Issues With Multi-State Payroll Tax Withholding: What You Need To Know
So you have or are planning to hire employees who live or work out of state or work in multiple states.
These hiring situations can lead to some confusion when it comes to withholding and remitting payroll taxes. In fact, 48% of employers indicate that state-to-state withholding and reporting is either currently a major issue or a growing concern for their organization as workers become more mobile.
And this can be a major problem. Depending on the state, you’ll need to pay the tax obligations plus penalties and interest if you don’t get withholding right.
Complete Payroll Solutions is a payroll provider that works with lots of clients who have employees from all different areas. And a common question we get asked is how to determine withholding obligations when employees cross state lines.
In this article, we’ll break down the requirements so you can make sure you’re properly withholding payroll taxes, no matter where your employees are located. After reading, you’ll know how to avoid potential issues and costly fines.
Do Employers Have to Withhold State Taxes?
With each paycheck, you need to withhold and deposit payroll taxes to cover several obligations. At the federal level, these include income taxes, the employee’s and employer’s share of Social Security and Medicare taxes and FUTA.
But you may also be responsible for state withholdings, including:
- State income tax. In the vast majority of states, you’ll need to withhold state income taxes from employees’ paychecks. There are some exceptions, however. For example, there is no income tax in the following states: Alaska, Florida, Nevada, South Dakota, Texas, Washington, Wyoming. In addition, New Hampshire and Tennessee don’t tax wages.
- State unemployment benefits: In addition to FUTA, employers typically must pay taxes to fund the state’s unemployment program, or SUI. In many states, SUI is an employer-only tax. But in some states, like Alaska, New Jersey, and Pennsylvania, you’ll need to withhold SUI taxes from employees’ wages and remit them to the state.
- Temporary disability: In a handful of states, including California, Hawaii, New Jersey, New York and Rhode Island, you’ll need to withhold deductions from employees’ wages to fund the state’s temporary disability insurance (TDI) benefits program.
- Paid family and medical leave: Certain states like Massachusetts have paid family and medical leave (PFML) programs that require employers to withhold and remit PFML contributions from employees’ paychecks.
These withholdings will vary from state to state. To understand exactly what you need to withhold, the first step is determining the correct state for purposes of income tax and the ancillary taxes we just discussed.
How Do I Determine Where to Withhold My Employees’ State Income Taxes?
Income tax is the biggest and most common withholding so we’ll start with that.
As a general rule, you’ll use the state where your employee performs work to determine your withholding obligations. Wages are sourced to the state where the worker provides the service.
It may help to remember the phrase: employees are taxed on where they work, not where they live.
But that’s not always the case. Sometimes, it can be more challenging to figure out what state governs income tax withholdings for individual employees. There are certain situations that are more complicated, such as:
If the employee resides in a different state than where they work.
These workers are called dual-state employees and they typically file income taxes in both the state they reside and work in.
In some cases, there may be reciprocal agreements between states. This basically just means there is a document stating that one state will not require income tax withholding from the other state’s residents working there. Some examples are between Arizona and California or Virginia and Washington, DC. In these cases, you would only report wages to the employee’s state of residence.
Whether you have nexus in another state based on your presence or connection there.
Establishing nexus — which determines whether you’re required to withhold tax for a given state — requires more than just incidental service like going to a meeting across state lines. Generally, it arises when you have workers performing activities in the state that exceed a certain period of time. Individual states set their own thresholds. For example, in New York, it’s 14 days present in the state in a year. If you establish nexus in a state, you will be responsible for withholding income taxes in that state even if you aren’t located there.
When an employee splits their time and works in multiple states.
In these cases, when there is no reciprocal agreement, you’ll need to allocate the correct amount of the worker’s wages to each state where they work and withhold income tax accordingly.
So, for instance, if a nonresident employee performs services partly in and out of New York, the amount of wages allocable to New York would equal the compensation for the number of days worked in New York compared to the total number of days worked out of the state.
If a state has specific requirements.
For example, in Massachusetts, you must withhold income tax from all residents’ wages for services performed in or out of the state and nonresidents’ wages for services performed in Massachusetts.
What are Multi-State Withholding Requirements?
Once you’ve identified what states you need to withhold taxes for, you’ll need to follow three steps to make sure you’re compliant with the regulations.
- Step 1: Register. Each state will have its own taxing authority that you’ll need to register with for income tax withholding. Many offer the option to register online. Once you register, you’ll get an ID that you’ll use when you remit the taxes.
- Step 2: Calculate State Tax Withholding: We’ll discuss this in more detail below, but you’ll want to reference state rules to determine the withholding amount for workers. Typically, this involves referring to their tax tables or the percentage set by law.
- Step 3: Make Timely Deposits: Follow state rules for making the deposits and submitting any necessary filings that report how much you withheld. You’ll want to make sure you do this on or before the deposit due date or you risk being penalized.
Do I have to Withhold Taxes on Payments to 1099 Multi-State Workers?
While you need to withhold income, Social Security, and Medicare taxes on wages paid to an employee, you don’t generally have to on payments made to 1099 independent contractors no matter where they work. Just be sure your workers are correctly classified as independent contractors versus employees.
There is an exception to this rule, however. If you receive a backup withholding notice from the IRS, you’ll need to follow the instructions in the notice and withhold income taxes from the independent contractor at a rate of 24%. Backup withholding is required when an individual fails to provide a correct taxpayer identification number or report interest, dividend, or patronage dividend income. If you made payments to a 1099 worker that are subject to backup withholding, you’ll need to send Form 945 to the IRS to report the amount you withheld. For 2020, the form was due on February 1, 2021.
How do I Calculate State Income Tax Withholding?
Each state dictates your rates for withholdings. When it comes to income tax, the rates are based either on a tax table or a flat percentage. While most states use tables to determine withholding amounts based on an employee’s annualized income and their exemptions, some places, like Pennsylvania, tax everyone at a specific percentage.
For your state’s rules, check with your taxing authority like a Department of Revenue or Division of Taxation. The Federation of Tax Administrators has a list of each state’s tax agency’s website. You’ll want to check every year since the tax tables can change and you always want to make sure you’re working with the latest versions.
What about Unemployment and Other Ancillary Taxes?
We’ve covered withholding for state income tax but as we mentioned at the beginning, there may be other taxes you need to withhold based on the state.
Unemployment is generally an employer-only tax. But as we explained before, in Alaska, New Jersey, and Pennsylvania, employees will also be assessed a tax. In these states, you’ll need to withhold the state unemployment tax and remit it to the state.
To determine if you’ll need to withhold state unemployment tax in one of these states, you’ll first have to identify your jurisdiction for remitting state unemployment insurance taxes. Usually, you look to the state where the employee performs services. But there are some exceptions, especially when employees work in multiple states. To make the determination in these cases, you’ll need to consider four factors:
- Whether your services are localized in a state
- If your base of operations and some of the services are performed in the state
- If you exercise direction or control in the state
- If these first three factors don’t result in a determination, then the employee’s state of residence is used
An employee’s state for unemployment purposes may also dictate your responsibility for withholding other taxes for paid family and medical leave programs.
For example, Massachusetts has a state-paid family and medical leave program that requires employers to withhold the employee’s contributions for workers whose unemployment state is Massachusetts.
Whether you need to withhold state disability taxes is also tied to the state where you’re responsible for remitting unemployment taxes. So, if your employee’s unemployment state is Rhode Island, you’d also be responsible for withholding taxes for temporary disability insurance (TDI) from a worker’s paycheck. Each of the states with TDI programs have slightly different eligibility requirements, so make sure you familiarize yourself with the rules if you need to remit TDI.
Getting Multi-State Payroll Right
As you can see, multi-state payroll issues can be pretty complicated, especially when states all treat it differently. And if you make a mistake and don’t withhold correctly, you can be on the hook for costly penalties and interest as the employer.
What you really need is to avoid financial consequences by getting withholding right. Our state and federal resources page can give you a solid understanding of the laws to keep you compliant in your local area.
If you’re looking for personalized guidance on your unique situation, Complete Payroll Solutions can make it easier on you with a team of experts who know the rules and can get withholding determinations right and taxes remitted properly.