Remote Legal Staff – Understanding the State and Local Tax Consequences of Remote Work
State and Local Tax Team
6.16.22 | Practice Made Perfect
One of the many effects of the pandemic on law firms and other professional services firms is the evolution of remote working from an alternative arrangement into a mainstream business practice. As many firms look to implement either a hybrid or fully remote working policy, it is essential for them to understand their potentially expanding multistate tax compliance footprint. This is a major concern if the remote employee is working in a state where the law firm does not have an office or does not regularly conduct business. Potential additional state tax and other state compliance burdens include in part:
- Entity level income tax
- Information returns
- Nonresident partner withholding
- Withholding on employee compensation
- Unemployment insurance tax
- Business license taxes
- Attorney Occupational Taxes
- Registration with the Secretary of State
Entity Level Income Taxes and Nonresident Partner Withholding
Law firms organized as corporations are likely to be subject to state income taxes where their remote employees work. In most states, law firms organized as flow-through entities (i.e., partnerships, limited liability companies, and S corporations) are not subject to income tax. However, such law firms may be required to file information returns with the tax department and source income to the state where their remote employees work (resulting in partners paying income tax in the state). Additionally, such law firms may be required to withhold income tax on nonresident partners. Failure to consider and plan for these potential compliance obligations could expose the firm to the risk of tax penalties and interest.
Remote Working and State Income Tax Withholding
In general, state tax withholding rules are designed to approximate the employee’s state income tax liability and avoid double withholding on wages in two different states. However, how state income tax withholding rules impact employers and employees can vary. Employers should consider this before implementing a formal remote working policy. The following two scenarios exemplify divergent withholding requirements.
Scenario 1 – Remote Working Attorney and Law Firm in Different States
Something that has become quite common for law firms is the decision by some of their attorneys to work primarily from a state where the firm does not have a physical presence (e.g., an attorney who works from their home in New Jersey, but the firm’s only office is located in California). In this scenario, the law firm is generally required to withhold in the employee’s state of residence even if the employer has no office and does not otherwise conduct business in the state. A law firm that fails to withhold on the attorney’s wages may incur penalties, including potential liability for the employee’s unpaid income taxes.
Scenario 2 – The Convenience of the Employer/Employee Rule and Remote Working Attorney
Both New York and Connecticut have a nonresident sourcing rule known as the “convenience rule.” This example focuses on the New York convenience rule because it applies more broadly than the Connecticut rule.
When a nonresident employee works from home for their own convenience instead of their assigned primary office in New York, the associated compensation is sourced to New York (taxable in New York) for income tax and withholding purposes. This scenario generally does not result in double taxation when the employee is a resident of Connecticut or New Jersey.
Connecticut tax law provides a resident credit for taxes paid to New York, even for income sourced to New York under the convenience rule. New Jersey Division of Taxation policy allows residents to claim a credit for taxes paid to New York under the convenience rule (although this policy might change in the future, especially with the growth of remote working arrangements). Many states are not so accommodating. This situation creates the potential for double taxation of an attorney’s wages. Furthermore, law firms may be required to withhold income tax in New York as well as in the state where their employees reside.
Tax Planning for the Convenience Rule
There are ways to plan around the double taxation and double withholding issues. First, under New York’s audit guidelines, a nonresident remote employee who never works in New York is not subject to New York income taxes on their wages (and consequently, the law firm is not required to withhold on the employee’s wages in New York). Secondly, the convenience rule only applies if the employee’s primary office is in New York. So, if possible, the law firm should assign the remote working employee to an office in a state that does not have a convenience rule (in addition to New York and Connecticut, Arkansas, Delaware, and Pennsylvania also have convenience rules). This solution is not always practical if the employee’s direct report is based in New York. Finally, if the employee’s home office is deemed a bona fide employer office, compensation earned working from home will not be sourced to New York. In practice, it is very difficult for a home office to qualify as a bona fide employer office.
State Unemployment Insurance (SUI)
Employers generally pay state unemployment tax to the state where they withhold employee income taxes. States have adopted uniform rules to determine the state of employment when an employee works in multiple states. As such, law firms must apply the following four-part test when assessing SUI:
Services are allocated to the state in which they take place. States consider services to be localized within a state if they are performed both in state and out of the state, but those performed out of the state are incidental to the services performed within the state. Examples of incidental services are:
- Transitional in nature
- Isolated transactions
Base of Operations
If services are not localized in any one state, allocate all services to the state where the employee has their base of operations. (Some services must be performed in that state.) Do not apply this test if the employee has more than one or no base of operations.
The base of operations of an employee is the place they:
- start to work (in two or more jurisdictions)
- return to receive instructions or communication from their employer
or another person
- replenish stock and material
- repair equipment used
- perform any other functions of their trade or profession
Place of Direction and Control
If neither of the two prior tests results in allocation of services in one state, look at the place of direction and control. If the place of direction and control is only in one state where the employee performs some services, then all services are allocated to that state.
Direction and control mean the place from which the employer directs and controls the activities of employees. It does not need to be the location of the principal office. It can be the place that is the source of:
- basic authority over the supervision
- job assignments
- personnel and payroll records
If none of the previous tests result in allocation of services to one state, then allocate the employee’s services to the state where they reside if some services are performed in that state.
As noted above, many states and cities impose annual business license taxes and/or attorney occupation taxes. Law firms are often required to register with the secretary of state for authority to conduct business, even if the only connection to the state is a single remote working attorney. These registrations frequently require annual reports, and states impose penalties for failing to comply. Finally, law firms should reevaluate their workers’ compensation insurance policies and malpractice policies for coverage in states with remote working employees.
Now that remote working is a common practice for many law firms, knowing where your firm’s employees work is essential for accurate state and local tax compliance and for licensing, state registration, and insurance purposes. It is vital to incorporate proper internal processes to track employee work locations so you can plan accordingly to protect your law firm’s bottom line.
If you have questions, contact your Berdon Advisor.