10/17/2022

Remote Employees Can Have Significant State Tax Implications

All of her company’s employees cheered when Renee^[1] announced that they could work remotely. They wanted freedom to be able to work from anywhere and potentially even live in a different place. Renee wanted to keep her employees together as a team and knew that retention in her industry could be difficult if she demanded they work from her Nebraska office.

Now, 12 months later, her employees were truly a national group. Renee saw many beautiful locales through her web calls and was envious of employees in warmer locales during the winter. However, some of those employees were starting to grumble about having Nebraska income tax withheld from their paychecks – particularly those who would also have to file an income tax return in another state. In addition, Renee’s accountant had informed her that her company may have to start filing income tax returns in each state in which her employees worked – even though it had no other presence there.

State Tax Implications from Having Remote Employees

While having remote employees is a growing trend, and is likely to continue in the foreseeable future, employees located in other states can have significant state tax implications for a company. In addition, it can be a challenge to comply with state income tax laws – both for withholding and for those employees themselves.

We’ll highlight some of the key issues with remote employees that we are seeing in our practice.

Nexus: Legal Presence In A State

Under the U.S. Constitution, a State cannot impose tax on a taxpayer without some connection between the taxpayer and the state. In brief, nexus is a sufficient connection between a state and a taxpayer that allows the state to impose its taxing jurisdiction on that taxpayer. In other words, if a taxpayer has nexus in a state, that state can require the taxpayer to collect tax and pay tax.

For companies, it has been a long-time rule (even before the recent U.S. Supreme Court decision in Wayfair) that physical presence of an employee within a state gives a company nexus in that state. In fact, a New Jersey court case decided ten years ago illustrated this. In that case, a Maryland company had one remote employee who lived in New Jersey and no other connections with New Jersey. The New Jersey courts confirmed that this presence in New Jersey was sufficient to give that employer nexus in New Jersey – and expose that employer to New Jersey income tax.

In addition, presence of a remote employee in a state will often mean that a company loses the protection of the federal Public Law 86-272. Public Law 86-272 restricts states from imposing income tax when a company’s presence in a state is limited to soliciting orders for goods, if those orders are approved and filled in another state. Most activities of remote employees go beyond the specific protections of Public Law 86-272.

Having nexus in a state has several state tax implications. The company must collect and remit sales tax on all taxable transactions sourced to the state. In addition, the company must file and pay state income tax on its income that is sourced to the state.

Given this, companies that have remote employees should fully understand the tax implications of having a remote employee in a given state. Those companies may need to start collecting sales tax in that state. Those companies may need to file and pay income taxes to that state. In addition, those companies may have a withholding tax requirement in that state.

Sourcing Income for State Income Tax Purposes

The presence of employees in a state can actually change how the company’s income is apportioned for state income tax purposes. This is because some states apportion certain types of income based on where the company incurs the costs of performance paid to generate that income. Other states apportion income based on the relative sales, property and payroll in a state – the latter two being affected by the presence of employees.

In addition, under certain fact patterns, income can be apportioned to more than one state for state income tax purposes resulting in a form of double taxation. This is because states have differing rules for sourcing income. Because the rules differ, income may be subject to tax in multiple states – because each state has a claim to that income under their apportionment rules. These implications should be fully understood before undertaking any operations in a new state – including allowing employees to work from a state.

Income Tax For Employees

The traditional rule is that employees are subject to income tax on income they earn while in a state. For this reason, if an employee lives in Iowa and works in Nebraska, they are subject to Nebraska income tax on their income.

Given this traditional rule, employees who leave Nebraska, but continue to work for a Nebraska based company remotely, generally do not expect to pay Nebraska income tax on their wages. However, the Nebraska Department of Revenue has, by regulation, instituted a rule commonly known as the convenience of the employer rule. Under this rule, service that could be performed in Nebraska, but is performed outside of the state only for the employee’s convenience, may still be subject to Nebraska income tax. The Department’s regulation states:

“If the nonresident’s service is performed without Nebraska for his or her convenience, but the service is directly related to a business, trade, or profession carried on within Nebraska and except for the nonresident’s convenience, the service could have been performed within Nebraska, the compensation for such services shall be Nebraska source income.”

Based on this rule, it is possible that the Department may claim that the work done by remote employees is still subject to Nebraska income tax – even though those employees work entirely outside of Nebraska.

In addition, the state where that employee resides may claim that the wages of that employee are subject to income tax in that state as well. To address this, companies should be considering and documenting whether their remote employees are only located outside of Nebraska for the employee’s convenience or whether a company business reason may exist for their location.

Income Tax Withholding

Nebraska’s rules regarding income tax withholding are largely set by Department of Revenue regulation, and those have not yet been updated to specifically address remote employees. This has been leading to uncertainty for some remote employees.

One specific regulation for employees working outside Nebraska states (in relevant part): “Wages paid to a nonresident employee for work performed entirely outside of Nebraska are not subject to Nebraska income tax withholding.” On its face, this seems to provide a clear answer: Nebraska income tax withholding is not required for Nebraska companies employing remote employees who are not Nebraska residents.

However, a general Nebraska Department of Revenue regulation also states that an employer must deduct and withhold Nebraska income tax if (a) the employer is maintaining an office or transacting business in Nebraska; (b) the wages are subject to federal withholding; and (c) the wages are “taxable under the Nebraska Revenue Act.”

As reviewed above, under Nebraska’s convenience of the employer rule, a remote employee’s wages could potentially be subject to Nebraska income tax (depending upon the circumstances of that employment). In that case, the general regulation could be claimed by the Department of Revenue to provide a different answer: Nebraska withholding may be required for wages paid to certain remote employees.

While we believe the regulations should be interpreted so the specific regulation controls, we suggest Nebraska employers employing remote employees closely consider whether to withhold Nebraska income tax on their wages.

Conclusion

Of course, the specific state tax implications of having a remote employee will vary by state and a company’s specific fact pattern. If you or a client would like assistance in considering the state tax implications of having remote employees, feel free to contact a member of the McGrath North Tax Group.