One of the many complexities of running a business is managing employees. A main component of employee management is processing their payroll, which can be complicated. However, when having one employee working in multiple states, withholding taxes becomes even more complex. In this guide, we’ll walk through the multi-state income tax withholding policy to ensure you understand the best way to ensure employees working in multiple states are withholding taxes correctly.
General Rule for State Income Tax Withholding
The general rule for state income tax withholding varies by state, as each has its own rules and regulations. However, there are a few common principles each state shares, such as using a percentage-based method to calculate state income tax withholding, providing employers with tax tables that help employers calculate the amount to withhold from an employee’s paycheck and using employee W-4 forms to determine how much in taxes to withhold.
Exceptions to the Rule
When it comes to multi-state tax withholding, there are sometimes exceptions to the rule that can affect when taxes need to be withheld from an employee’s paycheck. Below are a few scenarios where exceptions may arise:
De Minimis Thresholds
While the de minimis tax rule often applies to customs duties, such as imported goods, sales tax and VAT on transactions, these rules can also apply to income taxes. Regarding multi-state tax withholding, de minimis thresholds are minimum levels set by tax authorities to help streamline compliance for low-value transactions or activities, such as income from interest or dividends.
Backup Withholding
Backup tax withholding often involves nonresident payments, where the payer, such as a client, must withhold a certain percentage of the payment and remit it to the proper tax authorities. This method can help ensure taxes are collected upfront to maintain compliance.
Reciprocal Agreements
When it comes to one employee working in multiple states, withholding taxes is sometimes made easier with reciprocal agreements. A reciprocal agreement is an agreement, often between two states that neighbor each other, that permits residents of one state to work in another state and be exempt from withholding taxes in the state where they work, or they may have taxes withheld from the state where they reside.
Convenience of the Employer Rule
With remote work on the rise, which was accelerated by the COVID-19 pandemic, more employees found themselves living in one state and working in another virtually, which can complicate tax withholding. Unlike states with reciprocal agreements where an employee can avoid double taxation, the convenience of the employer rule requires employees to pay income taxes in the state where they work and where they live. As the name suggests, it is more convenient for employers to calculate how much taxes to withhold.
Temporary COVID-19 Exceptions
As a result of the COVID-19 pandemic that forced workers to shelter in place, certain exceptions arose that simplified multi-state income tax withholding. While these exceptions varied on a state-by-state basis, some employees could live in one state and work in another without being subject to double taxation.
Challenges to Compliance
With employees working in multiple states, withholding taxes can become increasingly complex. Various challenges can make compliance more difficult, and understanding tax withholding for remote employees is complicated. Below are some of the top challenges employers face when it comes to having one employee working in multiple states.
Location of Employees
Of course, the top challenge of multi-state tax withholding is the location of your employees. If your business operates in one state and you have employees living in other states, you’ll be responsible for calculating tax withholding for their states.
System Limitations
Depending on your HR software, it may not be able to calculate how much taxes to withhold for each state where your employees live. Having an HR solution with limitations can make it more challenging to remain compliant with state tax regulations.
Employee Notification (HR issues)
As an employer, it’s your responsibility to inform employees of tax rules that can affect their pay. However, when having one employee working in multiple states, withholding taxes can be difficult to calculate and understand, and your HR team might not have accurate information to notify affected employees, which can result in noncompliance.
Recommendations
There are certain elements of multi-state tax withholding compliance that companies can follow. Below are some of our top recommendations.
Understand System Capabilities
Having a solid understanding of your payroll systems capabilities is essential. As you look for a payroll solution, ensure it has the capacity and functionality to calculate tax withholding for all the states where your employees reside to ensure you withhold the correct amount for each employee.
Set Realistic Expectations About Compliance
As an employer, it’s important to understand that complying with multi-state tax withholding is extremely complex and challenging. With that said, it’s important to set realistic expectations about compliance regarding the resources, time and effort required to maintain compliance with each state to ensure you allocate the necessary resources.
Start With Remote Work and Nonresident Withholding Policies
To begin the compliance process for one employee working in multiple states, start by drafting remote work and nonresident withholding policies. For example, you can limit states where you hire remote workers to simplify the payroll tax withholding process or set clear policies determining how you handle tax withholding for employees working in different states.
Incorporate ‘Self-Reporting’ into Your Policies/Procedures
It’s often recommended to require employees to self-report their work locations and residency information to ensure you have the most up-to-date information on each employee for tax withholding purposes.
Overcommunicate, Overcommunicate, Overcommunicate
Lastly, it’s essential to overcommunicate your company’s tax withholding policies and information with your staff. This means providing employees with information and resources that help them understand their tax responsibilities, as well as information on the latest tax laws or company policies that can impact multi-state income tax withholding. At Experian Employer Services, our workforce management solutions can help simplify the payroll tax withholding process to maintain compliance and boost your bottom line.
