Tax Analysts Blog

Nonresident Income Taxes Likely to Remain a Focus for State Tax Authorities

Posted on Nov 26, 2014

There has been an uptick in the enforcement of nonresident income taxes and employers and employees should expect this trend to continue. Historically, there has always been a significant amount of noncompliance regarding nonresident income taxes, both in terms of payroll withholding by employers and remittance of individual income tax by nonresident employees. The noncompliance stems from the administrative complexity of withholding taxes from multiple states and general ignorance about the fact that income tax could be due in a state in which employees do not reside.

The scenario goes like this: An employee, who lives and works in State A, travels to and conducts business in State B for a total of 30 days a year. The employer should, in some circumstances, withhold payroll taxes from both State A and State B in proportion to the number of days worked in each state. The employee would file a resident income tax return in State A and a nonresident income tax return in State B. State A would likely give the employee a credit for any income tax paid to State B. Although the end dollar amount in taxes paid may be the same for the employee, there are potential penalties for failing to timely file or failing to withhold. So even though nonresident income tax seems to be nothing more than money changing hands between State A and State B, states see it as a revenue source.

Nonresident income tax laws have been on many states' books for decades. State and local governments are permitted 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 taxes on their books well before 1991, but that year marks the true beginning of those taxes being imposed on athletes.

Today most states impose a nonresident income tax, and enforcement efforts have gone well beyond the targeting of professional athletes. Nonresident income taxes can be an albatross around the necks of many business professionals, even those who only occasionally travel for work. Most states that levy an individual income tax have rules that require nonresidents to file a return if they spent time in the state and employers to properly withhold. These obligations create a variety of issues for employees and employers.

Employers and employees generally try to comply because there are penalties for failing to do so. Many companies now do more planning to determine whether sending an employee into a state will create a need for withholding. Although this can be extremely burdensome for businesses, particularly small businesses with limited resources, these steps may be necessary given states' increased audit activity in this area.

Employers may also forget that telecommuting can present significant issues for withholding. That is because the default is for employers to withhold income tax for the state in which an employee performs services. However, an employee may telecommute from State A but report to State B. In most instances, the employer will have to withhold from State A because that is where the services are performed. Various state rules, such as those in New York, have complicated the issues surrounding telecommuting.

Several bills have been proposed in Congress to simplify the complexity of nonresident income tax obligations for employees and withholding obligations for employers. The Mobile Workforce State Income Tax Fairness and Simplification Act, which has been proposed several times in Congress, most recently in November 2013 as S. 1645, would limit state and local government authority to tax the income of nonresident employees working within their borders on temporary assignments. The act provides that wages paid to an employee working in multiple states would be subject to the law of the employee's state of residence as well as any state in which the employee is physically present and performing services for more than 30 days during the calendar year.

Whether such a bill will ever gain traction in Congress is unclear. New York, in particular, is unlikely to get behind it because the state stands to lose a lot of revenue if the bill were passed. The Multistate Tax Commission has a model mobile workforce statute that provides a threshold of 20 days. The model statute would provide exceptions to that threshold for athletes, entertainers, and some other "highly compensated" individuals.

Compliance with nonresident income taxes is difficult for both employers and employees. Although an employee is typically permitted to take a tax credit on his home state's tax return for income taxes paid to other states, complying with and filing tax returns in multiple jurisdictions is a challenge. For employers, determining when their withholding obligations begin can be a daunting task, as can the simple process of establishing a system for withholding from all employees who cross state lines. Unfortunately, those are burdens that employers and employees will continue to face for now as states step up their audit activity, and efforts at simplification and unification across all states seem more like a lofty goal than a reality.

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