Remote workers have become a staple of the workplace, but hiring out-of-state employees can lead to payroll tax complications. Multi-state payroll tax withholding done incorrectly can lead to penalties and interest for employers and create tax headaches for employees. Payroll remediation by experienced state and local tax advisors can alleviate these difficulties by working with the appropriate state and tax authorities to rectify past mistakes and ensure future compliance.

Key Takeaways:

• Employers are responsible for state tax withholding for remote employees and employees who reside out-of-state and commute into the state the business is located
• Misclassifying an employee as an independent contractor can result in employer liability for the employee’s taxes
• Certain states require employers to withhold state unemployment taxes which would then be paid to the state
• Additional funds must be withheld from certain state residents’ wages to fund state benefit programs like temporary disability insurance and paid family and medical leave
• Mistakes in multi-state payroll processing can be fixed through payroll remediation and working with relevant state or tax authorities

Employer Responsibilities for State Tax Withholding for Remote Employees and Independent Contractors

To remain in compliance with state and local payroll tax obligations, employers should first determine which category their remote workers fall under. Are your remote workers classified as employees or as independent contractors? This determines whether you as the employer are responsible for withholding payroll taxes. If your remote workers are independent contractors, then you are not responsible for withholding payroll taxes from their earnings, they would instead be responsible for managing their own taxes.

According to the IRS, “an individual is an independent contractor if the payer has the right to control or direct only the result of the work and not what will be done and how it will be done.” Be aware that misclassifying an employee as an independent contractor with no reasonable basis for doing so can result in stiff punishment, including being held liable for employment taxes for that worker without the ability to access relief provisions.

State Income Tax Withholding

After classifying your worker as an employee, the next step is identifying their state of residence. As an employer, you are already required to withhold state income tax from employee wages, even for nonresident workers. Take note that nine states do not have a state income tax, so it is unnecessary to withhold funds in Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington and Wyoming.

Some states, on the other hand, tax all income of their residents, including wages earned for work completed in another state. Residency definitions vary among the states, so you must consult and review relevant state laws and regulations to ensure compliance.

State Payroll Reciprocity Agreements

It’s possible for remote or out-of-state workers to be taxed twice, but this double taxation can be resolved by the taxpayer when preparing their state tax returns. The taxpayer would then be refunded for taxes withheld unnecessarily from their paycheck. This does create a slight burden on the taxpayer, which is why some states have reciprocity agreements. Reciprocal tax agreements allow residents of one state working in another to pay taxes on their income based on the laws and regulations of their resident state.

State Unemployment Tax Withholding

The State Unemployment Tax Act (SUTA) refers to a type of payroll tax states require from employers. While many states consider SUTA an employer-only tax, there are three states that require employers to withhold SUTA taxes from employee wages and remit them to the state: Alaska, New Jersey and Pennsylvania.

Additional State Deductions

Some states require additional funds to be withheld and remitted to the state for certain programs. Five states, including California, Hawaii, New Jersey, New York and Rhode Island, require employers to withhold temporary disability deductions from employee wages in order to maintain the states’ temporary disability insurance (TDI) benefits program.

Several states also have paid family and medical leave (PFML) programs. Residents of Colorado, Connecticut, Maryland, Massachusetts, New York, Oregon, Rhode Island and Washington are required to have PFML contributions deducted from their wages and paid to the proper state or tax authorities. Two states, Delaware and Wisconsin, have similar policies that will go into effect in 2025 and 2024 respectively.

How Employers Can Remedy Incorrect State Tax Withholdings

With employees across multiple states, mistakes can happen. Many companies rushed into remote work due to the COVID-19 pandemic and may only just not be realizing that paid taxes to the wrong state or withheld the incorrect amount of state taxes. While there are steep penalties for businesses who knowingly and purposefully neglected to properly withhold state taxes, there are opportunities for businesses who made an innocent mistake to remedy those incorrect payroll filings.

Hiring a third-party service provider for payroll remediation purposes can not only help your business resolve any multi-state payroll compliance issues but also ensure future compliance with payroll taxes for out-of-state employees.

Our experienced state and local tax advisors work with local, state and federal tax authorities to rectify payroll compliance issues for employers, empowering businesses to focus on achieving high-level goals. Learn more about our state and local tax services.