Hiring a remote worker outside a company’s home state has state tax implications. Many companies understand that they will likely have new payroll tax obligations, and that they may have established nexus that creates new income tax and/or sales tax filing obligations. A less-considered aspect of multi-state remote work is the impact on the company’s state income tax calculation – not just whether an income tax return needs to be filed, but how much more (or sometimes less) income tax the company will owe overall because of the remote worker.
Apportionment is the primary variable in calculating state income tax. States require the calculation of an apportionment percentage to determine how much of a company’s overall taxable income will be taxed in each state. States’ apportionment formulas vary but are typically based on either in-state sales divided by total sales or the average of in-state property, payroll and sales divided by the totals of these three factors. In either case, the hiring of a remote worker in a state can impact the apportionment formula and, thus, the amount of state income tax paid.
Payroll Factor in Three-Factor States
The most obvious way hiring a remote worker can impact apportionment is if the company files returns in any state using three-factor apportionment formulas, as the remote worker’s wages will impact the payroll percentage. About 15 states still use three-factor formulas, most significantly Pennsylvania (pass-through entities only), Massachusetts, Virginia, and Florida (C Corporations only). For instance, hiring an employee in Massachusetts will increase a company’s Massachusetts apportionment percentage and taxable income, but, if the company is a pass-through entity with Pennsylvania non-resident owners, it will also decrease the Pennsylvania apportionment percentage and taxable income. Additionally, there could be an impact on the sales factor, as discussed below.
Sales Factor in All States
At first, it would seem that a remote worker would not affect the apportionment sales factor, but there are two instances where this is possible.
- For a company that sells services, about 15 states still use cost-of-performance sourcing rules to determine to which state the service revenue is assigned for the sales factor. Hiring a revenue-generating remote worker in one of these states (e.g. Delaware, Florida, South Carolina) will increase the sales factor, and ultimately the taxable income, in that state. However, because of the various ways states implement cost-of-performance sourcing, there is planning that can be done to mitigate the income tax impact and maybe even to turn a negative into a positive.
- For a company that sells products, hiring a remote worker can have a beneficial impact on the company’s sales factor in states that have a throwback rule. By establishing nexus in another state via the remote worker, the company can reduce its sales factor in the state from which it ships products because sales shipped to the state where the remote worker is located no longer have to be thrown back to the ship-from state. This can be helpful for companies with warehouses in states like California, Illinois or Massachusetts, and for some pass-through entities in Pennsylvania.
The key to all of this is planning. Certainly, if you have a choice of hiring a remote worker in several different states, you would want to factor in the income tax impact of Candidate A vs. Candidate B, all else being equal. But even if you have only one candidate for hiring, or you are considering letting an existing employee move to a new state, it is much better to know in advance what impact this will have on the company’s income taxes, instead of just letting that consequence become known well after the fact.
RKL’s State and Local Tax team is available to help you analyze all the tax consequences of hiring a remote worker, so that you can make well-informed business decisions.