If you’re an employer in the US, you’re required to withhold state taxes in the state where the work is performed by the employee. In theory, this should be relatively straightforward. However, with increasing levels of remote work coupled with the return of business travel and traditional assignments, employees’ work locations can become harder to ascertain. This can make it more difficult to accurately determine employer payroll withholding obligations. Understanding and managing this aspect of payroll can be complicated, but it's essential if you want to remain compliant. It often also requires cross-functional coordination. In this blog, we'll walk through state-to-state tax withholding requirements and provide actionable steps for businesses to help streamline the process.

Understanding state-to-state tax withholding

Each US state has its own set of rules on taxes, rates and regulations regarding employee income. Usually, state taxes are withheld in the state where work is performed by the employee. However, post-pandemic, workforces have never been more dispersed. For example, an employee could be living in one state but working in a designated office in another, as is often the case in border states. Or an employee could be working remotely from home in a different state to their employer. Business travel too, can muddy the waters when it comes to tax withholding. Sales executives, for example, might spend much of their time traveling between different states for events, conferences or to meet clients. And employees may need to be relocated across borders for periods of time on assignment. This means that companies have many factors to consider if they want to manage payroll withholding in a compliant way.

Key factors to consider when calculating state income tax withholding

Key factors to consider when calculating state income tax withholding include:

1. Source income principle
2. Reciprocity agreements
3. Nexus
4. Convenience of the employer rule

We’ll go into each of these factors in more detail below.

The source income principle means that states have the right to tax income that was derived in their states. For example, if an employee lives in Pennsylvania but works in New York at the company office, New York would be the ‘source state’ because the employee performed the work in that state. In this case, the employer would have to withhold New York taxes for the Pennsylvania resident employee.

Many states have what is known as reciprocal agreements with (usually) bordering states that allow employers in states with such agreements to withhold based on the state in which the employee lives instead of where the employee works. Here is a handy list of states that have reciprocity agreements.

3. Nexus

Nexus refers to the connection or relationship between a business and a state that triggers the requirement for the business to withhold state income taxes from an employee's wages. This connection can be established through various factors, such as the physical presence of the business or its employees in the state, the amount of economic activity or income generated in the state, or the number of sales transactions in the state. For example, if a company is headquartered in New York but has a nexus in Pennsylvania then the company may have to withhold Pennsylvania as well as New York state taxes.

4. Convenience-of-the-employer rule

The convenience of the employer rule applies to certain taxpayers who work from home. This rule means that an employee is taxed as if they work in the employer’s state, even when they don’t. The employee may need to file both a resident and a nonresident return, unless you live in a reciprocal state or a state without income tax. The convenience of the employer rule may apply to employees who live or work in Delaware, Nebraska, New York, Oregon or Pennsylvania. Additionally, Connecticut and New Jersey tax the income of nonresidents working from home only when that taxpayer’s home state applies a similar tax.

Steps for businesses to manage state-to-state tax withholding

1. Know where your employees are

It sounds basic, but in today’s era of work location flexibility, it can be challenging to know where all of your employees are at a given point in time. Using processes, tools and technologies to keep track of employee work locations is critical

2. Know the location of the primary residence of all of your employees

Know the location of the primary residence of all of your employees and make sure that your employees understand the importance of informing HR of any change in address.

3. Familiarize yourself with state tax laws

It’s important to understand the tax laws and regulations of each state where your employees work and reside. Some states don’t have state taxes on employee income. Some states have reciprocity agreements with other states. It’s important to understand the rates and filing requirements of each state. For example, eight states have no state tax at all. These are Alaska, Florida, Nevada, South Dakota, Tennessee, Texas, Washington and Wyoming. New Hampshire only taxes interest and dividend income.

4. Keep up-to-date with changes in state tax laws

Tax rates and filing requirements are subject to change. It’s important to keep up-to-date with these changes so that you can remain compliant with your withholding obligations.

5. Determine tax liability

Determine the employee's tax liability in each relevant state based on their residency status, work location, and any applicable reciprocity agreements between states.

6. Withhold taxes accordingly

Withhold state income taxes from the employee's wages based on the applicable tax rates and withholding allowances for each state. Use state-specific withholding forms and guidelines provided by the respective state's tax authorities.

7. Communicate with employees

Keep employees informed about any changes or updates related to state tax withholding. Provide guidance on how changes in residency or work location may impact their personal tax obligations.

8. Remit taxes to states

Ensure timely and accurate remittance of withheld state income taxes to the appropriate state tax authorities. Follow each state's requirements for filing and payment deadlines.

9. Update payroll systems

Update your payroll systems to accommodate state-to-state tax withholding requirements. This includes configuring the system to accurately calculate and withhold taxes based on employee residency and work location(s).

10. Use technology to help

Managing state-to-state tax withholding obligations can become overwhelming, particularly if you are running large business travel and/or distributed work programs. If you are struggling with manual processes, a technology solution might help.

In summary

Managing state-to-state tax withholding is a crucial aspect of payroll administration for HR teams, especially in companies with employees living and working across multiple states. By understanding the basics of state tax laws, accurately determining tax liability, implementing proper withholding procedures and leveraging technology, HR professionals can ensure compliance and minimize the risk of costly penalties or fines. With careful attention to detail and proactive communication with employees, HR teams can navigate the complexities of state-to-state tax withholding with confidence.

Nothing in this article should be considered or construed as tax advice. Topia does not dispense tax advice and always recommends that taxpayers consult their accountants or lawyers.