Tax Implications of Hiring a Remote Employee

By Raffi Yousefian, CPA | Published on 2/23/2022

“How will hiring an employee in another state affect our income taxes?” “What accounts do I need to register when hiring an out-of-state employee?” These have been the most frequently asked questions by our clients since the rise in hiring remote workers. Hiring out-of-state remote workers has multiple benefits such as reducing overhead costs, improving team morale, increasing productivity, and attracting more qualified candidates.

States are aware of this trend; therefore, they have drastically changed their tax laws to ensure they are not missing tax revenue that can be collected from businesses benefiting from having a presence in their state. In this article, we break down the tax implications of hiring an employee outside of your home state. This is an extremely complex topic with many variables, but we will simplify it by explaining the theory, then show you some examples of the theory in practice. This article assumes you are a professional services company structured as a pass-through entity, such as S-corporation or partnership. The principles can be applied to other businesses models, but other business models will have additional variables such as inventory, digital vs non-digital goods, etc. that will not be covered in this article.

What do I need to register?

When you hire an employee in a state that you are currently not registered in, there are multiple accounts that you will need to register.

First, you may be required to register as a foreign entity (LLC (Limited Liability Company), corporation, etc.) in that state, or apply for a business or professional license. We recommend asking an attorney or checking the Secretary of State (SOS) website to determine the registration requirements for each state in question.

Second, you will need to apply for an income tax withholding account with the state’s department of taxation or revenue. This account allows you to withhold income taxes from your employee’s paycheck and remit them to that state government. This will not apply to states that don’t have personal income taxes such as Florida and Texas.

Third, you will need to apply for a state unemployment insurance (SUI) account with the state’s SUI office. This account allows you to remit the unemployment taxes on the wages paid in that state. Some states, such as DC, require employers to pay a tax that funds their state’s family leave and/or disability insurance program. Frequently, the state SUI and PFL programs are both administered by the state’s unemployment office, so you can apply for these accounts in the same place.

When registering your business with the SOS, department of taxation, or SUI office, you may be required to register for a business or franchise tax account # as well. Requiring these accounts reassures the state that they should be expecting a business income tax return from you. For example, in DC you cannot register for an income tax withholding account without first registering your business with DCRA (Department of Consumer and Regulatory Affairs) and registering for an unincorporated or corporate business franchise tax account.

We recommend using a service like Corpnet or an attorney to register your business in a new state so nothing falls through the cracks. Most payroll service providers like Gusto will request these tax account IDs when the employee’s home state address is added to the profile, but the payroll service provider does not perform the registration on your behalf.

Now that you know about the several types of accounts that need to be registered when hiring an employee in a new state, let us dive into the income tax implications for the business and its owners.

What triggers an income tax filing requirement?

For a state to be able to tax a business, the business must first file a tax return in that state declaring their taxable income attributable to that state. Having “nexus”, or a sufficient level of economic activity in a state, is the trigger that requires the company to file an income tax return in that state.

Historically, nexus was triggered by having a physical connection to a state. Physical connection means having an office, employees, fixed assets, or inventory in a state. Since the internet revolution and a massive increase in online sales and remote virtual services, physical connection has become less relevant for doing business in a particular place. Therefore, most states have adopted economic nexus standards in addition to physical presence standards.

Economic nexus standards look at a business’s economic (non-physical) connections with the taxing state’s market or customers to determine if there is a filing requirement. Every state has different economic standards; some are specific, and some are very broadly written. For example, Washington, DC requires all companies “doing business in DC” to file a DC business tax return. New York requires companies to file a business return in NY if they derive $1,138,000 or more in revenue from an activity in NY. NY further clarifies that you must file if you have at least 1,000 of the following: (1) credit cards issued to in-state customers; and/or (2) in-state locations covered by merchant customer contracts where payments were remitted for credit card transactions. As you can see, economic nexus triggers can vary drastically from state to state.

Having a physical presence in a state, such as hiring an employee, will automatically trigger a business income tax return filing in that state. If you do not have a physical presence in a state, you might have an economic presence according to that state’s tax laws that will require you to file a business income tax return. The process of determining where a business has nexus for tax purposes is called a State Nexus Tax Study. Many CPA firms offer this study as a separate service, but we have integrated it into our normal annual tax preparation process because it is vital for determining filing requirements accurately.

Here is an example of a state nexus study in action:

Agency X is an LLC (taxed as S-corporation) registered in DC, because that is where the owner lives. Its net federal taxable income for the year was $100k. The agency generates $300k in revenue from clients in DC, $300k in revenue from clients in New York, and $300k from clients in Florida. It has an employee in Pennsylvania who earns $80k/year, and an employee in Massachusetts who earns $80k/year. The owner’s salary is $100k/year. Below are the business income tax return filing requirements for Agency X in each state and why:

State	Business Income Tax Return Required	Why
DC	Yes	Physical presence (employee) and an economic presence
FL	No	Pass-through businesses are not required to file a tax return in FL
NY	No	No physical or economic presence; only sales over $1,138,000 triggers an economic presence
MA	Yes	Physical presence (employee)

 

How will I be taxed in that state?

Now that you know when a business income tax return filing is required, we will show you how it will affect your taxes. Having nexus in a state does not mean you owe income taxes to that state, it just means you have a tax return filing obligation in that state. The tax return will then calculate how much tax you owe to that state if any.

The starting point for most state business tax returns is the business’ federal taxable income. If you experience a loss for federal tax purposes, then you will [generally] not owe state taxes even if you must file a tax return in that state. If you have federal taxable income, then the state tax return will ask you to “apportion” that federal taxable income to that state. The apportionment calculation is different for each state. For example, New York apportions federal taxable income based on your revenue derived from NY as a percentage of total revenue. Massachusetts apportions federal taxable income based on your property, payroll, and sales in MA as a percentage of your total property, payroll, and sales. However, MA double-weighs the sales in the formula.

In addition, you have the concept of “nowhere” sales like we have in the example above. Nowhere sales are sales apportioned to a state where you do not have nexus or income tax. What happens with the 1/3 of the federal taxable income that will not be taxed in FL since FL does not have an income tax? Does it go untaxed? No, not really, because many states, like MA, NY, and DC have apportionment laws that require you to “throw out “ those nowhere sales from the denominator or “throw back” the nowhere sales to the numerator when calculating sales apportionment.

Let us see how Agency X will be taxed in MA assuming all the facts above:

The agency has no office or fixed assets, so the property factor is not applicable. We divide the MA employees’ wages of $80k by the total wages of $260k, to get a MA payroll factor of 31%. We divide the MA sales of $0 by the $600k ($900k minus $300k of FL “nowhere” sales) of total sales, to get a sales factor of 0%. Next, we add the property factor of 0, plus payroll factor of 31%, plus 2x the sales factor of 0%, then divide by four to get the final apportionment factor of 7.75%. This means 7.75% of the agency’s $100k in federal taxable income will be subject to MA income tax. This MA taxable income will flow through to the owner’s MA personal return and be taxed at the state’s income tax rate of 5%. The owner of Agency X will pay $388 (7.75% x $100k to get the MA portion of $7750 – then 5% of $7750) in MA income tax because they hired an employee in MA.

The calculation may seem straightforward, but there are a lot of other variables that affect the process above, such as determining how each state sources revenue when determining the sales apportionment. Some states source sales based on where the employees are performing the work for those clients, not where the clients are located. How each state sources the sales will need to be determined before allocating sales between the states for apportionment purposes.

Finally, the taxable income of pass-through entities flows through to the shareholders/partners and gets reported on their personal tax returns. Not only will the business have to file a tax return in that state, but the shareholders/partners of that business will have to file personal returns in that state as well to pay allocable state taxes (Note: some states use composite filing to have all allocable taxes paid at the entity level). However, this does not mean that the partners/shareholders will pay tax on the same income in multiple states because the home state typically allows the taxpayer to claim a credit for taxes paid to other states on income that is already being taxed in their home state. For example, the $388 tax paid to MA in the example above can be used to offset any state tax owed on business income in the owner’s home state (DC), thus ensuring the owner does not get double-taxed on the same income.

There may also be additional taxing agencies or taxing levels. Some states, like DC, do not recognize pass-through entities for out-of-state business owners, therefore the tax is paid by the business, not the partners/shareholders. This results in double taxation on business income. NYC, even though not a state, even imposes a similar entity-level type tax on businesses doing business in NYC. There are few jurisdictions that impose additional taxes like this, but it should be considered when hiring out-of-state employees.

Summing it up

The tax implications of hiring remote workers can be complicated, so we recommend that you hire a professional to determine your filing responsibilities. Most tax practitioners can streamline the nexus and apportionment process with different software research tools. It can get expensive and time-consuming to do this, but with the appropriate tax advisor, the process is well worth the benefits you get from hiring remote workers. Believe us, our entire team is working remotely, and all our professional services clients are fully virtual businesses as well!

Feel free to contact us if you want to know the tax implications of hiring a remote employee in your business.