Payroll for Out-of-State Remote Workers: Who Withholds What?

If businesses learned anything from the recent COVID-19 pandemic, it's that remote work is here to stay. However, out-of-state employees come with considerable headaches for payroll processing. So much so that states like Massachusetts simplified payroll taxes for remote workers during COVID-19. However, those special measures ended after the governor declared the end of the "state of emergency" on June 15, 2021.

Massachusetts companies with remote workers in other states have to handle the complexities of hiring non-resident employees for the foreseeable future.

What Are Employers Responsible for Withholding?  

Employers have a mandated responsibility to withhold certain taxes and benefits from employee wages. There are payroll laws to master:

• Federal Payroll Taxes - Federal Insurance Contributions Act (FICA) for Social Security withholding and the Federal Unemployment Tax Act (FUTA) that helps fund state unemployment agencies  

• State Income Tax - rates vary state by state 

• State Unemployment Benefits - payroll tax required to fund state unemployment insurance programs

Federal laws also affect non-withholding requirements, such as:

• Fair Labor Standards Act - provides guidance on minimum wage, child labor laws, garnishments  

• Davis Bacon Act - provides prevailing wages rules that apply to public work projects over $2,000 

• Equal Pay Act - provides that men and women in the same workplace deserve equal pay for equal work

In addition, states like Massachusetts have state-specific laws that require employers to deduct contributions from an employee's paycheck. For example, there are mandatory contributions for the Paid Family and Medical Leave Act.  

Where Should You Withhold State Income Taxes?  

For employers who employ non-resident workers, the question becomes which state income taxes to withhold. The default rule is that employees are taxed in the state where they work, not their state of residence. However, when it comes to employees who live and work in different states, they may need to file income taxes in both states.

 Some states avoid employee double-taxation by using tax credits. Whether these rules apply depends on several special considerations. In addition, HR staff must bear in mind the states (nine at this time) that do not have state income tax, such as Washington State, Alaska, New Hampshire, Tennessee, Florida, Nevada, South Dakota, Texas, and Wyoming. States retain the power to tax all state residents' income even if it is earned in another state.

HR staff must research the definition of resident for each state because they vary based on each jurisdiction's state law and regulatory guidance. 

What Special Considerations Impact Withholding?  

Various considerations impact withholding, such as whether there is a:

• Nexus   

• Reciprocity Agreement 

• State-specific Requirement

What is nexus? 

State laws may require an employer to withhold state income tax from an employee's compensation even when the employee does not work in the state of residence if the employer has a business presence or conducts operations within that state. This is known as having a tax nexus.

An employer may create a tax nexus with a state by having an office, store, or factory there. A nexus also occurs when a worker makes a sales call or performs a service call in the residence state. An employee who works remotely from his state of residence may create a nexus for the business that employs him.

During the recent pandemic, many states waived the nexus rules for employees who worked remotely from home solely due to the pandemic. States may re-establish nexus rules for remote work extending beyond the declared emergency period. 

What is a reciprocity agreement? 

If an employee works in multiple states, then each state's tax laws come into play. In practical terms, that means the employer may need to withhold state income taxes for both the residence state and the work state. Most states try to avoid double taxation for employees by using reciprocity agreements.

In this context, a reciprocity agreement is an agreement between two states to make tax issues administratively easier by allowing only the state of residence to withhold income taxes. The reciprocity agreements may include allocation rules and credits for taxes paid to other states.

Only some states have reciprocity agreements. At this time, 17 states have at least one reciprocity agreement in place:

• District of Columbia 

• West Virginia 

• Arizona 

• Maryland 

• Michigan 

• Illinois 

• Indiana 

• Kentucky 

• Iowa

• Montana 

• North Dakota 

• Ohio 

• Minnesota 

• Pennsylvania 

• Wisconsin 

• Virginia 

• New Jersey 

HR staff should keep abreast of the laws of each of these states to determine for which states employees need to file exemption forms to avoid double withholding. 

State-Specific Requirements  

Individual states may have state-specific requirements regarding the withholding of state income taxes. For example, in Massachusetts, employers must withhold income tax from all a state resident's wages for services performed in or out of the state as well as non-resident's wages for services performed in Massachusetts.  

Staying Compliant Is Complicated 

Employers' HR staff need to follow and comprehend federal and state laws concerning payroll issues, as well as regulations on the municipal level. To further complicate matters, if two remote workers live in the same state, but live in different parts of the state, specific local laws may apply in each case. Withholding becomes even more complex if a remote employee does business in multiple states.

Many small and mid-size businesses do not have payroll specialists on staff. Some may consider outsourcing payroll processing to experts in the multi-state withholding rules. Bear in mind, however, that dedicated payroll processors can compute the business's payroll taxes, but the employer remains responsible for filing the taxes on time and error-free.

Alternatively, a comprehensive HR outsourcing solution becomes your HR partner by providing necessary payroll services. They will remit taxes on your behalf, and they remain partially liable for any payroll mistakes.

A comprehensive HR outsourcing partner helps businesses because it:

• Provides affordable employee benefits, 

• Contains the costs of HR administration, 

• Performs payroll tasks, and 

• Keeps abreast of compliance responsibilities.

A comprehensive HR outsourcing partner enables the in-house HR staff to devote their time and energy to helping to grow your business. Let someone else handle the complexity of out-of-state payroll so that your team can focus on what matters.