When running a business, one of the top priorities is remaining compliant with state and federal laws and regulations — one of the top and often most complicated sets of laws centers around taxes. Businesses are responsible for paying a wide range of taxes, from sales taxes to property taxes. Employers operating across multiple state lines have even more on their plate; Experian Employer Services’ Brian Elfrink explores the complexities of multistate payroll tax withholding compliance.
Payroll taxes fund various government programs and services and can be used at the local, state or federal levels. When navigating multistate payroll tax withholding compliance, federal payroll taxes will remain the same, as these taxes are at the federal level and the same for each state. Federal payroll taxes are withheld to help fund programs like Social Security, Medicare and federal unemployment.
Multistate employers, including those with growing mobile workforces, have an especially challenging task in payroll tax compliance. Many states attempt to work together to make tax withholding compliance more manageable for employers, through tax nexuses, reciprocity agreements and nonresident tax certificates.
Tax nexus
A tax nexus is a connection shared between a state and a business that determines whether a company has a tax liability in that state. Often, a tax nexus occurs when a business has a physical presence in a state, such as employees working in that state or a physical location.
Understanding tax nexuses is important because it helps companies determine whether they’re responsible for paying certain taxes in a particular state, such as sales tax, use tax, income tax or workers’ compensation tax. Additionally, after South Dakota v. Wayfair, the Supreme Court ruled that a sales tax nexus could also be formed from e-commerce activity. If a business is generating enough revenue in a state from a large number of transactions, it might be obligated to remit sales taxes to that state.
Tax nexus varies on a state-by-state basis. For example, one state might have a threshold for the number of transactions conducted to establish a tax nexus, while another state might have a threshold based on the number of sales in their state. Additionally, others might have broader standards based on the presence of employees or property in their state.
While a tax nexus doesn’t directly affect multistate payroll tax compliance, businesses need to understand how to remain compliant when operating in multiple states.
Reciprocity agreements
Some states, typically those that border one another, have agreements in place to prevent employees working in one state and living in another from facing double tax withholding, called reciprocity agreements. Reciprocity agreements make it easier for employers to manage multistate payroll tax compliance, as employees are only required to pay income tax in their state of residence.
Reciprocity agreements help lower employee tax liabilities and make tax filing requirements easier. However, reciprocity agreements typically don’t apply to self-employed individuals, and the terms and conditions can vary on a state-by-state basis. Currently, there are 17 states and the District of Columbia with reciprocity agreements, including:
- Arizona
- District of Columbia
- Illinois
- Indiana
- Iowa
- Kentucky
- Maryland
- Michigan
- Minnesota
- Montana
- New Jersey
- North Dakota
- Ohio
- Pennsylvania
- Virginia
- West Virginia
- Wisconsin
It’s also important to note that reciprocity agreements don’t always mean that a neighboring state is part of that agreement. For example, Indiana and Missouri aren’t part of Illinois’ reciprocity agreement, but Iowa, Kentucky, Michigan and Wisconsin are. It’s important to understand the nuances of your state’s reciprocity agreement, if applicable, to ensure you remain compliant.
Nonresident tax certificates
Along with tax nexuses and reciprocity agreements, another factor that can affect multistate payroll tax withholding compliance are nonresident tax certificates. A nonresident tax certificate verifies an employee’s status as a nonresident for state tax purposes. A nonresident tax certificate is used to claim exemption from certain state or local taxes in a state where that individual doesn’t reside but works.
