Many employers question in which states they must have their employee’s income taxes withheld and to which states they must pay unemployment taxes. Such questions arise when an employee works in one state and lives in another, or when an employee is a salesperson or repair technician whose territory covers multiple states. In such cases, determining which state’s employment taxes apply can be confusing. This article will help employers gather necessary information to make a correct determination.
There are many instances where the state for withholding would differ from the state for paying unemployment taxes for the same employee. The determination of the correct state for each of these employment taxes should be made separately.
STATE INCOME TAX WITHHOLDING
First, let’s discuss how to determine which state is the correct state for withholding income taxes for a given employee. The employer needs to know the answer to two questions:
1) In which state is the employee a resident?
2) In which state does the employee provide services?
Most states define a resident as a person being domiciled in the state or spending more than a specified amount of days in the state. “Domiciled” is generally defined as the place where an individual has a true, fixed, permanent home and principal establishment. This is usually demonstrated by property ownership, driver’s license, vehicle registration, and voting registration in the state.
Determining in which state an employee provides services can be tricky. Where does the employee work on a daily basis? If the employee works in an office or a factory each day, then the state where the office or factory is located would be the state in which the employee provides services. If the employee is a traveling salesperson or repair technician with a territory covering multiple states, then the employer would need to determine how much time is worked by the employee in each state. This can be determined by ascertaining the actual time spent or by estimating a percentage of time spent in each state. Potentially, an employee could have multiple states’ taxes withheld from each paycheck, depending on the states in which he works.
There are two rules of thumb to determine for which state to withhold income taxes: 1) the place where the work is performed, 2) a reciprocal state agreement. Generally, an employer should withhold state income taxes for the state in which the services are performed. For example, if an employee works and lives in Pennsylvania, the employer would withhold Pennsylvania income taxes.
What happens if the employee works in Pennsylvania and lives in West Virginia? The employer would need to determine if Pennsylvania and West Virginia have a reciprocal agreement. A reciprocal agreement allows all of the wages earned in one state to be taxed in the employee’s resident state. This simplifies the withholding requirement for the employer and the income tax filing requirements for the employee. Many neighboring states have reciprocal agreements, and the employer must honor the agreement. If the states are reciprocal, then the employer would not withhold state income taxes for the state services that were provided, but possibly would withhold for the employee’s state of residence. If the employer has nexus in the reciprocal state, the employer would be required to withhold state income taxes from the employee. The employer may not be required to withhold for the reciprocal state if the employer does not have nexus with that state. If this is the case, the employee would need to make quarterly estimated payments to their state of residence to avoid any underpayment penalties. Just because states share a border doesn’t mean a reciprocal agreement exists—as in the case of Maryland and Delaware. Also, there are states that are far apart that have reciprocal agreements, such as Pennsylvania and Indiana. The employer should check to see if there is a filing requirement for employees asserting reciprocal state residence. In Pennsylvania, the employee would be required to file Form REV-420. The employer should check on nexus requirements, because applying for an [employer withholding account can require them to file other taxes and/or generate questions from the state. An employer has nexus in a state if it has a business connection with the state—usually through a business presence (i.e., office, store, factory, or entry in the state making a sale or performing a service call). So, if an employee works in Pennsylvania, but lives in West Virginia, the employer would withhold either West Virginia taxes or nothing. West Virginia and Pennsylvania are reciprocal states, which would rule out Pennsylvania withholding for the employee. The employer would be required to withhold West Virginia taxes if the employer had nexus with the state. If the only connection with West Virginia is the fact that an employer employs a resident of West Virginia, the employer would not withhold state taxes at all, and the employee would be required to make quarterly estimated tax payments to West Virginia.
States with reciprocal agreements do not tax residents of the other state. If an employer withholds tax from a resident of the other state, the employee would need to file an income tax return for that state showing no income, in order to request a refund of the taxes paid to the worked-in state. The full income earned would be reported to the employee’s resident state.
If the employee works in multiple states with no reciprocity, the employer would be required to withhold multiple state income taxes from the employee’s paycheck. For example: A plumbing company is based out of Rehoboth Beach, Delaware. Being based near the Delaware-Maryland boarder, the company frequently sends plumbers into Maryland. Delaware and Maryland do not have a reciprocal agreement. The employer estimates that 50% of its employees’ time worked is in Delaware and 50% in Maryland. When the employer calculates the paychecks, 50% of the wage is taxed to Delaware and the other 50% is taxed to Maryland. The employee would be required to file income tax returns and pay tax in both states. They would be able take a credit on their resident state income tax return for taxes paid to the other state.
STATE UNEMPLOYMENT TAXES
Once the correct income tax withholding has been determined, the employer needs to determine to which state it will pay unemployment tax. There are cases where the withholding does not match the unemployment taxation. The rules determining to which state unemployment taxes should be paid include these tests: where services are localized; where an employee’s base of operations is located; the location of the employee’s place of direction; or the employee’s resident state.
First, determine whether the services are localized. The employer would be subject to unemployment taxes in the state in which the employee performs services (with only incidental services in another state). If the employee works in Pennsylvania and lives in West Virginia, the employer may be withholding West Virginia income tax to honor the reciprocal agreement, but paying unemployment tax to Pennsylvania due to the fact the work is localized there.
If the services are not localized in one state, then the employer would look at the base of operations. If the employee works in more than one state, the employer would need to look at where the base of operations is for the employee. The base of operations is where the employee reports to work, receives instruction from the employer, receives mail and supplies, has an office or retains business records.
If there is no base of operations, then the employer would look at the place of direction or control. The employer would pay unemployment taxes to the state where the employee receives his place of direction or control. This would be where the employee’s manager would be if it is in one of the states where the employee performs services.
If all of the other tests are failed, then the employer pays unemployment taxes to the employee’s resident state.
If an employee is transferred from one state to another while working for the same employer with the same EIN, the employer can apply the state unemployment taxable wage base to the other state. This applies to all states except for Minnesota. For example, an employee works in Pennsylvania and makes $9,000. The employer transfers the employee to Maryland where he makes $20,000. Pennsylvania’s wage base is $8,000 and the employer pays tax on the first $8,000 the employee earns in Pennsylvania. When the employee is transferred to Maryland, the employer pays Maryland unemployment tax on the first $500 earned [in Maryland,] because Maryland’s wage base is $8,500 ($8,500 Maryland wage base - $8,000 Pennsylvania wage base).
This article reviewed the criteria for state income tax withholding either by where services are provided or to honor a reciprocal agreement. It also discussed the rules for determining to which state an employer will pay unemployment taxes by either localization, base of operation, direction and control or resident state. There are cases where no state withholding is correct and where the state for which income taxes are withheld does not match the state to which unemployment taxes are paid. The two employment taxes need to be looked at independently of each other. Keep in mind that the information in this article covers general rules for state income withholding and unemployment taxation. Please refer to the specific state for laws determining the appropriate taxation of wages.
Schneider Downs provides accounting, tax, wealth management and business advisory services through innovative thought leaders who deliver the expertise to meet the individual needs of each client. Our offices are located in Pittsburgh, PA, and Columbus, OH.
This advice is not intended or written to be used for, and it cannot be used for, the purpose of avoiding any federal tax penalties that may be imposed, or for promoting, marketing or recommending to another person, any tax related matter.