Multi-State Taxation in the Post COVID-19 Era

The COVID-19 pandemic that began in March 2020 left an indelible mark on societies, economies, and businesses worldwide. While multi-state taxation was already a difficult landscape for payroll professionals to navigate, the pandemic created even more complexities in this area.

Employee Nexus, State Tax Laws

Businesses were already navigating complex rules regarding multi-state taxation before the onset of COVID-19. An employee’s primary work location had to be taxed as well as their state of residence. But there was typically no uniformity. Each state can make their own reciprocal agreements. Not only did this impact withholding and taxation, but also unemployment insurance and other taxes.

Pre-pandemic payroll tax obligations all centered on the concept of nexus. Typically set up as where the employee performs services, nexus encompasses where the employee is physically performing services and how long they are in a specific area. When an employer had nexus in a certain area, they were liable for tax withholding, state unemployment, and other taxes as required by law.

The first major complexity that companies must deal with in the post-pandemic era is keeping up with state tax laws with the proliferation of remote working. As employees are now able to work from home, or anywhere, companies must be familiar with the laws of each state where an employee is working.

Typically, nexus triggers tax liability in a state. However, many states are implementing new rules based on the premise of employer convenience. If an employee works remotely from home due to the employee’s convenience, rather than the employer’s requirement, laws in some states may require the employer to withhold taxes where the employer is located and where the employee lives and works.

Several states have already enacted “convenience of the employer” legislative requirements—and what happens when an employee works remotely at their convenience. The expectation is that states are going to issue new regulations providing clarity on when employees need to be taxed in multiple locations.

In addition to remote work, some companies are adopting hybrid work models. This will cause additional challenges regarding multi-state taxation, and even more so multi-locality. States will need to determine how to tax for hybrid work environments—if needed for their appropriate situations. Some states tax based on where an employee is based in this environment, while others still tax based on where an employee is sitting at that moment. It still needs to be determined what the appropriate method will be to determine the appropriate amount of withholding.

New Tax Compliance Burden

The onset of remote workers during and after the pandemic revealed that employees were working in states or countries that were different than their principal work location. And, even my former clients discovered that employees had relocated to different countries to care for loved ones during the pandemic.

The administrative and system support burden for employers is to keep up with changes related to tax compliance. Many employers did not keep up with tax legislation in the states where they have nexus before the pandemic, yielding a much larger burden today. The assumption was that the system automatically did this, which is true. However, there are many aspects of a system that must be maintained by the company when they enter a different state. For example, HSA contributions in California are after-tax for state income tax purposes (not pre-tax for federal income tax purposes). Few, if any systems will track this automatically and will require configuration adjustments to your system.

Compliance audits have become a challenge in the post-COVID era. Audits focus on income and state taxes that should be calculated and remitted to the states properly. Given the surge in the remote workforce, compliance audits are being enhanced to determine if the company has a nexus in the state where the employee is working. Most will engage a tax attorney in advance to determine if nexus was created, which is often the case. Auditors will ask for pay records, tax records, and at times, interview the impacted employees to determine if taxes are owed. These are typically triggered by tax filings, random selection, whistleblowing, or industry-related incidents.

Typical audit penalties are the payment of back taxes, interest, and penalties. Depending on the severity of the violation, penalties can be quite steep. Companies have the right to challenge the results of the audit and it is strongly recommended that tax attorneys and/or consultants that specialize in these tax matters be engaged to assist in that process.

There are many changes being proposed by the states and federal government. The advent of remote working and the impact on multi-state taxation has basically opened a can of worms across the state and federal governments in response to this ever-changing dynamic.

New Compliance Agreements

Many states are faced with the challenge of maintaining revenue yet keeping processing consistent for all the companies that do business in their state. To balance this, state tax reciprocal arrangements have been enacted—or have been proposed—to streamline the compliance requirements for employers.

Additionally, several states have entered into agreements or compacts, with the most famous one being the Multistate Tax Compact. The Multistate Tax Commission (MTC), which consists of the District of Columbia and all states except Nevada, was formed in 1967 to focus on multi-state taxation issues. It is up to the individual states as to whether they adopt the MTC models, but it gives a means of uniformity between the states.

 One of the areas states and the federal government are looking at is the harmonization of compliance policies between the states. This is one area that will assist in this new era of remote and hybrid working, thus reducing the administrative burden on the employer. One of the largest areas in this new harmonization of tax compliance will be the streamlining of regulations for telecommuters. With the ability to work in multiple states, cities, or countries at any point in time, the determination of nexus becomes important. Also, there needs to be a uniform threshold for state taxation of nonresident income. Some states currently have up to 14 consecutive days, others are 24 hours. With telecommuting, the federal government should harmonize this across all states.

Another area of concern that may be addressed is data sharing and compliance. Just like today when states share information regarding new hires, it may become necessary for them to share multi-state time information. In this manner, states can determine if a taxable event occurred within their jurisdiction and ensure that employees are paying the appropriate tax.

Multi-state taxation has always been a challenge. It is very easy to be out of compliance and end up with fines and penalties owed to the various state agencies. Given the challenges that have been realized by companies since the onset of the COVID-19 pandemic, this concept will become far more difficult to manage. This really can only be resolved by streamlining rules and regulations for consistency in state processing. Regardless of the state, before embarking on any remote or hybrid work policies, it will be important for any organization to leverage a tax attorney or a consultant who specializes in multi-state taxation for assistance in determining those policies.

Jeff Hill, Ph.D., CPP, is a Principal at Commit Consulting, LLC. He currently volunteers as part of PayrollOrg’s Ask an Expert, the Strategic Payroll Leadership Task Force (SPLTF) Best Practices and Global Payroll Subcommittees, and the Board of Contributing Writers. He was also PayrollOrg’s Payroll Man of the Year in 2019.