Revamped teleworking arrangements that have become the “new normal” following the COVID-19 temporary shelter-in-place paradigm could trigger new state income, sales and use, or employer withholding tax obligations that some businesses may have overlooked. Nearly two years have passed since our worlds were turned upside down, including from a tax perspective. If you haven’t recently examined where your employees are working and the effects on your state and local taxes, business strategies, and operating policies, the consequences could be surprising.
Generally, a company has a tax filing requirement when it is considered to have nexus with the jurisdiction, which is generally created by having a physical presence (e.g., maintaining employees or property in the state) or by exceeding an economic threshold such as sales greater than $100,000. Many states granted temporary tax nexus relief for businesses with employees teleworking from their residences in a different state than the employer’s location because of the COVID-19 pandemic. However, several states have since terminated those waivers and returned to pre-pandemic rules. For example, California, New Jersey, and Pennsylvania eliminated their COVID-19 tax nexus waivers during 2021. With companies shifting to a hybrid working alternative, and states terminating tax nexus waiver relief, employers must navigate the tax laws in various states in which their employees have their “home office.”
The rules governing whether a state or locality can impose tax on a business are complex and the failure to comply with the taxing authority’s filing requirements can come with steep penalties. This alert breaks down key dimensions of state tax nexus rules and provides insights into the implications and traps for the unwary. Specifically, we address the following:
- Business Income Tax: Protections at Risk
- Sales and Use Tax: Teleworkers Trigger Nexus
- Employer Withholding Tax Obligations: Navigating Source Rules
Business Income Tax: Protections at Risk
Since the onset of the pandemic, about one-third of the states provided employers with some corporate income tax nexus relief for temporary work arrangements associated with COVID-19. However, many states, as mentioned above, have since terminated those waivers and returned to pre-pandemic rules. In general, the only relief from nexus-based corporate income tax obligations can be found in the Interstate Income Act of 1959, Public Law 86-272, which prohibits states from imposing a net income tax on income derived within a state if the only business activities performed in the state are the solicitation for sales of tangible personal property for which orders are approved and filled from outside the state. As a result, certain companies can avoid state income tax even though they had a “physical presence” in the state so long as their representatives engage only in these limited activities. As companies allow employees to work from an in-home or other remote out-of-state office and perform activities not protected under P.L. 86-272, they could become subject to filing requirements and income tax.
A&M Insight: The relief granted in P.L. 86-272 is quite limited and with the changing workforce and location of employees, companies that did not satisfy a state’s economic nexus standard before COVID-19 could now face new corporate income tax filing obligations. As a result, employers should consider implementing procedures to determine where their employees are working and the specific services they perform. In addition to the administrative costs associated with the new filings, companies may be surprised to find the lack of conformity on the apportionment methodology (e.g., a single sales factor approach, a cost-of-performance approach, or an alternative multi-factor-based standard aimed at determining economic presence), which determines the amount of income subject to tax within a particular state. The states’ varying approaches could result in a portion of the company’s income being double taxed. Therefore, a cost-benefit analysis might be warranted to determine whether the company wants to restrict employees from teleworking in certain states after assessing the increased tax and administrative costs; the benefits of teleworking policies in retaining and attracting qualified employees; and other factors.
Sales and Use Tax: Teleworkers Trigger Nexus
In addition to the potential implications regarding business income taxes, companies should be aware of the effects of teleworking policies on their sales and use tax profiles. States generally require businesses to collect and remit sales tax on certain sales within a state if they have economic nexus — that is, their sales or transactions in the state exceed certain thresholds— or they have a physical presence. While a company may not have economic nexus, having a single remote worker in a state could be a sufficient physical presence to create nexus for sales tax purposes, regardless of the activity the employee performs, which could surprise businesses that do not otherwise satisfy the economic nexus thresholds. Many states granted temporary nexus waivers for sales tax purposes due to the pandemic, however, like the business income tax waivers, most of the states have since terminated the sales and use tax relief. That means some businesses, depending on their circumstances, could face severe consequences if they fail to register, collect the sales tax, and remit it to the taxing jurisdiction.
A&M Insight: Having robust reporting and procedures to ensure sales tax compliance is critical to avoiding surprises and adverse consequences that could arise with changes in employee work policies. Thus, businesses should develop and implement processes and systems to ensure timely collection and remittance of sales taxes in any jurisdiction in which an employee works remotely from a different state than where the company is located. Again, monitoring the state tax laws and rules and implementing employee tracking and reporting could help mitigate risks.
Employer Withholding Tax Obligations: Navigating Sourcing Rules
Lastly, having telework employees could give rise to withholding tax obligations, even if a company has a single employee working remotely in the state. Generally, employers are required to withhold income taxes in the state where the employee performs services and not necessarily where the employee resides. Some states, however, require an employer who pays wages to employees whose residence is within the state to withhold state income tax from those wages even if the work is performed in another state. In those situations, employees could face double taxation, however, most states generally provide a credit for taxes paid to other states. Some states have reciprocity agreements with neighboring states, which simplifies the withholding rules. For example, Pennsylvania has reciprocal agreements with Indiana, Maryland, New Jersey, Ohio, Virginia, and West Virginia. This generally means that for a Pennsylvania resident working in New Jersey, the employer should withhold Pennsylvania tax and not New Jersey tax.
Further complicating the withholding tax rules is the convenience of the employer rule discussed in our previous client alert adopted by at least six states — Connecticut, Delaware, Nebraska, New York, New Jersey, and Pennsylvania — and on a temporary basis during the pandemic by Massachusetts. If a business is located within a convenience of employer state and requests that the employee work in a different jurisdiction, then, for state income tax purposes, the employee is subject to withholding based on the state rules of the second location. But if an employee chooses to work in another location (e.g., their home) for their own convenience, then the employee’s wages are subject to withholding based on their “assigned” location as opposed to the actual location they worked.
A&M Insight: Businesses should understand the realm of state sourcing rules and stay abreast of changes to determine the states in which they must withhold income taxes for their employees working remotely in another state. Employers may have to withhold income taxes for multiple states for an employee or in some cases cease to withhold taxes because the employee’s location has changed. Some employers will be faced with determining at whose convenience is the employee working at a remote out-of-state location, which could depend on the company’s decisions to downsize physical space, their teleworking policies, and specific responsibilities employees perform.
A&M Tax Says
Generally, companies should regularly reassess their tax nexus profile due to changes in business operations and state tax nexus rules. As discussed above, the new normal of many employees permanently working remotely in a different state than their employer, either for a few days a week or just one day, could trigger significant business and tax implications. A company that had tax nexus in one or two states before the pandemic, could suddenly have nexus in many states, triggering new filing obligations, and in some cases increased tax liabilities. Determining a company’s potential nexus applicability is critical as the consequences could be severe and imminent, but that is just the first step, as businesses should consider how their new state and local footprint might affect their strategies and employee policies. If you are interested in a tax nexus assessment of your businesses or assistance with developing strategies and workplace policies, please feel free to contact Kevin M. Jacobs or Emilio Martinez.