Chapter 14

State Income and Payroll Tax Considerations in Multistate Tax Planning

Companies that have employees working in other states must pay close attention to each state’s payroll tax regulations. In many cases, payroll tax will be owed to California and to the other states where your employees are working.

Payroll taxes are determined on the proportion of income that is generated per state and must be paid to each state. It is common for employers to pay all payroll taxes to California instead, and in those cases, California will refund the overpayment. It is important that the refund is applied to the tax balances in the other states.

Independent contractors are a huge issue when it comes to payroll taxes. California has very specific criteria that must be met to categories a worker as an independent contractor versus an employee.

This is where a lot of businesses run into problems when they classify a worker as an independent contractor and thus, does not pay any payroll taxes.

Payroll tax audits frequently determine that an independent contractor was indeed an employee, and the business owner will be responsible for paying back payroll taxes. 

One important note is that during the pandemic, California is presently not assessing payroll tax on companies that have employees telecommuting in other states. 

If you conduct business across state lines, it might be helpful to give me a call. We have helped companies determine to which states they owe payroll taxes.

In some instances, we have even recommended relocation to a state with a lower tax rate. We can work with you to maximize your tax planning and keep you out of trouble with the state.

State Payroll Taxation and Nexus

Traditionally, states view state income tax from an apportionment standpoint. They look at where the percentage of a company’s revenue comes from, where the employees are located and where inventory is being held. They also look at a company’s level of contacts with their state and tax the company to the extent there are nexus-creating contacts. 

For example, if a company in California has employees in California and Illinois, Illinois will pursue a proportionate share of the revenue that is earned in Illinois or that is being generated by employees within the state. For this reason, it is important to consider where the sales are taking place, where the employees and inventory are located, and in what proportions. 

If you are based in California and do business in multiple states, your entire tax liability for the year should not be paid solely to California. Instead, your income tax should be apportioned between the various states in which you are doing business. 

Refunds for Tax Paid to Other States

However, there is always a difference between what businesses should do and what they actually do when it comes to where they report their income. A common scenario we see is that businesses report all of their income to the jurisdiction in which they are located, only to get audited by another state years later when the statutory refund deadline of the businesses’ home state has passed. 

Refunds for overpayment to another state may be requested either within a year from the date in which taxes were paid to the other jurisdiction or before the expiration of the general statute of limitations, whichever date comes later.

The statutory deadline is four years after the due date of the original return or four years after the date of a timely return that received an extension. 

Without a refund, multistate businesses that paid all their taxes to one jurisdiction and are audited end up having to pay tax twice on the same income. High tax states like California will give taxpayers a credit for income tax they paid to other states.

However, if there is a difference between the income tax rates (such is the case between the rates in California and Illinois), the jurisdiction with the higher tax rate will tax you on the difference.

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Implications for Service Businesses

When it comes to service businesses, states will generally impose state income taxes in the location where services are being performed. This can get complicated because there may be situations where services are being performed for particular items that are generating revenue in a variety of different states.

For example, a California company can have a client in Arizona and is as a result, providing service in both states. 

Ultimately, tax apportionment is a balancing act. It is not possible to take a fee for a service project and microscopically split it between two states but you can just do a general balancing test to ensure you are paying the right proportion of tax to the proper jurisdictions. The benefit to proactively reporting income tax is that you get a chance to take the first position. 

As one of our clients has put it, filing an income tax return serves as an opening offer. 

There is a certain amount of truth to this notion because you get to take the first position and California must affirmatively challenge that position if it disagrees with your “opening offer.” Without doing anything wrong or evasive, you can take the reporting position that best benefits you.

Location, Location, Location

If you are a multistate entity, the one thing you really want to look at is choice of entity considerations. If you are doing business in multiple jurisdictions, ask yourself if it makes sense to be located in a high tax state such as California. Figure out if you have options, based on the logistics of your operation, to switch your headquarters to a different state. 

Your decision may also be informed by whether you have employees working across different states.

When you are a multistate company, you have the freedom to decide the location of your home base and there are certain tax advantages that some states offer over others. Keep these considerations in mind when deciding where to locate your business.

However, there are limits to how businesses can take advantage of certain jurisdictions’ lower tax rates. For example, a business cannot simply pick Nevada as its home base tax jurisdiction if the owner is a California employee and all the employees and inventory are located in California. 

States have statutes in place that enable them to tax businesses that are incorporated in one state while having strong nexus in their jurisdiction, such that they are essentially a corporation of their state. Otherwise, businesses have significant leeway to determine their location and this is an important consideration in multistate tax planning.

Who to Pay?

Additionally, we find that a lot of businesses are not properly reporting taxes to the jurisdictions in which they do business. Sometimes, clients even report to the wrong jurisdiction.

It is important for businesses to have clear rationale as to which states they are reporting to and why. 

Furthermore, in forming this rationale, businesses must ensure that they are making the decision that is most beneficial to them.

There are situations in which businesses encounter conflicts between the laws of the jurisdictions in which they operate.

Due to the nature of state taxation, there will be gaps in how the laws are written and how they are enforced. Multistate companies must be prepared to confront these types of issues but having the guidance of trained attorneys can significantly lighten the burden. 

If You are Audited

Invoices are particularly important to manage because they are what gets reviewed during an audit. To ensure that you are charging the proper amount of tax, start by analyzing your invoicing method and make sure that you are either itemizing or grouping invoices together appropriately. Improper invoicing methods is a problem we see across various industries.

Along with monitoring your invoices, make sure to understand how an auditor would look at them and keep procedures in place to ensure you are in compliance.

Taking the aforementioned steps is the best way to mitigate any issues associated with taxable labor. Another issue to consider is how to manage payroll taxes.

Multistate Payroll Taxation

There is a lot of misunderstanding and confusion surrounding how to report payroll taxes. Taxpayers must be aware of this one principle: states will expect to collect payroll taxes associated with services provided in their respective jurisdictions.

There are some exceptions to this rule, but this principle is applicable in most scenarios. 

The issue of multistate payroll taxes has especially become a topic of interest during the COVID-19 crisis, Because many people began to telecommute from other jurisdictions since the start of the crisis.

In California, companies that previously did not have connections to another state will not be deemed to be doing business in the state simply by virtue of their employees telecommuting there during the crisis.

If an individual from California flies to Florida to perform services exclusively in that state, they would not need to file a California payroll tax return. Rather, the individual would be expected to file payroll tax returns in Florida. Even if somebody is physically living in another jurisdiction, payroll tax liability will extend to the state in which their services are being rendered.

Payroll taxes can also become a problem when a business has agents, affiliates or independent contractors located in another state.

To the extent that they have independent contractors in multiple states, companies may potentially be subjecting themselves to state payroll and income tax liabilities.

The relationship between independent contractors and business/individuals is being highly scrutinized by a variety of states.

Independent Contractors

The states, including California, are making a proactive attempt to narrow the scope of what constitutes an independent contractor. The states likely are narrowing the scope of what constitutes an independent contractor because they collect payroll tax revenue from people who are considered employees of a business. 

Traditionally, people think of independent contractors as workers who might work a limited number of hours, perhaps work from home, or maybe provide services to various people. However, that may not be the criteria states use to determine who is an independent contractor. 

California has a test for determining whether somebody was or was not an independent contractor: 

  1. the amount of control the employing unit has over the independent contractor
  2. how integral the job function of the independent contractor is to the production of revenue for the business. 

If a business’ production of revenue is dictated by the services being performed by people who they believe are independent contractors, typically, the state would not consider those people to be independent contractors. Instead, they would be considered employees.

If an independent contractor cannot answer in the affirmative when asked if they are in the business for themselves, then that person will be considered an employee.

The use of independent contractors, particularly those working across multiple states, gives rise to various tax considerations. 

Payroll tax liabilities for these workers can be significant depending on how many independent contractors the company is using and the jurisdiction in question. If a company uses a large pool of independent contractors in a particular state, it can be cruising for a payroll tax audit.

Depending on the state, if an independent contractor is physically located in a state in which your business is not physically present, that could create a state income tax liability.

In such a scenario, if those individuals who are believed to be independent contractors are found to actually be employees, a state income tax liability is guaranteed to be imposed. If the purported independent contractor is deemed by the state to be an agent, that also may possibly give rise to a state income tax liability. 

There are also state income tax considerations to take into account when a company has employees or agents in another state where the company is not otherwise physically present. This is important to think about when considering the dispersion of employees through a variety of states. 

Companies must be aware of where their labor force is located geographically, what types of services are being performed, and where they have a payroll tax liability. It is important for businesses to understand the landscape so they can properly administer their payroll taxes and discover where any gaps in reporting or any inconsistencies are.

Your Tax Implications If Your Have Remote Employees

If you have employees scattered throughout the nation, you need to be very careful where payroll taxes are concerned. The rules surrounding payroll taxes can get messy and you may find yourself owing money to multiple jurisdictions.

One area that trips up many small businesses is independent contractors. Independent contractors have been in the crosshairs of the state of California for quite some time and it has a series of tests to determine a worker’s status. You need to be particularly cautious here as you do not want to be part of a payroll tax audit.

Lastly, if you have employees working from home in other states due to COVID-19, California will not impose payroll taxes on those workers. Just make sure that you check the rules in those other states where your employees are working.

My firm, Brotman Law, specializes in small business taxation. If you are concerned about your company’s multistate payroll status, give me a call. The voice of experience can prove very valuable, especially with the tricky situation of independent contractor status. 

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