As the world begins to adjust to a “new normal” in a post COVID-19 world, companies are shifting to allowing more employees to work from home on a permanent basis. Employees who have worked successfully from the comfort of home do not see the need to go to an office, and this provides opportunities for employers to downsize their current buildings, reducing rent and overhead costs. However, this leads to new state tax issues that must be addressed.
During the midst of the crisis, many states took a very taxpayer-friendly approach and announced that having an employee who normally worked in one state but was now working from home in another state would not create nexus. They also took the position that the income would be considered earned by the employee in the jurisdiction where it was normally earned. Basically, their approach was “let’s pretend this pandemic never happened,” allowing employers to get their employees out to a safe working environment without having to concern themselves with any lasting state tax implications.
As more states begin to open during this pandemic, states and cities are going to be facing the harsh reality of unprecedented deficits. Unlike the federal government, most states must pass a balanced budget which includes making up for prior year shortfalls. They will be looking to refill the coffers. Raising taxes could be a solution, but for many states this is an election year and raising taxes is not a pragmatic decision with their citizens still recovering financially. A politically noncontroversial way to raise taxes would be to tax nonvoters.
If you are not a State and Local Tax professional, you may not be familiar with the term “nexus.” The simple definition is connection or “touches” with a state. For tax purposes, a business must have some sort of connection to a state before it is required to file an income tax return or have an obligation to collect sales tax. The connection required differs based on the type of tax. There is a federal law that protects businesses from a state’s income tax if the only presence in the state is for the mere solicitation of tangible personal property. This law is not applicable to other types of taxes, such as franchise or sales tax. The solicitation of services or real property is also not protected. Therefore, a sales employee could be based in a state and not subject a business to state income tax if their only function is solicitation of tangible personal property. As soon as their services go beyond mere solicitation, the business could be subject to income tax. Additionally, the activities of that salesperson may protect the employer from an income tax obligation, but having an employee performing work in a state regardless of their job description will certainly trigger sales tax implications in that state.
Income Tax Nexus
An employee working from home, performing administrative functions for the business, is not protected under federal law. As we move beyond the crisis, businesses may be looking to reduce costs by downsizing their occupancy costs. They may continue to allow employees to work from home, which is different from the location of the business. If this situation occurs, businesses will need to consult with their tax advisors to determine their obligations.
If a business is considering allowing its employees to work from home, there are some matters they need to examine:
- Are the duties of the employee protected from income tax exposure?
- Will the employee give them nexus in a state in which they did not previously have nexus?
- How are they taxed? Are they taxed as a C Corporation, a Pass-Through Entity?
- If they are a pass-through entity, will the owners be able to utilize the credit available for taxes paid in another state?
- How does the other state source revenue – cost of performance or market-based?
- Will the entity be subject to a franchise tax in the state?
- What other registration and filing requirements will the business have?
- What employment rules must be followed in a state?
An employee working from home for an out of state company also needs to consider their own income tax exposure. If the employer allows them to split their time between the office and home, and they live in a different state than the office, they will be subject to tax in both states and will need to track their days worked in each state. The employee may have tax withheld in multiple states, thus requiring them to file income tax returns in multiple states. Employees may have opportunities to get a credit against taxes paid in any additional states or be refunded taxes withheld in an additional state depending on the circumstances.
Whether or not an employer has an obligation to withhold on an employee is dependent upon the states at issue. Some states, such as New York, have the convenience of the employer test. Under this test, for example, a telecommuting employee’s income is apportioned entirely to the state in which the taxpayer’s employer is located. New York has upheld the test several times in appeal. There are currently five other states that impose the convenience of the employer test: Connecticut, Delaware, Nebraska, New Jersey, and Pennsylvania. The application of the convenience of the employer test can lead to double taxation where the employer’s state applies the test and the state from which the employee resides does not.
It is important to examine these issues before deciding whether employees should be able to continue to work remotely. Tax is the land of unintended consequences. The employer may intend to offer more flexibility in order to attract and maintain qualified employees or reduce expenses, only to be subject to additional taxes. These matters should not be ignored, getting ahead of state tax issues allows for a smoother transition as the business grows and expands into multiple taxing jurisdictions. If you would like to discuss the state tax consequences of remote employees, please reach out to your HBK Advisor.