Remote work has never been so salient for America’s employers and employees. Since the dawn of the COVID-19 pandemic, many employers have become more flexible about permitting remote work. However, many of those same employers and employees are unaware of the burdens of state tax laws for remote workers, though some are beginning to examine how to comply with tax rules when they have remote employees in another state.

This article summarizes tax issues arising from remote work arrangements and explains the triggers for employer liability for state taxes for remote workers. Finally, this article considers several updates to the state tax regime intended to reduce the increasing cost of state tax compliance.

REMOTE WORK AND STATE TAX BACKGROUND

While remote work is no longer at its 2020 peak, it is much more common than it was in 2019. Even before the pandemic, the number of employees working remotely was already on the rise — a trend that does not seem likely to reverse itself.¹ Employees are now deliberately pursuing remote work opportunities, increasing the talent pool for many employers, especially those outside of coastal cities.² To increase competitiveness, many employers may wish to allow remote work arrangements and therefore attract workers from other states who may only infrequently come to the physical office.

The rise of remote work has had some obvious benefits, such as employers being able to recruit more global talent, employees being able to move to be near a sick parent, and employers being able to test new markets and geographies before physically expanding.³ However, employers must investigate the tax consequences of hiring a remote employee in a state where it previously had none.⁴ Hiring an employee in a new state could make an employer liable for complying with requirements such as state payroll income tax withholding, state unemployment tax withholding, state sales taxes, and state business taxes.⁵

Most states provided initial relief from tax rules for remote employees in March 2020, but these provisions have generally sunsetted.⁶ Many employers joined the remote work world while these relief provisions were in effect, so they might be surprised to find they owe state taxes for 2022, including amounts that needed to be withheld from their employees.⁷

To make matters more confusing, each state treats each type of tax differently and many states have additional taxes or variations on these taxes (for example, Florida has no personal income tax), so employers will need to invest considerable resources to determine which taxes are owed for each state, how to comply with these taxes, and how to comply with them annually.⁸

PAYROLL TAXES: ONE WORKER FOR ONE DAY

Most states require compliance with payroll taxes when a company has even a single employee performing services in the state,⁹ so remote workers almost certainly cause compliance burdens with payroll taxes.¹⁰ Payroll taxes include income tax withholding and unemployment tax withholding. States can require payroll obligations to be withheld if even a single day of work is done in the state, but some states allow for an employee to work remotely for a limited number of days without requiring withholding. Illinois, for example, allows for 30 days of remote work until withholding is required.¹¹ A silver lining is that many payroll companies are experienced at handling this issue, which reduces the burden for some employers,¹² but small to mid-sized companies may not have the same luxury.

Reciprocity agreements are a special exception to the harsh payroll tax rules and are meant to prevent double taxation. Since most states tax their residents’ income wherever it’s earned as well as all income earned by individuals in their state, a Michigan resident who works in Indiana could hypothetically find themselves owing taxes to both states. In many cases, state governments will provide tax credits for income taxes paid to other states, but these tax credits do not reduce compliance burdens; employers still must withhold for both states and employees still must file with both

states. Under reciprocity agreements, when the resident of one state earns income in another state, only the state of residence taxes that worker’s income.

REMOTE WORKERS CAN CAUSE CORPORATE NEXUS

States tax businesses in a variety of ways. Most have sales taxes and corporate income taxes, which are the most common, but there are many other types of taxes such as partnership or LLC taxes, profit taxes, or industry-specific taxes.

States would like to tax any company that sticks a toe into their state, but the United States Constitution requires a certain level of connection — or nexus — with the state before assessing business and sales taxes.¹³

The commerce clause of the U.S. Constitution provides that Congress has the power to regulate commerce among the states,¹⁴ and one consequence is that states are unable to tax in a manner that interferes or discriminates against interstate commerce. Using its authority under the commerce clause, Congress has limited state taxation several times for issues such as:

1. Prohibition on imposing an income tax on sales solicitation;¹⁵
2. Prohibition on states taxing retirement income by state of residence;¹⁶
3. Prohibition on taxes placed on activity in navigable waters.¹⁷

The U.S. Constitution’s due process clause prohibits state governments from depriving any person of property without due process of law, making states unable to levy taxes that impose undue burdens on interstate commerce.¹⁸ In the U.S. Supreme Court decision in South Dakota v. Wayfair in 2018, Justice Anthony Kennedy clarified that the commerce clause and due process standards for state taxes, while not identical, have significant parallels so the prohibition on imposing undue burdens on interstate commerce is similarly provided by the commerce clause.¹⁹

These principles were made into a framework for assessing the validity of state taxes in 1977 when the Supreme Court created a four-part test:

1. The activity has a substantial nexus with the taxing state;
2. The tax is fairly apportioned;
3. There is no discrimination against interstate commerce;
4. The tax is fairly related to services the state provides.²⁰

The most important factor is nexus and in Wayfair, the Supreme Court overturned prior precedent requiring a physical presence for a state to have a nexus. Instead, it uses an economic presence standard requiring only gross sales or sales volume in the state.

States have different levels of nexus that trigger tax, which also varies by tax type.²¹ Since the Supreme Court decision in Wayfair, most states have established a gross revenue threshold for sales taxes, such as $100,000 for Michigan²² and $500,000 for California.²³ Many also include gross sale volume thresholds as well.

For entity-level business taxes, states typically follow a formula based on some form of sales revenue, number of employees, and value of real estate. Determining liability for a single state is time consuming and expensive due to the detail described above.²⁴

Moreover, some states go even further by taxing companies that do not have employees within their boundaries. For example, some states attempt to use a “for the benefit of the employer” rule²⁵ to require payment of state tax even when an employee’s work is performed outside of the state unless such work is “for the convenience” of the employer — think consulting at a client’s plant for a few months or managing a branch that is out of state.²⁶

The most notable state using this type of rule is New York, which could experience substantially more revenue loss than other states due to remote work.²⁷ Employers and employees will still need to file taxes in the state in which the remote work is performed, but they will likely receive credits for taxes paid to New York.²⁸ But for those who do not receive credit in their home state for taxes paid in New York, the “convenience of the employer” rule is a major drawback. Compliance with nuances such as these is yet another hurdle in handling remote workers.

COMPLIANCE CONCERNS WEIGH HEAVILY

The burdens of these various state taxes may be, at present, too much to bear for small and medium-sized employers who would like to open themselves to remote work to access a larger talent pool to remain competitive.²⁹ The cost of hiring a remote employee or allowing an employee to remain with the company remotely (a massive boon in reducing turnover) currently includes the administratively arduous and costly process of contacting attorneys and accountants to discern whether there are any filing and reporting requirements for remote employees in their state; deciding whether hiring the employee creates nexus; and creating withholding, unemployment, and business tax accounts in each state by adhering to myriad processes and filing many forms, all unique to each state.³⁰ Then, once the employee is actually hired, the company will need to annually calculate how much of each tax is owed based on formulas that vary by state; file information and tax returns for each state for each type of tax; and recalculate apportionment factors to include the new states with a single employee.³¹

The weight of this costly compliance does not fall solely on employers, as states have to police an increasingly complex system and project revenue based on income that is becoming more difficult to forecast.³² Given these difficulties, California actually increased its sales tax nexus threshold to $500,000 from its initial threshold of $100,000,³³ which mirrored the $100,000 threshold in Wayfair; enforcement at the lower threshold amount was reducing revenue due to administrative policing costs.³⁴

Larger companies are less affected by these rules because they can leverage their economies of scale to have teams dedicated to handling compliance issues such as state taxes.³⁵ Small and medium-sized employers are at a comparative disadvantage.³⁶ And while larger companies might be less affected, they too are ultimately worse off just like states, employees, and small and medium-sized employers.³⁷ Moreover, larger companies are more likely to engage in corporate transactions which have substantial documentation and compliance costs with all state offices where remote workers reside. All parties to this system are spending resources to police and comply with requirements.³⁸

SOLUTIONS AND CHALLENGES

While all parties involved in remote-worker state issues are harmed by having to comply, resolving these issues is a significant challenge. In any proposed resolution, some states will benefit more than others, making reforms politically challenging to enact.³⁹

One solution is reciprocity agreements. For employees and employers, the simplicity of this solution is ideal — only one state’s tax rules would require compliance. While reciprocity agreements normally deal with employees who cross state lines for work, a new section could be added to reciprocity agreements to clarify that the first 10 remote employees are treated as working in the other state when the employer’s headquarters is in that state.

There are preconditions that must be met for reciprocity, including state-specific procedures that must be followed,⁴⁰ and some states have reciprocal thresholds after which withholding obligations begin.⁴¹ Still, increased reciprocity among states on remote workers would bring some consistency to state income tax withholding requirements.

Another solution is having every state change their nexus and income withholding rules to provide an exception for a limited number of remote workers. This cap is like a state sales tax threshold requiring a minimum amount of sales. A minimum remote-worker threshold — such as 10 employees — would provide flexibility to smaller employers while preventing states from foregoing significant potential revenue. A universal threshold also would let employers know when they are required to begin complying with state laws.

A more unlikely method of simplifying taxation of remote workers is a federal law providing for the threshold under commerce clause powers, but the viability and constitutionality of this option is not clear and certainly has not been an area of legislative priority.

The challenge with the minimum employee threshold will be convincing states to enact it, as some states will forego revenue. However, the benefit of these rules is that some higher-paid employees will stay in states that would not otherwise offer those opportunities and the states losing those employees can still retain the tax revenue. The personal benefits of moving workers from expensive coastal cities to more affordable locations close to family are clear. States will also have substantially less compliance costs.