If your company has operations in more than one state, you may be faced with income tax withholding obligations for more than one state. Sometimes, you may even have to withhold income tax for more than one state from the same employee. Withholding can get even more complicated when you have employees who live in a different state than the one they work in or who perform services in more than one state.
Deciding which state’s income tax to withhold can be a confusing process. How do you determine who is a resident and whether you should follow the laws of the state of residence or the laws of the state where services are performed? Not all states answer these basic questions in the same way, and sometimes state laws conflict.
The default rule of state income tax withholding is to withhold income tax for the state in which services are performed, according to guidance from the Internal Revenue Service and the Social Security Administration. This rule can be applied in most situations where the employee lives and works in the same state (assuming it is not one of the nine states without income tax withholding: Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington, and Wyoming).
Three other withholding rules should be considered if the default rule is not clearly indicated.
- Definition of resident. The first determination is the state of residence of the employee. This is because a resident of a state is subject to the laws of that state, including its income tax laws. Furthermore, states have varying policies on withholding from residents who perform services in another state and from nonresidents who perform services within the state. To locate and apply the policies correctly, you’ll need to know which state(s) can claim the employee as a resident.
- Reciprocity. If an employee performs services in a state other than the state of residence, you must find out whether the two states have a reciprocal agreement. A reciprocal agreement allows you to withhold only for the state of residence, as opposed to the state in which services are performed. The general purpose of reciprocity is to make things administratively easier for the employee and employer. The employee will only have to file one state personal income tax return, and the employer will withhold only for the state in which the employee lives.
- Resident/nonresident taxation policies. If an employee is a resident of one state but performs services in another, and there is no reciprocal agreement, you must consider the laws of both states. The state in which the services are performed will almost always require withholding from nonresidents who come into the state to work (withholding only from the wages for services performed in that state). In general, an employer is always subject to the laws of any state in which it has an employee performing services, whether or not the employer has a facility in the state.
- The employee’s state of residence also may need to be considered even if the employee doesn’t work there. If the employer has a business connection (nexus) with the state where the employee resides, the employer is subject to the laws of that state, and may be required to withhold that state’s income tax in addition to the tax for the state in which the employee is working.
Source: Multi-State Income Taxation: For Which State Must You Withhold?, SSA/IRS Reporter, Summer 2014; https://www.socialsecurity.gov/employer/reporter/ReporterSummer14.pdf.