Multi-State Payroll Taxation

Payroll withholding can prove to be a daunting task, especially when it comes to Multi-State Taxation. An employee works in one state and lives another. What do you need to know? 

Which state income tax to withhold 

Depending on the states involved the employer might need to withhold income tax for multiple states from the wages of one employee. As a starting point, the default rule of state income tax withholdings is to withhold income tax for the state in which services are performed (the work state). Almost all states require employers to withhold tax from employee wages earned for work performed in that state, even for nonresidents. The analysis need go no further if theemployee lives and works in one state. 

An employee’s residence must be determined because a resident is subject to the laws of that state, including its income tax laws. States have the power to tax all income of state residents, even income earned for work performed in a different state. State definitions of residency vary, so state laws and regulations must be consulted when mading the determination. 

Nexus 

An employer might be required to withhold income tax from wages for an employee’s state of residence – even if the employee does not perform services there – if the employer has a business presence or operations in that state, also referred to as nexus. The presence of a business location, such as an office, store, or factory in the state will create nexus there, as will the mere entry of an employee to make a sale or perform a service call. Additionally, an employee working remotely from his or her state of residence on an occasional basis might be enough of a business presence to create nexus. 
 
During the COVID-19 public health crisis, many state tax agencies have issued guidance waiving nexus during the emergency period if it would have been established by the presence of resident employees working temporarily from home solely due to the pandemic. Most state guidance goes on to say nexus might be established in the future if the remote work continues beyond the emergency period. 

Reciprocity 

When two states have a reciprocal agreement for tax purposes, it makes things administratively easier for the employer by allowing it to withhold only for the state of residence (example: Indiana is reciprocal with Kentucky, Michigan, Ohio, Pennsylvania, and Wisconsin).  

Employees Working in Multiple States Without Reciprocity 

If an employee works in multiple states that do not have reciprocity with the employee’s state of residence, then the laws and requirements of both states must be considered. The employer might need to withhold state income tax for both the work state and the state of residency. 
 
Double taxation is not prohibited by the U.S. Constitution as long as it is not arbitrary, but most states help residents avoid double taxation via a variety of methods, including reciprocity agreements, allotment or apportionment rules, and credits for taxes paid to other states. Some methods will affect whether the employer is required to withhold for each state and the calculation of the amount to withhold for each state. 

Contributed By: Kim Grote | Payroll Manager | DWD CPAs & Advisors