must be aware of potential sales tax refund opportunities, particularly concerning multiple-points-of-use (MPU) software. When software is utilized across various states, the MPU exemption allows for an allocation of tax based on the proportional use in each jurisdiction.

For example, a service provider with headquarters in New York and a second office in California may pay New York sales tax on an entire transaction of software as a service (SaaS), even though a portion of software licenses are used in California. The business may seek a refund for the overpaid New York tax while allocating licenses to California, where SaaS is exempt. This may provide a financial reprieve for businesses that have adapted to a decentralized workforce model, but only if the location of licensed users can be tracked and documented.

It is essential for service providers to understand the eligibility criteria for such exemptions and the process for claiming refunds to capitalize on these opportunities.

The takeaway

The hybrid workforce model has introduced a new landscape of tax considerations that demand careful attention and strategic planning. Business and professional services providers must analyze revenue sourcing methodologies, understand the complexities of payroll and sales taxes, and adapt their tax strategies to remain compliant and financially efficient in this transformed work environment. As the workforce continues to evolve, so too must the approaches to managing state and local taxes.