The following article was posted with the permission of Carmody Torrance Sandak & Hennessey LLP. This summary provides high-level, general information about U.S. state employment tax sourcing rules, and is not intended to provide legal advice or to address every situation relating to the subject matter.
A growing challenge for HR and payroll departments is determining which state income taxes to withhold when employees work remotely, outside of the state where they otherwise might perform services for the employer.
This—and an increasing number of various scenarios involving interstate employment—has led to more employers seeking professional advice on when they must withhold income taxes for another state, and register with that state to pay such taxes from payroll.
The prospect of more permanent remote workforces evolving out of the COVID-19 pandemic has a good possibility of accelerating the trend toward telecommuting, and the state income tax withholding questions that follow.
Perhaps the first important idea to understand about state income and employer withholding obligations is that each state sets its own rules for when it will tax an employee for work performed in that state.
Second, most states follow the general principle that it will consider income earned from work physically performed in the state to be “sourced” to that state, and therefore subject to its income tax and employer withholding obligations.
Connecticut, for example, does not impose its income tax on non-resident employees of a Connecticut employer when the employee performs services (including remotely) entirely outside of Connecticut.
There are a few exceptions to this general rule in Connecticut for residents of certain states that impose a tax when an employee works outside of that state only for their own convenience (currently New York, Pennsylvania, Delaware, Arkansas, and Nebraska).
For residents of those states, Connecticut imposes its income tax and employer withholding obligations when such individuals work for a Connecticut employer but outside of Connecticut only for their own convenience.
This is known as the “convenience of the employer” rule.
In addition, Connecticut currently permits non-residents to work up to 15 days per year in the state before becoming subject to the state’s income tax. However, once a non-resident of Connecticut works more than 15 days in a year, that employee is subject to Connecticut income tax on all wages earned during the days that the employee worked in the state.
While Connecticut gives an annual 15-day buffer to most non-resident employees who enter the state to work, not all states do.
Some allow a minimum amount of earnings which are “sourced” to the state before imposing tax on those earnings, while other states have no exemption.
The result of these inconsistent and often complicated rules is a patchwork of many potential withholding scenarios that have long vexed HR and payroll departments, but must be carried out nonetheless.
In the hopes of at least partially ameliorating these challenges for employers, legislation has been introduced in the U.S. Congress during each of the last several years that would establish a minimum number of days (most recently, more than 30) that an employee must work in a state to become subject to the state’s income tax.
Even if such legislation is enacted, employers will need to continue making individual assessments about withholding and registration obligations based on the locations of the employer and the employee, the income sourcing rules of each state, and the facts in each case.
About the authors: Timothy Klimpl and Mark Williams are attorneys with Carmody Torrance Sandak & Hennessey LLP, providing employee benefits, compensation, and tax advice and related services to a variety of private and public sector clients.