In today’s highly mobile society, businesses can have employees that travel extensively throughout the country. The company CEO may travel from Iowa to Illinois on Monday to meet with a new customer, then on to New York on Tuesday to work on a project. Wednesday finds her in Arizona meeting with a supplier, Thursday she is closing a deal in Michigan. Finally it is Friday, and she retreats to her vacation home in Door County, Wisconsin, where after a few more hours of work she is ready to relax and enjoy the weekend. While the business may be flourishing due to all of this activity, it could also be faced with a growing area of state tax exposure: payroll tax withholding. The CEO will need to determine if she is required to file state income tax returns in the five states where she worked during the week because states can impose an income tax on personal service activities occurring within their borders.
A state can generally also tax all of the income of its residents, no matter where a resident earns his or her income. This can lead to the same wages being taxed by more than one state. For example, New York taxes certain wages paid to employees working for a company located in New York, even though the employee is not physically working in New York. Many states, including Connecticut, require employees to pay income tax on wages earned while physically working in the state. Therefore, an employee working in Connecticut for a New York-based company could have both New York and Connecticut taxes withheld on the same pay.
Before a company starts withholding state income taxes on employees working in multiple states, it needs to determine if withholding is required. A few states have a de minimis exception whereby if an employee works in the state for less than a stated threshold, such as number of days or dollars earned, withholding (and state income tax filings) are not required. Arizona does not require withholding in certain circumstances if a nonresident works in Arizona for less than 60 days. However, most states with a number of days threshold have it set far lower. Oklahoma uses a dollars earned threshold. Withholding is not required if the nonresident employee earns $300 or less. Illinois has tried to simplify withholding by not requiring nonresident withholding when nonresidents only work in the state an “incidental” amount of time.
Another exception to the general rule exists when states enter into reciprocity agreements whereby wages paid to a resident of a state are treated as earned in the state of residence. Iowa and Illinois have a reciprocity agreement in place. Therefore if an Iowa resident works in Illinois the employee can be exempted from Illinois withholding, and should report the wages as earned in Iowa on his income tax return. Just as Iowa has a reciprocity agreement in place with Illinois; Illinois currently has agreements with Iowa, Kentucky, Michigan, and Wisconsin.
To avoid some instances of double taxation, the federal government has considered legislation, the Multistate Worker Tax Fairness Act, that would allow a state to impose an income tax or withholding requirement only on compensation paid for time a nonresident employee is actually working in the state. However, this legislation has not progressed very far through Congress.
States are aware that not all companies have procedures in place to properly capture where employees are spending their time and to properly withhold state income taxes. As a result, there is an increase in state audit activity in this area. If your company is concerned about the complexities surrounding payroll, you should review and potentially revise existing employee state income tax withholding procedures to ensure proper compliance with current payroll withholding requirements across all states where you conduct business.
Originally published in the Tri-State Business Times