Yet Another Hazard to Avoid: Unexpected State Taxes
As appeared in Financial Advisor Magazine.
While the year 2020 will be remembered primarily for the Covid-19 pandemic, social and racial injustices, and political division, it also will be remembered for its historic economic swings. The year has seen record unemployment, unparalleled market drawdowns, and a sudden end to the longest bull market in history. And yet it also has seen a dramatic, albeit uneven, economic rebound, fueled mainly by unprecedented financial and monetary stimuli provided by the federal government.
But while the federal government has shown its ability and resolve to stimulate a damaged economy, state governments have had a substantially different experience. Hit hard by the turmoil, their economies have proved to be more fragile, with their resources strained to dangerous levels. In turn, some states ultimately may find themselves pressured to take aggressive tax positions as they apply their old laws to an entirely new set of circumstances. Taxpayers beware.
States with income taxes generally tax their legal residents on all income, including from sources outside the state. To mitigate double taxation, residents are entitled to limited tax credits from their home state if they must also pay taxes to another.
State-level estate and inheritance taxes are also focused on residents. Those states that impose these transfer taxes generally do so only on people who die while they’re legal residents. Many states impose tests and presumptions relating to time spent within their borders to determine whether people are legal residents.
Under this residence-based system, people who spend substantial amounts of time in more than one state often plan carefully to ensure that they qualify as a resident of the one they prefer and not others. But the pandemic has changed living arrangements too. People are now spending unusual amounts of time away from their chosen states of residence because the infection rates might be different elsewhere, because they’re working in different places, or because they need to care for other people like family members. So they might find themselves inadvertently treated as a resident of another state, subjecting themselves to taxation in the new state if they are not careful about the time they are spending there.
This is not a theoretical issue. It’s real, requiring specific attention to the pronouncements of any states that may be involved. Maine, for example, has already said that someone living in a second home there for more than 183 days during the tax year would be considered a statutory resident, even during the pandemic.
The pandemic is also having unexpected consequences for many employees now working from home. For state income tax purposes, an employee’s earned income is generally taxable under rules that source the income to the states in which they work. That doesn’t change anything for those people who live and work in the same state. But others may be working from home now after commuting to a different state in the past.
There is also the related issue of employers’ withholdings on wages. In general, businesses must withhold state taxes on wages paid to employees working within that state. But a remote workforce presents an entirely new challenge for businesses trying to understand their withholding obligations.
What does this mean? Again, the answer depends on the positions taken by the various states—and those positions are not always consistent. Massachusetts, for example, has said non-residents who once worked and paid taxes there must still pay taxes even though a declared state of emergency has them working elsewhere. Seem aggressive? New Hampshire thinks so, as it recently announced plans to sue Massachusetts in the Supreme Court to protect its residents who are now working at home and no longer across the border to the south. Here’s what New Hampshire Governor Chris Sununu had to say: “Massachusetts cannot balance its budget on the backs of our citizens, punish our workers for making the decision to work from home and keep themselves and their families and those around them safe.”
If you’re starting to get concerned, it may get worse as we address the possible implications to businesses. Companies must consider the potential for myriad new state-tax consequences attributable to their remote workforces. First, they now may be subject to taxation by those other states where they have employees working from home. Some states could ultimately conclude that they can use their full taxing powers on a company with even the temporary presence of an employee or two within its borders—whether or not there’s a pandemic. Kentucky, for example, has not offered much comfort on the topic, vaguely indicating it will continue reviewing each company’s circumstances case by case.
Many states, however, have taken at least a somewhat more comforting approach—for now. California has said that one single employee of a company teleworking in the state during the governor’s stay-at-home order doesn’t mean the company has built a tax nexus there.
As for companies that, in fact, are subject to multi-state taxation, another issue is how income is “apportioned” among the states in which they are taxable. Many states use a “payroll factor” to determine how much of a multi-state company’s income should be subject to taxation in each place. This factor typically involves analyzing the percentage of a company’s total payroll attributable to employees working in each state. With employees potentially working in different places because of the pandemic, businesses must be wary of how the states might apply the payroll factor.
The apportionment issues become even more complex when states look at property or sales factors. The former measures the percentage of a company’s property in the various states in which it is taxable. Depending on how the states apply their rules, remote workers permitted to bring company computers and other property home may very well be triggering state-tax consequences for their employers.
The sales factor requires calculating the percentage of a company’s total sales attributable to different states. Some states take the position that sales should be apportioned based on where any underlying services are performed, and that again calls into question the implications of employees performing services in different states.
The events of the past year have everyone watching the federal government very carefully, and rightly so. But the states’ responses must also be considered. Their reactions to the pandemic could have far-reaching and highly impactful tax consequences, especially to the unwary.