Out of State Employees: Tax Traps for the Unwary

Kelly Huggins, Tax Manager
August 2014

Are you considering hiring an employee to work in another state? Does the business have employees who live out of state and either work from home or commute to work within the state where the business is located? Do you send employees out of state to perform work or solicit sales?

All of these scenarios could have different tax consequences and trigger different filing requirements - it’s important to understand what the business’s obligations as an employer might be. This article will provide a general overview of items to consider with regard to state employment and income tax filing requirements for business entities having employees living and/or working in more than one state.

Employment Taxes

When an employee is hired or begins working in a new state, one of the first things to be considered is whether or not the business needs to register for income tax withholding and state unemployment compensation insurance (SUI) within the state. Most states require that employment taxes be paid and returns filed if a business has an employee working in that state. But of course there are always exceptions. Whether or not a filing requirement exists might depend on the activities being performed by the employee and the amount of time the employee is spending in the state.

A business entity must register with a state (typically the state’s Department of Revenue or a similar agency) to establish a tax account before it can either begin withholding income taxes from an employee’s wages or file employment tax returns. Therefore, as soon as an employee is hired in a new state, the entity should register for the appropriate payroll taxes. (Please note that there are specific tests to determine in which state an employer must pay SUI related to each specific employee. Those tests are not addressed in this article.)

If an employee lives in one state but commutes to the business’s work location in another state (such as a Maine resident commuting to work in New Hampshire), then the business can register in the employee’s home state to withhold that state’s income taxes from the employee’s wages. As discussed below, this is often done as a “convenience to the employee” and does not impact the business entity’s income tax filing requirements.

Income Taxes

The second area that should be considered is whether or not having employees in other states creates an income tax filing requirement for the business entity within those states. In general, the activities and duties of the employee(s) will determine whether or not an income tax filing requirement exists. This area can become especially important when dealing with businesses within service industries. There is a federal exemption from state income tax for some businesses that sell tangible personal property and whose employees perform only specified activities within a state. However, the exemption does not apply to service businesses. Even the simple act of sending employees into other states to meet with existing or prospective customers can create an income tax filing requirement within those states for service businesses.

If it is determined that your employee’s activities within a specific state do create a filing obligation, then apportionment of income and tax return filing requirements would need to be addressed. The states’ apportionment rules often differ, adding to the business’s record keeping requirements and the complexity of compliance. Also, depending on the type of business entity, there could be multiple return filings required within one state.

Even if it is determined that there is no income tax filing due, there might still be other filing requirements. Some states impose franchise or capital stock taxes which are non-income based taxes for the privilege of doing business within the state.

Other Considerations

In addition to the two main areas of focus discussed above – employment taxes and income taxes – this is a short list of additional items to keep in mind when there are business activities within multiple states:

  • Sales Taxes – are the products or services subject to sales tax within a particular state?
  • Composite Tax Filings – if the business is set-up as a pass-through entity (S corporation, partnership or limited liability company filing as a partnership), the state may permit the filing of a composite return for the owners. This could be beneficial, as it would eliminate the need for the owners to file individual income tax returns in those states.
  • Withholding for pass-through entities – in addition to composite filings, pass-through entities may be required to remit income tax withholding on behalf of their owners.

In conclusion, this is a very general overview of some things to consider if you’re thinking about hiring employees within other states or sending your current employees to perform activities within other states. Each situation is different and can result in varying tax consequences.  Having a general understanding of the various tax issues that may arise can raise awareness, promote helpful conversation between you and your tax advisor, and result in better tax compliance at the state level.

Please contact Merrill Barter, BNN’s state and local tax practice leader, or your BNN tax advisor at 1-800-244-7444 if you would like to discuss these topics further or have any questions about your specific situation.

Disclaimer of Liability: This publication is intended to provide general information to our clients and friends. It does not constitute accounting, tax, or legal advice; nor is it intended to convey a thorough treatment of the subject matter.

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Pursuant to requirements imposed by the Internal Revenue Service, any tax advice contained in this communication (including any attachment) is not intended to be used, and cannot be used, for purposes of avoiding penalties imposed under the United States Internal Revenue Code or promoting, marketing or recommending to another person any tax-related matter. Please contact us if you wish to have formal written advice on this matter.