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State Tax Implications of Employing Telecommuters Editor:
Authors:
Karen
Nakamura, CPA
Editor’s note: Ms. Rood and Ms. Nakamura are members of
the AICPA Tax Division’s State & Local Taxation Technical Resource Panel
(TRP). Mr. Peterson chairs that TRP. For more information about this
column, contact Ms. Rood at
drood@bkadvice.com, or Ms. Nakamura at
karen.m.nakamura@us.pwc.com. Although telecommuting can lower the cost of office space, reduce employees out-of-pocket expenses and decrease commuting stress, it can create significant state tax implications for both telecommuters and their employers. Despite this drawback, telecommuting and virtual offices are all the rage. Employees are taking advantage of telecommuting to save time and money. Business owners and top executives are telecommuting from their principal residence or second home, or on the road. Even consulting groups work from home when not traveling for work. More importantly, telecommuting appears to be here to stayaccording to the International Telework Association & Council, approximately 44 million U.S. workers telecommuted in 2004.1 A rising number of states support telecommuting, often as a way to alleviate congestion on roads and as an incentive for employment in rural areas, as indicated by the growing number of business credit and incentive programs offered at the state level.2 Perhaps the principal business advantage of telecommuting is that it allows businesses to hire employees from a broad geographical area, which is a key factor when skills are in short supply or creativity is at a premium.
State Tax Barriers to Telecommuting According to a 2001 General Accounting Office report, state taxes are a significant barrier to telecommuting.3 The report notes that uncertainties about the application of state laws and what constitutes interstate business are obstacles. It also suggests that telecommuting may establish a physical business presence in a state where none previously existed and (1) expose employers to additional corporate tax filing obligations, (2) expose employees to additional personal income taxes, (3) create an obligation to collect and remit taxes in states where telecommuters reside and (4) increase potential litigation over tax issues. The uncertainties involve businesses and employees alikebusinesses need to know how telecommuting affects their state tax filing requirements, and employees need to know whether they have to file individual income tax returns in multiple states and whether they are subject to double taxation when states differ in how they source wage income.4 To complicate matters, each state has its own filing thresholds and one states laws may be in direct contrast to anothers. As a result, each situation requires a separate analysis. Also, because telecommuting is evolving, businesses would be prudent to watch for developments in the applicable jurisdictions as state tax departments apply their rules to the changing nature of business.
Nexus: Overview A state cannot tax a business unless the business has nexus with the state. Nexus is generally defined as some definite link, some minimum connection, between a state and the person, property, or transaction it seeks to tax.5 The concept of minimum connection usually arises in the context of the Due Process Clause, which emphasizes fundamental fairness and notice, and does not require physical presence as a prerequisite to taxation.6 In general, a minimum connection will be achieved under a due process standard when a nondomiciliary company regularly and systematically exploits a states marketplace or purposefully directs its activities toward the state, even though it maintains no business location or property there. In contrast, the Commerce Clause requires substantial nexus, which is generally defined in terms of physical presence with a state, thereby limiting the state burden on interstate commerce. Substantial nexus is generally understood to be more than the slightest presence, but not necessarily a substantial presence. State courts differ in their interpretation of substantial nexus.7 Physical presence in a state can occur via property (e.g., inventory or assets) or people (e.g., employees or sales representatives). The presence of an employee or agent in the state may be sufficient to create withholding, sales and use, franchise (i.e., nonincome), and, in some cases, income tax nexus. However, under P.L. 86-272, a state is prohibited from imposing income taxes when a companys only activity in the state is soliciting orders for sales of tangible personal property sent outside the state for acceptance and filled from an out-of-state supply of goods. Solicitation generally includes ancillary activities that serve no independent business function apart from requesting an order for the sale of tangible personal property. P.L. 86-272s protections of solicitation will not be lost when a taxpayer performs activities that exceed the scope of the solicitation, if such activities are de minimis.8 This involves determining whether an activity creates a nontrivial additional connection with the taxing state.9 Some states have adopted a de minimis exception in their nexus rules or specifically exclude certain activities, such as participation in trade shows for a limited number of days,10 meetings with business service providers (e.g., accountants, attorneys and advertising agencies) or in-state purchasing activities.11
Personal Income Tax Withholding Requirements In general, a state can tax the income that a nonresident individual earns in the state or that is attributable to in-state sources. All income earned by a resident individual is taxable in his or her state of residence; resident states generally allow an income tax credit for income subject to tax in another jurisdiction, if certain criteria are met. In general, states look to an individuals physical location in determining whether income is earned in the state;12 however, other criteria may apply, such as New Yorks convenience of the employer test.13 This test generally provides that when a nonresident individual works for a New York employer, the nonresidents wage income will be attributed to New York unless the performance of services (out of necessity, not convenience) obligates the employee to out-of-state duties in the services of the employer.14 In general, states require nonresident individuals to file income tax returns when they exceed a threshold level of activity or income in the state.15 Accordingly, nonresidents may find that they are not subject to an income tax return filing requirement in certain nonresident states where they work, despite the fact that their employer withholds wages on income earned in that state as a result of its nexus with the taxing state. Consequently, individuals may need to file nonresident returns to claim a refund of income taxes withheld and remitted to the state in excess of any amount ultimately owed. Different standards: States may assert that an employer is subject to a withholding requirement merely by establishing a minimum connection in the taxing state under a Due Process Clause standard. However, states may apply a higher standard before requiring withholding.16 Under a due process standard, an employer will be required to withhold income tax on wages paid to an employee working in the state to the extent such efforts further the employers market presence in the state (such as through the in-state solicitation of sales). Some states do not require an employer to withhold tax until the wages paid exceed a threshold17 or the employees in-state presence exceeds a minimum number of days.18 States may be limited in their ability to impose an income tax withholding requirement on an employer when the employees activities do not further the employers ability to exploit the in-state marketplace. In general, employers must detail state-specific income tax withholding information on Forms W-2 issued to employees. Accordingly, when a resident employee works in his or her home state for a portion of the week and the remaining days at his or her employers corporate headquarters in another state, the employer must issue state-specific W-2s that detail the proper allocation of income among the states. Proper withholding becomes more challenging when an employee travels extensively. Accordingly, employers need to have systems in place to allow them to determine the level of taxable wages earned in a specific state by each employee. Such systems may include an electronic time-reporting system that requires an employee to disclose the location where he or she works each day. Employers subject to a withholding requirement must register with the respective state taxing agency and timely remit taxes withheld. Such registration may generate nexus questionnaires for other types of taxes (e.g., sales and use, income and franchise). Accordingly, employers should be aware of their obligations for all types of taxes when they register with any state agency.
Sales and Use Tax A telecommuters presence in a state may create the requisite physical presence necessary for his or her employer to be subject to sales and use tax collection and remittance obligations, regardless of whether the telecommuter is performing a sales solicitation activity. Illinois: According to the Illinois Department of Revenue (DOR), an out-of-state business is subject to a use tax collection obligation when it hires a webmaster/software developer who resides in the state.19 The taxpayer argued that because its employees activities could be conducted anywhere and it did not require the employee to live in Illinois, the state could not impose a use tax collection obligation. The taxpayer also argued that court cases that created a physical presence requirement did not anticipate telecommuting; as a result, the physical presence standard should not apply to telecommuting. The DOR rejected these arguments. California: The California State Board of Equalization took a different view of a similar business operation in a ruling.20 It stated that it would not regard an out-of-state web-based retailer as doing business in the state when the retailer does not engage in business in California and hires a website designer who telecommutes from his home there. Under the rulings facts, the designer would be responsible for improving the quality of communication on the companys websites, as well as for graphics, information and interface design, usability testing and evaluation, documentation, special projects, teaching, consultation and quality assurance. The designer would not have any contact or involvement with the retailers customers and would not actually be involved with orders they placed. The ruling held that when the only business activities conducted at the designers home were telecommuting activities included in his job description and no portion of the home is held out as a business location of the out-of-state company (i.e., placing a sign out front or holding classes at the home), the out-of-state retailer would not be regarded as engaged in business in California for sales and use tax purposes. Tennessee: A similar view was taken by the Tennessee DOR when it found that a corporate officer working from his home in the state did not create a taxable presence for his employer when the corporation did not provide an office and the corporate officer did not direct business activities in the state.21 The DOR held that imposing Tennessee franchise and excise tax on the corporation would violate both the Due Process and Commerce Clauses, because the corporation did not purposefully direct its business activities at Tennessees economic market and did not avail itself of the states benefits or protections. Other concerns: Although the economic burden of sales and use taxes generally falls on the ultimate user, collecting and remitting sales and use tax is a time-consuming process for the vendor. In addition, failure to comply with sales and use tax laws can lead to unintended (but significant) liabilities when a state agency holds the vendor responsible for unremitted taxes, penalties and interest. As a result, businesses should be very cautious in complying with all applicable sales and use tax laws. In general, tangible personal property is taxed based on where the product is delivered and/or put into use. In contrast, service transactions are taxed using a variety of criteria. Given the potential for increased sales and use tax nexus as a result of telecommuters in the state, a business needs to ensure that it clearly understands not only the nexus rules in the states in which it employs telecommuters, but also the application of sales and use taxes to services performed in the state or sold to in-state customers.
Income and Franchise Taxes In general, a telecommuters in-state activities will determine whether an employer is subject to corporate income taxes there. If the employees activities are limited to the protected solicitation under P.L. 86-272, an employer should not be required to file net income tax returns. As noted above, however, activities protected by P.L. 86-272 are quite limited. The Multistate Tax Commission has issued a policy statement22 identifying protected (no nexus) and unprotected (nexus) activities performed by sales representatives. Several states have adopted the policy statement as their nexus standard, and certain other states follow it in practice. Some of the activities that telecommuters selling tangible personal property may perform which create nexus, according to the policy statement, include:
Unfortunately, many businesses employ telecommuters to sell or provide services in conjunction with the sale of tangible personal property. As a result, they are not protected by P.L. 86-272 and should file income tax returns. Compliance costs aside, in a perfect world (one in which all states tie to Federal taxable income and adopt the same allocation and apportionment methods), a businesss net income tax burden may not increase by having to file in another state. However, given the (1) increased disallowance of deductions for intercompany expenses, (2) conflict between state consolidated return and combined reporting rules, (3) reality that state apportionment rules may not conform to the standard three-factor method, (4) conflicting application of throwback and throwout rules and (5) move toward single-factor formulas, taxpayers may see a significant increase in their income tax burden when a telecommuter creates corporate income tax nexus in a state. Further, failure to understand the nexus rules clearly may create unwelcome surprises when a business discovers its filing obligation after the fact (i.e., when, in addition to owing taxes, penalties and interest that can be assessed on nonfilers for many years absent a statute of limitations (SOL), a taxpayer is barred from claiming a refund as a result of the tolling of the SOL in its home state).
Unemployment Insurance States have adopted the following uniform order of priority in determining when an individual engaged in interstate employment is employed for purposes of remitting state unemployment insurance payments.23 Services localized in a single state: Employment includes an individuals entire service, performed in or both in and out of the state if the service is localized in the state. A service is localized in a state if (1) it is performed entirely in such state or (2) performed in and out of such state, but the service performed out of such state is incidental to the individuals service in the state. For example, it is temporary or transitory in nature or consists of isolated transactions. Services not localized in a single state: Employment includes an individuals entire service performed in or both in and out of the state if the service is not localized in any state but some of the service is performed in such state, and (1) the individuals base of operations is in such state; or (2) if there is no base of operations, then the place from which such service is directed or controlled is in such state; or (3) the individuals base of operations or place from which such service is directed or controlled is not in any state in which some part of the service is performed, but the individuals residence is in such state. The above definition covers the entire services of a multistate worker in one state onlythe state in which he or she would most likely look for a job when becoming unemployed. Under this definition of the localization of employment, a traveling salesperson living in Wisconsin and working for a firm headquartered in Illinois, for example, would be covered in Wisconsin (with Wisconsin as the site of the localization of services) if the work (or most of it) was done there and if any work done outside the state was incidental and temporary. If no state could be deemed the site for the localization of services, the entire service could still be covered in one stateIllinois, where the services were directed, if some of the work was done there, or in Wisconsin as the salespersons place of residence, if some work was done in that state and some of it was done in neighboring states while the salesperson was traveling. Most of the states subscribe to the Interstate Reciprocal Coverage Arrangement, under which services performed by employees in more than one state for an employer are deemed to be performed entirely in one of the states where the employee performs services. If an employee files for unemployment benefits, he or she would do so at the local office, which would work with the state that collected the unemployment taxes.
Telecommuter Tax Fairness Act Primarily in response to the perceived unfairness of the New York convenience/necessity test, separate versions of The Telecommuter Tax Fairness Act of 2004 were introduced in both the House and Senate during the 108th Congress.24 The bills would have prevented the double taxation of telecommuters and others who work at home, and allowed a state to treat a nonresident as working in that state only to the extent the employee is physically present in the state. In addition, the bills would have prevented states from treating a nonresident as physically present in a state based on the fact that the employee was working from home for his or her own convenience. The bills sponsors and co-sponsors, all from Connecticut, stated that the bills would have:
The bills were not acted by the end of the 108th Congressional Session; however, reintroduction in the 109th Congress may be possible.
Conclusion Telecommuting is on the rise due to the advances in computer technology and telecommunications during the past 10 years and the many tangible and intangible benefits that it provides to both businesses and employees. As the trend to hire telecommuters becomes more and more prominent and telecommuting options continue to grow, in-house tax directors and business advisers need to ask more detailed questions about the types of activities that management and employees conduct in the various states. It is not uncommon for business owners or top executives, especially those who work in dense urban areas, to spend time working from home or remote locations. Key decisionmakers are spending more time telecommunicating than at the office. Similarly, business meetings may even be held at remote locations via teleconferencing. If significant business decisions are made outside the home office, a state could argue that such decisions create nexus. From a state tax perspective, the principal consequences include personal income tax withholding obligations; sales and use tax collection and remittance obligations; corporate franchise and income tax obligations; and other miscellaneous tax and filing obligations, including local taxes and unemployment insurance filing obligations. Understanding state and local tax and filing obligations before starting to do business in a state will avoid problems later and allow proper planning at the start. |
