When remote workers relocate, new payroll tax regimes might apply

When it comes to income tax for out-of-state employees, every state (and locality, even) has its own set of rules. An employee who lives and works in New York state, for example, will have his or her wages taxed based on New York state income tax withholding requirements. If that same employee moves to another state, the employer must address its payroll tax obligations in the other state (and potentially locality) and how any tax obligations might interact with or affect the employer’s obligations in the state of origin.

Some states require income tax withholding based on the employee’s assigned office location, while others base withholding requirements on where the employee has established residency or provides services to the employer. Some states require income tax withholding from the first moment services are provided within their borders, while others have a grace period. A few states have reciprocity agreements, meaning state income tax will be imposed in the state where the employee resides but not in the state of the employee’s office location (or vice versa), while many do not. In other cases, states require employers to withhold income taxes where services are performed (or based on the assigned office location), but only above the amount required to be withheld in another state.

No two situations are the same, and employers must carefully review the requirements of the states involved to ensure compliance and avoid exposure to potential penalties.

A separate analysis applies for unemployment insurance tax obligations. Even when a state income tax obligation might not apply with respect to an employee, state unemployment insurance tax could. Unemployment benefits have become more significant and employees generally cannot obtain those benefits when an employer has failed to register for payroll in a state where an employee is entitled to unemployment benefits – an important requirement before any employer payroll obligations (including unemployment insurance tax) can be met.

States often follow federal income taxation rules with respect to various forms of compensation and benefits. Certain travel expenses that meet stringent requirements under federal tax law and rules are exempt from wages for federal income and Federal Insurance Contributions Act (FICA) tax purposes (that is, reporting and related withholdings and payments). However, commuting expenses generally are not exempt from an employee’s wages and are not deductible by the employer as a result of 2017 tax reform. Thus, if an employee has moved for personal reasons to work remotely from the employee’s assigned office location, employer-paid or -provided travel expenses between the employee’s residence and office are not excludible from the employee’s wages or deductible by the employer.

In addition, after 2017 tax reform, from 2018 through 2025 employer-paid or -provided moving expenses are not excludible from wages (subject to certain exceptions for the military).

U.S. persons working abroad

U.S. persons (including U.S. citizens, green card holders, and tax residents) working abroad pose a different set of tax issues. Generally, employers continue to have payroll tax obligations (federal income and FICA wage reporting and related withholdings and payments) with respect to such individuals. Various exceptions from withholding (but not reporting) might apply – whether under statute, treaty, totalization agreement, or otherwise. But complex substantiation requirements must be satisfied for an employer to avail itself of such exceptions.

Under IRC Section 911, a significant exclusion from wage withholding for an annually indexed amount ($107,600 for 2020) applies to a U.S. citizen or green card holder providing services outside the U.S. This exclusion generally requires the employee to establish “bona fide residence” abroad and to meet a specific physical presence test of continuous time abroad (generally, at least 12 months). Prior to the service abroad, an employer is required to substantiate the employer’s income tax withholding exemption on such amounts based on the employee’s intention to satisfy Section 911. Employers could fail the substantiation requirements, however, if assignees were required to return to the United States as a result of COVID-19. Certain assignees could be eligible for specific IRS relief this year, however, so employers should check with their assignees in these circumstances to ensure continued payroll compliance.

Employers might be tempted to assume that compliance expectations will be eased because of the pandemic or that the rules will change in response to the increasing prevalence of remote work arrangements. While the IRS has provided limited relief on the international front, from the state and local standpoint these assumptions might be folly for two reasons: 

• First, state and locality resources today are stretched thin as state and local governing bodies work to contain the damage wrought by the pandemic. While fewer than a handful of states have provided limited temporary relief, over time, as the threat of COVID-19 recedes, states are expected to examine whether employers have met their tax obligations with a focus on remote workers. With budgets overwhelmed, states and localities will be hungry for resources, and significant penalties could accrue for companies that are found to have handled payroll improperly. 
• Second, it is worth noting that over the past two decades, a number of legislative proposals have come before the U.S. Congress to impose a consistent payroll standard across states for temporary services of employees within a state’s borders, but such a bill never has been passed into law. Though a version of one such proposal has resurfaced in recent months, strong opposition by certain states continues. 

As many workers likely will continue working remotely well beyond the pandemic, employers who take steps today to address the attendant obligations this new paradigm imposes can be positioned to efficiently manage their workforces and payroll compliance obligations in the months and years ahead.