June 26, 2014
Kessler Orlean Silver & Co., P.C.
Thanks to our computer age employees may no longer need to report to a fixed location in order to perform services for their employer. Telecommuting, a work arrangement where employees typically work out of their home, has become increasingly accepted and popular. However, this arrangement may have unexpected state tax consequences when the employer is based in a state other than where the employee lives and works.
For the employee, the issue is which state or states taxes their wages. Let’s take the example where John is a salaried employee of Elsewhere, Inc. He receives a steady paycheck and is issued a W-2. John lives in Illinois, but Elsewhere has its corporate headquarters in New York. If Elsewhere had an office in Illinois, and John reported to that office and performed his services there, it’s clear that John’s wages would be taxed in Illinois but not in New York. Does the result change if John works solely out of his Illinois home?
The answer is—maybe. Forty-one states impose a tax on personal income. Of those, 36 follow a physical presence rule. They allocate an employee’s wages for personal services based on where the services were rendered. Therefore if Elsewhere is headquartered in any of those 36 states, those states will not allocate John’s wages and his salary will be solely taxed in Illinois, the location of his physical presence.
However, at present five states do not follow the physical presence rule. Those states are New York, Pennsylvania, Delaware, New Jersey and Nebraska. In those states all wages earned from an employer based in that state are allocated to that state, unless by necessity the nonresident’s work must be performed from his or her out-of-state location. Basically, these states will tax a nonresident telecommuter’s wages if the work is performed out-of-state for the convenience of the employee. For example, if John writes computer code, and there’s no particular reason why Elsewhere needs him to do this from his home in Illinois rather than its New York office, New York will tax those wages. On the other hand, if John is a scientist and an Illinois laboratory has the equipment he needs to conduct his work, but Elsewhere cannot provide a laboratory with similar equipment in its home state of New York, then New York will not tax those wages.
In John’s case, should he be required to pay New York state income tax then he will receive a credit for those taxes on his Illinois income tax return. However, he will be required to file a New York income tax return, and it’s possible, based on the formula Illinois uses to calculate the state tax credit, that his total state tax liability will be higher than it would be if all wages were taxed in Illinois.
On the flip side, an employer who employs an out-of-state telecommuter should also consider the state tax implications. A business is generally subject to income tax in a state if it is deemed to have sufficient connection to the state such that it is fair and reasonable to impose a tax. One of the prevailing factors in determining whether or not this connection exists is whether the business has employees in the state. Almost every state which imposes a business income tax holds that employment of a telecommuter establishes the necessary connection. At present the only states which are exceptions to the general rule are Indiana, Kentucky, Maryland, Mississippi and Oklahoma. As an example, if Illco, Inc. operates a corporation in Illinois, and all of its sales and property are located in Illinois, but it employs a telecommuter living and working in Kansas, then it would be subject to Kansas income tax and would be required to file a Kansas corporate income tax return.
Illco will also have a payroll tax obligation in Kansas, since the employee is taxed in her home state. On the other hand, Elsewhere, the New York based employer with the Illinois resident telecommuter, should withhold New York taxes from the employee’s W-2 wages based on New York’s non-adherence to the physical presence test.
This is an evolving area, and if you have a telecommuting issue in a specific state you are encouraged to check on recent developments which may impact your client.
Disclaimer: This article is designed to provide information in regard to the subject matter and has been prepared with the understanding that neither the Illinois CPA Society nor the author of this article is providing accounting, tax or legal advice or is performing any legal, accounting or other professional service. If accounting, tax or legal advice or other expert assistance is required, the services of a competent professional person should be sought.