Withholding taxes: Are you compliant?

By Terry Barrett, CPA

By law, employers generally are required to withhold income taxes — federal, state and sometimes local — for their employees. While state laws vary as to how they define employers subject to withholding requirements, withholding is generally required if an entity has one or more employees performing services in the state and is deriving income from doing business in the state.

Think about that: Withholding may be required in a state if services are performed in that state. So if you have a workforce that travels, such as accountants, attorneys, contractors, engineers, salespeople, human resource personnel, to name a few, you may have withholding requirements in states other than Virginia (and your employees may be subject to income tax filing requirements in those other states). 

There is no uniformity among the states’ withholding requirements, which complicates the issue. As such, one cannot easily make reasonable generalizations in determining their withholding requirements. Fortunately, though, there are exceptions to withholding requirements, but these, too, vary by state. These exceptions include reciprocal agreements among states and state withholding thresholds.

Some states have reciprocal agreements, typically with surrounding states, in which one state agrees to not require withholding of tax for nonresidents who work in the state, provided the state of the worker’s residence provides a similar exemption from withholding for its residents. This helps address issues created by residents living in one state and working in another, but not all states have reciprocal agreements. In fact, fewer than half of the states have reciprocal agreements. Virginia has reciprocal agreements with Maryland, West Virginia, and Pennsylvania.

In addition, due to specific statutory provisions in Kentucky and the District of Columbia, no Virginia withholding on Virginia wages is currently required for residents of those jurisdictions who commute daily to a Virginia workplace — and vice versa. Virginia does not have a reciprocal agreement with North Carolina. Hence, Virginia requires Virginia tax withholding for North Carolina residents working in Virginia and North Carolina requires North Carolina tax withholding for Virginia residents working in North Carolina. That is problematic particularly for businesses located near the Virginia-North Carolina border. 

A withholding threshold is an event that triggers an employer’s withholding requirements in a state. This may be based upon the working days (or portion thereof) in a state, the payment of wages above a certain level or some combination thereof. For example, New York has a 14-day threshold for nonresident employees working in the states; Colorado requires withholding for nonresidents who perform services in the state for at least one day. California has a $1,500 threshold for wages earned within a year in the state; New Jersey a $1,000 threshold; South Carolina, $300. Other states tie the earning threshold to the income tax filing threshold. 

In addition to withholding taxes, businesses may be subject to other employment taxes such as workers’ compensation and unemployment insurance in those states.

Employers are not the only ones affected by the various state withholding requirements. Employees generally must file income tax returns in states where income taxes are withheld. This may substantially complicate their individual tax filings. Fortunately, though, to reconcile the potential for taxation by multiple states of an employee’s wages when the employees perform services in multiple states, the states generally provide a credit for residents for taxes paid to other states. 

Over the years, legislation has been introduced at the federal level that would limit a state’s ability to require withholding for nonresident workers. The “Federal Mobile Workforce State Income Tax Simplification Act of 2017,” H.R. 1393, passed the House back in the summer, and there is an identical bill on the Senate side (S. 540). The legislation prohibits a state from requiring the withholding of their state’s income tax for nonresidents who spend 30 days or less in a year in the state performing employment-related duties. There are limited exemptions from the act for athletes and entertainers, certain public officials and qualified production employees. 

H.R. 1393 clarifies what constitutes a “day” for withholding purposes, as this is one of the areas where the states differ.  Some states take the position that work performed for any portion of a day constitutes a day for which withholding is required. However, H.R. 1393 says that being present in a state for day (and thus a day for which withholding may be required) means that the employee performs a preponderance of his work in that state during the day. This means if an employee performs material duties in both a resident and nonresident state during the same day, the duties would be considered to have been performed in the nonresident state. If enacted, the legislation would be effective on January 1 of the second year following its enactment date, thereby giving states and employers time to comply with the new rules. If this legislation is not successful, odds are similar legislation will be introduced again in 2018. 

While the states do not like federal preemption of their rights, certainly this is an area where it is warranted and would be welcomed by employers and employees alike. Federal preemption with respect to withholding requirements is not new. Federal law currently restricts withholding by states for interstate motor, rail and water carriers. Only a state in which employees earn more than 50 percent of their wages can impose withholding requirements on such wages.

The disparate withholding state requirements are yet another burden on multistate businesses. There obviously are costs of compliance and noncompliance. Registering for, filing, and keeping up with the various states’ rules are time-consuming and can be costly. However, employers can be found liable by state auditors for taxes that should have been withheld from employees’ pay, and may be subject to penalties and interest. The states are actively auditing businesses for compliance with their withholding requirements.

Be aware that you may be subject to income withholding requirements in other states due to your hiring and business expansion efforts.  Before you allow an employee to work remotely from another state, or hire traveling sales people, consider the potential requirements. And of course, a topic for another day is the potential of other tax implications from having employees work in multiple states (income/franchise taxes, sales/use tax, etc.).  

Terry Barrett is a tax senior manager at Keiter. Terry focuses on state and local tax consulting, and primarily non-income tax issues, such as sales and use tax, and business license and personal property tax, in Virginia and other states.