Making the best choices for your business might mean hiring someone who lives in another state, accommodating a staff member who wants to move, or moving an employee across state lines to expand your customer base. For each out-of-state employee on your payroll, you’ll need to do some legwork to stay compliant with the applicable tax and employment agencies. The guide below can help get you started.
1. W-2 Employees vs. Independent Contractors
This article focuses on remote workers who qualify as W-2 employees, not independent contractors, but it’s an essential distinction to make right away. The IRS typically treats workers as independent contractors if they control how, when and where the work gets done, and if the employer only directs the desired outcome of the work. Otherwise, they’re a W-2 employee.
Note that this isn’t a cut-and-dry definition, and remote work can create gray areas. But the answer will determine if your business withholds state income taxes and pays Social Security, Medicare and unemployment tax. Businesses are not typically required to withhold or pay taxes on wages to independent contractors, but must do so for W-2 employees.
The IRS’s Independent Contractor or Employee page outlines 3 broad categories—behavioral control, financial control, and type of relationship—to help you choose the correct worker classification. Additionally, state laws can impact how you classify and pay your workers. California’s Assembly Bill 5 (AB5), for instance, makes it more difficult for businesses to classify workers as independent contractors.
2. Work State vs. Resident State for Remote Workers
Once you’re sure that your remote worker qualifies as a W-2 employee, it’s time to determine where your remote employee works and where they live. A remote employee might reside in one state and travel to work in another, but you will typically need to withhold and report taxes in the state where your remote employee works. If your company is based in Washington and has a remote employee who works in California and lives in Nevada, for example, you would withhold the employee’s income tax and pay state unemployment tax in California.
You can base your tax withholding on your employee’s self-reported work location if their answer is reasonable. However, there are a few possible exceptions to consider, including reciprocal agreements between states and de minimis or exemption rules.
Reciprocal agreements are between 2 neighboring states that permit residents of one state to ask for exemption from tax withholding in the other (reciprocal) state. Reciprocal agreements prevent workers from filing multiple state tax returns. If your employee’s work state and resident state have a reciprocal agreement, you will withhold and report taxes only in their resident state.
However, reciprocity is not an automatic concept. Employees must request that you withhold taxes in their home state rather than their work state. When your employee provides you with their state tax exemption form, stop withholding taxes for their work state and begin withholding taxes for their home state. Keep these state tax exemption certificates on file in your business records in case your employee’s work state audits your business.
De Minimis or Exemption Rules
If your in-state employee is working in another state on a very limited basis, they might not be subject to the other state's income taxes. De minimis or exemption rules define a threshold (such as a maximum number of days spent working in the state or dollar amount of earned income) which, when exceeded, requires an employer to begin withholding state taxes.
Most employees working in a state remotely exceed de minimis thresholds, and laws can vary widely from one jurisdiction to the next. Contacting the state tax department in your employee’s work location for state-specific guidance is therefore essential.
3. Seeking Professional Guidance
Managing payroll for employees working and living elsewhere may be the most complex aspect of building a remote team. Fortunately, there are professional services that can help.
Payroll providers can help your company comply with payroll tax laws and file withholding tax returns. Automating your payroll process also helps you pay the correct amount of taxes and avoid missing important due dates. Most payroll providers will ask you to register with the Department of Labor and obtain your employment tax ID so that they can withhold and remit taxes as your representative.
CPAs or Tax Professionals
Having an employee regularly working in a state is often enough to trigger “physical presence” nexus rules—though guidelines can vary from state to state. Nexus is when your business has a strong enough connection with another state to be liable for their income and sales taxes.
Visiting the Department of Revenue website in your employee’s work state can yield some answers—but whether or not your business has nexus is likely a complex question, and could include the need to register as a foreign business and appoint a registered agent in the state where your remote employee works. Meeting with your tax professional or CPA can help you understand and stay on top of your registration and tax obligations.
4. Local Labor Laws
It’s also important to learn about local labor laws in the jurisdiction where your remote employee works, such as minimum wage requirements and mandatory breaks. The Department of Labor’s Employer Guide is an excellent resource on this topic.
The state where your remote employee works will likely require you to register for unemployment insurance through the state unemployment insurance program. Failing to do so could expose your business to penalties and fees for non-compliance with the state’s unemployment insurance laws.
Almost every state requires employers to have Workers’ Compensation insurance, which protects your employee in the event of job-related injury or illness. You can sign up through either a commercial provider or your state’s workers' compensation insurance program. To learn more, reach out to the workers’ compensation official in the state where your employee will be on the job.