Teleworking Presents New Challenges for State and Local Tax
With many business leaders forecasting that remote work is here to stay, full remote work or hybrid telecommuting arrangements will likely be commonplace. Therefore, it’s crucial that both businesses and employees understand the potential state tax pitfalls of telecommuting.
The state and local tax (SALT) effects of telecommuting range far and wide, from business income tax to sales tax to payroll tax to tax residency.
With corporate income tax or sales tax, the impact of nexus is very apparent. For a jurisdiction to impose a tax, it is required that a sufficient connection exists, or what is referred to as having “nexus.” Traditionally speaking, a business establishes nexus when an employee is physically working from that state. Although a tax authority may provide limited exceptions to this, such as an employee working from home, an employee whose activities are de minimis (i.e., immaterial day count) or COVID-19 relief, these exceptions are few and far between. In fact, effective Oct. 1, 2021, New Jersey’s COVID-19 waiver of income and sales tax nexus no longer applies.
A more likely exception might be P.L. 86-272, but this federal law is limited to only income tax for businesses that only sell tangible goods, and the employee’s activities must be limited to sales. Although in most cases an employee working from home creates nexus, with states generally imposing widespread economic nexus provisions, for many businesses physical presence is not even a requisite to establish nexus. A business with economic nexus, absent of any exceptions, will nevertheless find itself with a filing imposition. At the very least, for many businesses, the remote employee will increase audit risk detection for noncomplying businesses.
With business income taxes, the reverberations of telecommuting with respect to state tax apportionment could be as consequential. While many states have shifted away from the traditional three-factor formula to a single-sales factor, many states still use payroll in computing state taxable income. Remote employees may dictate how businesses compute state-apportionable income due to a variable payroll factor. As a result, businesses should not overlook these effects, as even an apportionment increase of a couple of percentage points could result in a significant tax impact.
Possibly even more significant are states that still retain cost of performance (COP) sourcing for computing the sales factor of apportionment. Although there are many variations of COP sourcing, situsing revenues under COP, in effect, allocate revenues to the extent the business incurs expenses such as payroll in the state when rendering its services. As such, for service businesses subject to COP sourcing, such as New York City’s Unincorporated Business Tax (UBT), which sources income from services by the place where the services are performed, there may be an opportunity to significantly reduce entity-level UBT taxes as more employees work from home in the suburbs. This contrasts with New Jersey’s provision which sources sales based on the office at which its personnel (e.g., employees, independent contractors) are situated or connected to.
Payroll Tax Withholding
Another area that has garnered significant attention, even outside the tax community, is payroll taxes. Mainstream news media covered New Hampshire’s lawsuit against Massachusetts regarding taxation of New Hampshire residents who normally had worked in Massachusetts but who were working remotely during the pandemic.
Effectively, Massachusetts put in place a “convenience of the employer” rule, albeit temporarily. Traditionally speaking, a convenience of employer rule treats wages as state sourced for an employee assigned to the employer’s office, unless the work was performed outside the state at “the necessity of the employer,” as opposed to for the convenience of the employee. Employees may find themselves in the unique situation where they could be subject to tax in two states: the state they are working remotely in and the state of their employer’s office. Adding to this confusion are COVID-19 relief, reciprocity states, convenience of employer rule exceptions and credit for taxes paid considerations. Considering the lack of uniformity across the states, these rules have created a lot of havoc for payroll tax administrators.
Personal Tax Residency
Remote work has shown that, for many employees and business owners, work can be done distantly in a low-taxed state. Moving out of a state requires more than just changing a driver’s license or a voter registration. The failure to properly change a tax residency means that all of one’s wages, business income and intangible income will be subject to income tax.
In many states, tax residency may be established if a taxpayer’s tax “domicile” is in a state. Domicile is a subjective test, and multiple questions are considered in determining if a permanent move has been made, such as:
- Where does the taxpayer spend most of their time?
- What is the value and size of each residence?
- Where do they attend doctor appointments?
- Where do their children attend school?
- Where are their most precious possessions kept?
- Where are their business interests located?
If the taxpayer prevails that they changed their domicile, then often the focus turns to the statutory test. A taxpayer will still qualify as a tax resident if a permanent place of abode is maintained in a state and presence exceeds 183 days in a state. In the event a taxpayer is domiciled in one state but establishes a statutory residency elsewhere, this dual-residency status may result in double taxation. However, even a win on tax residency doesn’t mean there won’t still be some state-sourced income as a nonresident. Residency tax planning is vital; developing a residency position after the fact can sometimes be unworkable, since the position and documentation could be contradictory as states aggressively target lost revenue.
The Great State Tax Migration
There has been a significant uptick in businesses and people moving to states with more favorable business climates. However, the tentacles of state tax can be far reaching, and it’s essential that employers and employees understand all of the implications so they can engage in proper tax planning and put in place safeguards to mitigate any unintended tax consequences. This includes evaluating current operational models for nexus mitigation and apportionment optimization, developing remote workforce policies, implementing employee tracking procedures and executing residency tax planning prior to a move. Teleworking may present new challenges for SALT, but it also may present many tax and non-tax opportunities as well.
Jason L. Rosenberg
Jason Rosenberg, CPA, CGMA, EA, MST, is a senior manager in the state and local tax practice at Withum. He is the vice leader of the NJCPA State Taxation Interest Group and serves on several other NJCPA committees.
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This article appeared in the Winter 2021/22 issue of New Jersey CPA magazine. Read the full issue.