This article originally appeared June 30, 2020 in Accounting Today.
New York City; Philadelphia; Portland; St. Louis; Washington, D.C — these are just a few of the dozens of major U.S. metropolitan areas situated on the borders of two or more states. Therefore, it should not be surprising to learn that nearly 4 percent of workers live and work in different states, according to U.S. census data.
As state and local tax experts know well, state borders may not segregate minor differences in laws or cultures. State and local income and sales tax laws that govern how, and at what rate, businesses and consumers are taxed can vary significantly from state to state, even those that border each other.
Accountants who work in state and local taxes, otherwise known as “SALT,” typically ensure their clients or businesses fulfill their respective obligations and are not overpaying taxes. Often, tax planning strategies are created to reduce their client’s or business’s tax burden to the absolute minimum. But when employees suddenly empty their offices and set up offices at home, as they have due to COVID-19 concerns, a wrench can be thrown into that tax planning.
Employee movement may impact tax planning because states tax companies when the company has a taxable nexus, or a minimum amount of business activity (created in most states by either a physical presence or by reaching the more nebulous “economic presence” standard) in that state. Newly remote employees who live in a different state than their employer’s business operations may, in some cases, create a new state income tax nexus and new tax worries for the business.
For these new SALT issues happening in the middle of a tax year, businesses have two choices. They can evaluate everything at tax filing time — and potentially incur penalties as well as potentially overpay tax. Or they can take stock of their new remote employees and the new SALT laws they trigger now and plan ways to minimize their tax burden. As a long-time SALT consultant, I sincerely hope you choose the latter.
Planning, of course, begins with understanding. Business leaders and accountants should understand these three significant SALT issues, if they're expecting an increase of remote employees working in new state or local tax jurisdictions this year.
1. Remote employees may create taxable nexus in a new state or local jurisdiction
This may be a difficult issue because COVID-19 remote employees may only be temporary. It may not be fair for businesses to follow all new tax laws when their employees may soon be back in their offices when businesses re-open. On the other hand, it may not be fair to not file new state and local tax returns if the new remote employees like working from home and do not want to go back to their office for the rest of the year or longer. When should a business start filing new returns? Or do they ever have to? Does anyone know when remote employees will be going back to their old offices?
To answer this issue, nexus laws governing income and sales taxes have to be evaluated. To have taxable nexus in a jurisdiction means your business has sufficient business activity there to be subject to that state’s state and local tax laws. In the not too distant past, nexus generally existed if a business had a physical presence there. However, as business processes changed, state laws began to establish nexus based on a minimum level of business activity in a state, despite not having a physical presence. Ever since the June 2018 decision by the United States Supreme Court in South Dakota v. Wayfair Inc. — a case which focused on sales taxes, but the result of which is having ramifications for income taxes as well — states are more confidently collecting income taxes from businesses that are deemed to have an economic presence or economic nexus in their state. To establish an economic presence or economic nexus, a business need not have a physical presence in the state. It need only exceed a certain level of business sales to create sales tax nexus— the amount of which can range up to $500,000, depending on the state. Laws vary from state to state, instead of lawmakers trying to establish some form of uniformity across the county.
Despite the popularity of economic nexus, the concept of physical nexus is still very much alive, for both income and sales taxes. This is causing some business to worry that some newly remote employees who live — and now work — in a different state than the business may create income tax or sales tax nexus for that business in that state. Indeed, there is sufficient legal precedent for states to deem the presence of teleworkers within their boundaries sufficient to constitute taxable nexus.
The good news is several states have already declared that businesses with employees forced to work from home because of COVID-19 shelter-in-place orders will have the potential creation of income tax nexus waived. However, most states have yet to release any guidance regarding income tax nexus issues resulting from COVID-19. And with potential budget shortfalls in the offing, it will be hard to predict what positions on nexus states will establish related to COVID-19 remote employees. Accountants, and business leaders with remote workers in new states, will need to keep a close eye on developments in this area of law to ensure the success of financial planning efforts and to avoid any surprises around tax time.
This phenomenon around nexus and many of the same considerations also apply to city taxes, such as San Francisco’s payroll tax and gross receipt taxes. In the San Francisco Bay Area, many tech workers employed at large, suburban campuses in Mountain View or Cupertino actually live in San Francisco. Will these remote employees work from home long enough to subject their businesses to San Francisco’s payroll taxes and gross receipts taxes? With Philadelphia being the only major city to release guidance related to its city-level taxes so far, business and finance leaders also will need to keep an eye on local developments in their region to ensure they are meeting all of their SALT obligations and not incur penalties for failure to file and pay.
2. Corporate income tax apportionment for multistate taxpayers may be affected
If your business, or your client’s business, has taxable nexus in multiple states, it can be hard to know exactly how much business income is related or traceable to your business’s activities in specific states. That is why states have tried to formalize their rules to determine what percentage of the company’s overall profits are subject to income tax in their state. These rules and the process used by companies with nexus in multiple states is commonly referred to as the apportionment of taxable income.
State apportionment formulas are typically focusing more and more on what is commonly called a sales factor, which makes a business’s state income tax simply a function of the share of the company’s overall sales into that state. However, some states (approximately one-third) still include a payroll factor and a property factor in their formulas. In these jurisdictions, the state where the employee’s services are performed and the value of the property where those services are performed become significant factors in determining what portion of the business’s profits get taxed in a particular state.
The increase of remote employees who have previously worked in an office in a different state may have a material impact on apportionment calculations. Compensation to remote employees may now be paid in the state where they work remotely, rather than the state that houses the office they used to work in. And the property employees uses to perform their jobs might now be sourced to the state where they work, as well to impact a business’s tax liabilities paid.
As an example: Say your company has offices in Maryland — where a large majority of your employees work — and Virginia. Your office shuts down due to COVID-19 and everyone works remotely from their home. You do your homework and find out that your Maryland income tax is not impacted very much, because Maryland’s apportionment law is primarily focused on your sales and not very much on your in-state payroll. However, you discover many of your employees are now working from their Virginia homes. This now increases your Virginia liability, because Virginia apportionment law has a payroll factor in their three-factor apportionment formula. You are disappointed to find out your combined taxes for Maryland and Virginia went up just because more of your employees are now working in Virginia instead of Maryland. You did not know the increase in Virginia tax was not offset by an equal decrease in Maryland tax, because their apportionment rules are different.
The Maryland and Virginia result may not actually happen in all states, though, because several states, including Maryland, but not yet Virginia, have stated temporary work from home arrangements will not affect apportionment. Thus, SALT accountants and business leaders whose companies had to establish work from home arrangements this year will need to be aware of this issue and watch closely as more guidance is released.
3. A physical presence nexus for sales and use taxes may or may not be established
After the Wayfair decision in 2018, sellers began to worry about what particular actions will mean their business has an economic nexus in a given state. So, it is a bit amusing to see the attention suddenly return to whether a business has a physical presence in a state — in this case, a physical presence caused by a rise in the number of telecommuting workers.
Big businesses have less to worry about here: They already sell enough in most states to have economic nexus there. But smaller sellers, who have lacked both an economic nexus and a physical presence nexus in most states, may encounter new sales tax obligations if employees are or were working from home in a different state than before the COVID-19 precautions. Unlike the economic nexus threshold, which deems only businesses with a certain sales volume or number of transactions in that state to have a substantial nexus, the physical presence standard has no such threshold; a single employee can be sufficient to create a nexus in a state. The physical presence of remote employees could thus create significant new accounting and administrative burdens for small sellers to ensure they are collecting sales and use taxes properly.
Unlike income tax issues, sales tax nexus is a bigger financial issue because a seller may be making sales every day in the new state. If the seller does not collect sales tax on sales in the new states, and it is determined the seller should have collected it, the tax will come out of the seller’s pocket because the buyer likely cannot be contacted. On the other hand, if sellers do not want to take any chances and immediately registers to start collecting tax, they have just increased their collection and filing obligations by an additional state. If the state subsequently rules it will not take into consideration the temporary presence of COVID-19 remote employees for sales tax nexus consideration, it may not be very easy for the seller to withdraw its registration with the new state and stop collecting tax.
As another concrete example, a business headquartered in Nevada does not have to collect state or local sales tax on sales made to California individuals or businesses, if its sales of tangible personal property in the state are under the $500,000-a-year threshold and it has no physical presence there. However, if that business now has an employee working remotely from their home in California, going off of current laws, that employee’s presence would now constitute a physical presence and hence taxable nexus for the business.
Like many of the other SALT issues discussed here, we are still waiting on guidance from most state tax agencies whether they will consider a temporary physical presence in their state due to COVID-19 precautions to constitute nexus. Many states have issued some kind of waiver or relief; we are still waiting to hear from others. Accountants and business leaders should be aware that employees working from home across state lines due to COVID-19 precautions could affect sales and use tax collection obligations. As always, consult an experienced SALT accountant for in-depth advice and domain-specific expertise.
Plan now to minimize your business’s tax burden.
I know all of this is a lot to think about to avoid getting surprised in the future, and to make matters worse, a good deal of uncertainty still exists, making it difficult to take decisive action now. But waiting until tax time to settle everything is likely the worst approach to dealing with these issues.
Many businesses had their cash flow affected by decreases in revenue due to a variety of COVID-related factors. Having extra income taxes or penalties to pay at the end of the year could easily affect the financial health of your business. Moreover, analyzing your comprehensive, post-COVID-19 SALT position now could present you with opportunities to minimize taxation, freeing up additional funds to invest in your business.
Ultimately, between the country’s ad hoc approach to coronavirus relief and states desperate to make up for 2020 income shortfalls, your business may face unanticipated tax-related expenses this year. But with proper planning, the effects of these and any other SALT issues arising from COVID-19 on your business can be minimized.