4 Essentials of Multistate Taxation:
Detangling state taxation of remote workers on the move
Multistate tax is never a topic for a dinner conversation, but 2021 might prove to be different. The overwhelming majority of the U.S. states calculate tax liability for remote workers, often without regard for the location of the employee’s home. If you teleworked away from home this year, take a look at the states you visited now to avoid massive unpleasantness in April. There is still ample time to evaluate potential damages and set aside contingency funds.
Financial advisors across the U.S. have been raising red flags for months. WSJ, Forbes, and all major news outlets have already announced that doom is upon us. Their predictions are dire, explanations are scarce, and uncertainty is rampant. So why irritate readers rather than prepare us for this filing season? The main cause of confusion and panic surrounding state taxes is the absence of unified guidelines. There is no app to download (although that would be a grand idea), no research tool to use to clearly and quickly see how the combination of 2–3 states affect your particular scenario.
Why? Because state laws are not standardized. Applicable rates, filing requirements, residency tests and thresholds, reciprocity agreements are as diverse as the states themselves, often contradict each other and also change on annual basis. And while employers continue to adapt to a remote workforce, they are not equipped to assist with or even explain the consequences of multistate Form W2. There are, however, a few key factors that can help us to untangle state tax exposure and prepare for the thorniest April in tax history.
4 Essentials of Multistate Taxation for 2020
1. “Convenience” States
2. Reciprocity Agreements
3. Residency & Domicile
4. Safe Zones
1. “Convenience” states
In the wondrous year of 2020, seven (7) states rolled out what became known as Convenience of The Employer Rules:
Arkansas, Connecticut, Delaware, Massachusetts, Nebraska, New York, and Pennsylvania.
This new legislation requires teleworkers to pay tax to states where they did not work and also reserves the right of refusing to give credits for taxes paid elsewhere. How in the world does that work? -
If your position requires you to be present in your home state, let’s say Vermont, while you work for a New York employer, New York will not tax your income;
But, if your duties can be fulfilled via telework, New York can claim the right to tax your wages even if you worked from Vermont and never traveled to New York during the year.
To add insult to injury, New York will also refuse to give credits for taxes paid to Vermont. Based on local Vermont laws, no credits will be allowed for income earned within its territory...
The level of inconvenience to employees due to this law is ironically irrelevant. And the fact that many employees will be subject to double tax on wages is ignored. There is already a wide debate whether this legislation is incompatible with the U.S. Constitution, with some of the states suing their neighbors. State of New Hampshire v. Commonwealth of Massachusetts is already in the Supreme Court.
To add to overall frustration, only one state, Massachusetts, clearly expressed in which circumstances they will employ this law. If you worked in Massachusetts prior to the Covid-19 pandemic, you would owe income tax to that state even if you no longer commute there. It is now referred to as a pandemic-contingent standard. The remaining six states are still silent.
Tax Tip: Do not panic. There is a lot of controversy surrounding this legislation and the laws are vague, every tax professional is holding breath for the Supreme Court answer to New Hampshire. In the meantime, you can check what your taxes would have been if the pandemic never happened (look at 2019 tax returns) and set money aside just in case.
2. Reciprocity Agreements
Some of the northern states do not tax non-resident workers by virtue of reciprocity agreements. For instance, if you are a resident of Illinois but often work in Michigan, only Illinois will tax your wages. Agreements were designed to simplify filing requirements for individuals working in multiple states, but sadly resemble a Hunger Games movie — there are no clear or mutually exclusive alliances, and rules change annually. Personally, I enjoy using map visual created by The Balance and Tonya Moreno, CPA (“Reciprocity: States That Don’t Tax Nonresident Workers,” 2020).
Now, reciprocity does not equal “no filing requirement.” Generally, you need to file in a home and in a non-resident state, which is not a big deal. TurboTax can accommodate additional states for a mere $50. What we care about here is payroll. Continuing with the Illinois-Michigan example, if you temporarily moved to Michigan from IL to work from your lake house and notified your employer, payroll might automatically change your state taxes to Michigan and discontinue Illinois withholdings. If your move is indeed temporary, come April, you will need to file:
Non-resident tax return in Michigan and claim your payroll tax back based on reciprocity rules. A refund will take, on average, 3–6 months.
Full-year Illinois tax return, which will show tax due to be paid asap, since you were paying to a wrong state for at least part of the year.
Tax Tip: A quicker way to solve this cash-flow issue is to request a correction of Form W2 from the employer. A state tax refund will come directly via payroll within 2–3 weeks. Form W2 can be corrected even after December 31 — you cannot pay additional tax, but you can get a refund.
3. Residency vs. Domicile
While physical Residency tests are rather clear: if you spend more than N days in the state etc., you are a resident. Domicile is a true, fixed, permanent home, a place where you intend to return whenever you are absent. You can only have one domicile, but you can be domiciled in state A while also being a resident of state B.
For example, you and your immediate family moved to Colorado from California, but you still visit California, maintain a house there, have voting registration, driving license, bank accounts, etc., and/or intend to return to California in the future — congratulations, you are domiciled in California while also established residency in Colorado.
Both resident and domicile states will require tax return filings and potentially will tax the same income (wages, portfolio, etc.). To prevent double taxation, individuals can employ tax credits - offset taxes in one state by taxes already paid to another. But the maze of inconsistent rules comes into play even here. If we continue looking at California-Colorado:
California generally offers credit for taxes paid to another state if income can be sourced to that other state under California law. But no credit is allowed if the other state allows credit for income taxes paid to California. Colorado is one of these states…
Colorado, in turn, offers tax credits, but they do not apply to all income. For instance, Colorado will not allow credit for taxes imposed on income earned while in Colorado. Thus, wages earned while in Colorado will be taxed by Colorado and California.
Tax Tip: Sadly, double taxation is inevitable in some cases, but it can be minimized. Do yourself a favor and hire an accountant. It might be too complex to untangle on your own.
4. Safe Zones
Nine (9) states have no income tax on wages. This means that if you were temporarily present in these states, you would not have a filing requirement or tax liability on income earned while visiting. You might consider a permanent move to avoid state-level taxation altogether (some states will tax interest and dividends*).
Alaska, Florida, Nevada, New Hampshire*, South Dakota, Tennessee*, Texas, Washington, Wyoming
The trouble usually comes with the visits another way around as travelers from tax-free states rarely think of tax liability. If a resident of Washington temporarily works in California, income earned while in California is subject to tax there. If the employer was not notified about travel or notified too late, W2 would lack tax withholdings to cover California tax liability, and there will be tax due at the time of filing.
It should be noted that many states (California included) tax lump-sum distributions on a prorated basis, i.e., you worked 30 days in California during 2020, and your Christmas bonus of 20K covered the entire 2020 calendar year, which is 262 workdays: $20,000/262*30=$2,290 of your bonus is subject to California tax in addition to basic wages earned there. For employees with equity and incentives, things can quickly get complicated.
Tax Tip: A general rule of thumb is to look into states where you spent 10+ workdays and assess requirements while also checking your pay-stub for withholdings.
According to the October 2020 survey conducted for the American Institute of Certified Public Accountants, U.S. employees are painfully unaware of the multistate taxation issues: 47% were not aware that each state has its own tax laws related to remote working; 71% were not aware that working remotely in other states can have an impact on the amount of state taxes owed, and 54% were unaware that the number of days worked out of the state where their physical workplace is located may also impact the amount of state taxes owed.
In times of uncertainty, the best action is to educate yourself on the laws that might be applicable to you personally, review potential outcomes, and set money aside to avoid April-15-Shock. If you have any doubts, talk to a Certified Public Account. Fixing an error on a filed tax return will be a costly and lengthy affair.
Educate yourself and seek advice before you file your taxes.
This article is for informational purposes only. It should not be considered Financial or Legal Advice. Not all information will be accurate for or applicable to specific circumstances. Consult a Certified Public Accountant before making any major financial decisions.