Tax Analysts Blog

The Albatross That Is Nonresident Withholding

Posted on Jul 26, 2016

Managing nonresident employees has been a challenge for companies for several years -- in part because of states’ various requirements, but also because states continue to be aggressive in locating remote employees. It is part of the continuing trend by state tax departments to ensure they are getting every dollar of available revenue. This has translated into being more aggressive in enforcing their tax codes, including their nonresident withholding statutes. Although numerous states have had nonresident withholding requirements on the books for many years, recent budget strains have spurred states to increase their enforcement efforts.

Nonresident income tax laws generally permit state and local governments to tax not only the income of their residents but also the income of nonresidents if that income is derived from sources within their state or locality. Most states had nonresident withholding requirements taxes on their books well before 1991, but that year marks the true beginning of those taxes being imposed on athletes. In the early 1990s states were faced with difficult economic conditions, cuts in federal funding, and ever-growing budget deficits. As a result, taxing the incomes of nonresident athletes (or arguably shifting the tax burden) then became an attractive revenue source.

Now most states levy a nonresident income tax, and efforts at enforcement have gone well beyond professional athletes. Nonresident income taxes can be an albatross around the necks of many companies and business professionals. Most states that impose an individual income tax have rules that obligate nonresidents to file an income tax return if they spent time in the state, and employers to properly withhold. Those obligations create a variety of issues for employees and employers.

There are a variety of scenarios in which a company may find itself with nonresident employees. Take the following: A small company located in State A provides goods or services and has started expanding. During the expansion it hires several employees who work from home. At the time of their hire, the employees lived in State A. But because remote employees are by nature mobile, a few moved to State B. The employees are not soliciting business in State B and may have no contact with people in State B regarding the company’s business. Nonetheless, the company may have unknowingly created nexus with State B by virtue of the employees’ presence in the state.

To make matters worse for companies, states are getting increasingly savvy about finding remote employees. For example, many (if not most) states use an IRS database to see who in the state is receiving a W-2. From there, a state can see the payer and do a quick check to determine which reports the payer filed with the state.

Employers must be aware of the potential tax exposure and carefully review the state tax ramifications of allowing employees to telecommute from a location in which the employer does not otherwise have a presence. Businesses can find themselves subject not only to corporate income and sales tax, but also to withholding tax and state unemployment obligations.

Piecing together the puzzle of state laws regarding nonresident withholding is a daunting task for taxpayers. They have difficulty properly complying with the myriad laws. That said, states also have some difficulty properly tracking nonresident withholding, particularly if a complex corporate or partnership structure is involved. This is an area of the law that begs for uniformity, from both taxpayers’ and states’ perspectives.

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