Telecommuting arrangements: State tax traps and benefits
Telecommuting, a work arrangement in which employees have flexibility in their working location, has skyrocketed in recent years. Telecommuting can increase employee morale, better accommodate employees with child care needs, reduce the costs of keeping office space, and keep your workforce productive even during those Chicago blizzards. Conversely, telecommuting can expose you and your employees to a wide range of unexpected tax consequences. It is important to understand the potential tax pitfalls before approving a telecommuting arrangement.
What unexpected state tax consequences are there for telecommuting?
Nexus standards dictate where a company is subject to taxation. Standards differ by state and tax type (e.g., sales/use, income, franchise, withholding, unemployment), but most require some form of physical presence in order for a state to tax an entity. Allowing an employee to work from a state where your company did not previously have nexus may subject you to a filing requirement in that state. For most tax types, allowing an employee to telecommute from another state will meet these nexus thresholds. For instance, the telecommuter could be considered as physical presence in that state by both the employer and employee. Also, if the employer provides the computer to the telecommuter, this could be considered “property” within the state.
For example, a professional-services firm based in Chicago that has previously had no physical presence in Arizona receives a request from an employee for a telecommuting arrangement that would allow him or her to work from a home office in Phoenix. If the arrangement is granted, nexus will be created in Arizona for a number of taxes.
Firstly, the firm will be required to withhold Arizona individual income taxes from the employee's wages and pay Arizona payroll taxes. Secondly, the firm will be subject to Arizona sales and use taxes. While few services are subject to sales tax in Arizona, the firm will be subject to use tax on any property transferred to Arizona and all property used in Arizona for which sales tax was not paid. Lastly, the firm will become subject to Arizona income tax. A portion of the firm's income will be apportioned to Arizona and taxed by the state.
Almost every state is aggressively looking for out-of-state businesses in order to export as much tax liability as possible. Nexus is that minimal connection with a state that may allow for collection of income, franchise, employment, and sales taxes from the employer of a telecommuter.
Where will your employee be required to pay tax?
Generally, states tax all income earned by their residents regardless of where the income was earned. To avoid double taxation, many states allow their residents to take a credit for taxes paid to other states. Taxation of nonresidents becomes more complicated.
Of the 41 states that impose a tax on employee wages, 36 tax nonresidents based on the wages earned while physically present in the state. The remaining five states (DE, NE, NJ, NY, and PA) follow a “convenience of the employer” rule. If an employer located in any of these five states pays an employee who is telecommuting from another state, these five states will tax all of the wages paid to the telecommuting nonresident employee unless the telecommuting arrangement was for the “convenience of the employer,” not the employee. This opens the door to potential double taxation of employee wages since the remaining 36 states could very well decide to tax the same wages. Convenience of the employer generally requires that an employee could not perform his or her job at the employer’s premises. Lack of space has not been shown to be for the convenience of the employer.
Telecommuting has grown dramatically in the past several years and can offer needed flexibility in your workplace. However, allowing such an arrangement can subject your company to additional taxes and put you at the mercy of additional tax jurisdictions. Additionally, while a telecommuting arrangement can allow employees greater flexibility, it may subject them to double taxation. An analysis of nexus standards should become a required discussion item in any decision to allow telecommuting.