In response to the COVID-19 pandemic as well as to the ongoing staffing shortage in many parts of the country, more companies are allowing their employees to work from home. While initially concerned with the technology and communication challenges that remote work presented, companies now are realizing that remote employees residing in other states may pose increased income tax liabilities.
Having employees working remotely in different states may create “income tax nexus” with those states. “Nexus” refers to the criteria a state establishes for the frequency and nature of contact that an out-of-state company has in the state which makes it subject to the state’s tax laws and jurisdiction. Nexus can be created through physical presence, such as an office, facility, or employees in the state, as well as through economic presence (often based on the frequency or value of sales transactions with customers located in that state, as well as other more nebulous factors).
Almost all states that impose income taxes assert that a business with an in-state remote employee creates income tax nexus with that state. Thus, most states would require a business with an in-state remote employee to file and pay income taxes. This requirement has the potential to substantially increase the amount and complexity of required state tax filings for businesses with remote employees.
When the pandemic began, many states put forward temporary guidance that exempted companies from filing state income tax returns solely due to having an in-state remote employee during the COVID-19 pandemic. However, such temporary guidance has largely expired. Many state jurisdictions have ramped up their enforcement of filing requirements, often combing through payroll tax filings to detect businesses with in-state remote employees.
Where, Oh Where, To File Taxes
Upon learning that its remote employees create income tax filing obligations, a company must carefully assess where to file state income tax returns. Myriad factors come into play:
- The tax preparation and administrative costs to file a tax return may be substantially higher than any tax liability in the state, especially if the activity in the state is a one-time event or not expected to continue. However, the state tax and penalties for not filing in a state could be substantial.
- Fling a state tax return begins the statute of limitations on assessment. This means that the state can often only assess tax for three or four years after the tax return is filed. If no tax return is filed, then the state can assess tax for the year indefinitely—often long after records are not available and an adequate defense can no longer be prepared.
- If the company is generating tax losses, it must file a tax return to claim the losses in that state in order to offset future income with current losses. Many companies without tax liabilities in a state file tax returns in the state to claim tax losses to use in future profitable years.
- The company may need to file a state tax return to maintain a valid registration to transact business in that state. This is especially relevant for companies that must maintain state licenses such as those to practice law or medicine, or for contractors, liquor distribution, and consumer lending, as well as for companies that provide goods and services to state and local governments.
- Companies with a defined exit plan should understand that filing income tax returns in additional states may affect both (1) the tax on the sale of the business, and (2) the purchase price that a potential acquiror may be willing to pay. Depending on the ultimate form of the exit, an acquiror will likely quantify the tax risk from any missed state income tax filings and may consider requesting an indemnity.
- A company may be protected by Public Law 86-272 if its only connection to a state is an in-state remote employee engaged solely in sales and solicitation-related activity of tangible personal property.
- Once a company begins to file income tax returns in a state, the state may inquire why the company did not file income tax returns in earlier years. The state also may more carefully review whether the company is subject to sales and use tax in that state. To add another layer of confusion, the state tax nexus rules for sales and use tax are generally different from the rules for income tax.
- Filing state income tax returns for pass-through entities such as partnerships, limited liability corporations (LLCs) or S corporations also presents new tax challenges. The partner or shareholder in the pass-through entity may also have a filing requirement in such states, and the individual income tax ultimately owed to such states may need to be withheld and paid throughout the year.
There are many factors to consider in determining which states to file tax returns, and not all of them are tax-related. A careful prospective analysis can often provide much more value than ignoring or putting off the issue.
Steps to Take Now
Before year-end, companies with remote workers should undertake the following steps:
- Tax professionals charged with tax filings should coordinate with operations and human resources professionals to verify which employees are working remotely and in which states they reside.
- The tax department should compile a list of the tax filings that will be needed for each jurisdiction. These may include income, payroll, and sales and use tax filings for each state.
- Many states require filing a registration to pay taxes or to file tax extensions. It can be helpful to create a spreadsheet that lists tax filing requirements by state.
- Because individual state guidance can change quickly, the tax department should monitor tax requirements for each state where employees reside.
- The tax department should estimate the additional tax liability the company will incur due to these added filings. This information should be conveyed to senior management.
Your tax advisor can assist your company in developing sound tax planning strategies and finding ways to minimize tax liabilities. If you have additional questions about the tax implications of remote working arrangements, please contact us or call us at (408) 377-8700.