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Sunday, June 19, 2011

State income taxation of mobile employees - why the focus on source rather than residency?

When an employee is sent to another state to work on a project, help a client, etc., the employer needs to know when that state will start requiring the employer to withhold state income tax from that worker. The rules vary from state to state. In Oklahoma, withholding would be required once the worker earns more than $300 in a calendar quarter. In Maine, withholding is required once the worker is there more than 10 days. (For a list of most state laws on this topic, see COST testimony of 5/25/11, pages 9 and 10.)

Some states, such as New Jersey and Pennsylvania have reciprocity agreements such that generally, the person who resides in one state but does some work in the other state will only be taxed in their state of residence. But typically, a form must be filed to alert the state of the employee's presence.

With increased mobility of workers and states eager to be sure they are collecting all of the tax they are legally entitled to, states have been more focused on employees visiting their state.

The inconsistencies and the resulting complexity, uncertainty and lack of transparency has led to:
  • H.R. 1864 (112th Congress) - would provide uniformity among the states and use a 30 day threshold before the employee is taxable in the state. The House Judiciary Committee held a hearing on this bill on May 25, 2011. H.R. 2110 (111th Congress) also used a 30-day threshold, while H.R. 3359 (110th Congress) used a 60-day threshold, which states disliked due to possible loss of revenue. (See COST testimony of 5/25/11, pages 11 - 13.)
  • MTC's Model Mobile Workforce Act - calls for uniformity and a 20-day threshold before an employee would be subject to tax and withholding in a state.

In the 5/25/11 testimony of Patrick T. Carter, Director, Delaware Division of Revenue, on behalf of the Federation of Tax Administrators, he notes:

"Beyond the policy concern of intruding into state authority, the dominant concern of states is the 30 day rule contained in H.R. 1864. It will effectively convert state income tax systems to residency-based tax systems and goes well beyond what is necessary to deal with the burden and compliance issues present in the current system. It will allow an individual to work in a jurisdiction for over 12.5 percent of a work year and be absolved of any liability to the state in which he/she worked."

The FTA supports uniformity, but with a lower threshold.

My question - What should the proper focus be for determining when a state may subject a non-resident employee to a state's income tax?

General theories would suggest either (or some combination of):

  • Residence-based taxation - tax where you reside (your home state).
  • Source-based taxation - tax where the income is earned.

For most employees, residence-based is the easiest. What is the employee's address? In what state are they registered to vote? Where do their kids go to school? Where is his/her car registered?

Source-based is not always easy. Today, many employees have a 24/7 work window and can easily multi-task. For example, assume Sam works for BigCo as a software expert. His work includes software development, assessment of client needs and assistance with installation. Sam lives in California. This month, BigCo sent Sam to Oklahoma to assist a client for 10 days. Sam is at the client's from 8 - 5 each day (except for the weekend). While not at the client location, Sam is doing some research related to that work, but also assisting with some project of the home office and spending time on email and phone calls with clients in three other states. In addition to a salary, Sam's compensation also includes: bonus, stock options and a car allowance resulting in $400 of monthly income (a non-accountable plan). Sam flew to Oklahoma, he did not drive.

How much of Sam's income is attributable to the 10 days he was in Oklahoma? (There is some guidance on the stock option including some OECD information.)

Let's talk theories....

Why subject Sam to income tax in Oklahoma? What benefit will he get? Sam can't vote in Oklahoma (he is registered in California). Sam most likely can't get his kids registered in any Oklahoma public school while he is there (he won't have proof of residency such as utility bills). Sam isn't going to claim any government benefits while in Oklahoma.

Sam is going to buy food and other items while in Oklahoma and will pay sales tax. He will likely pay a transient occupancy tax on his hotel charges. He will pay gasoline excise taxes when he fills his rental car. So, Oklahoma is getting some tax from the limited benefits it will provide to Sam while he is there (use of roads and fire and police protection if needed).

AND, Sam's employer is most likely paying income tax in Oklahoma. The fees paid by its Oklahoma customers may be sourced to Oklahoma (depending on the sourcing rules of the state, which the state can change to ensure that it is sourced to Oklahoma). Oklahoma can also structure its apportionment rules to ensure that it captures some of BigCo's aggregate state income taxes. The arrangement between the Oklahoma customer and the work it is getting is really between the customer and BigCo, not with Sam. If Oklahoma is concerned that the Oklahoma business gets a deduction for payments make to BigCo, then be sure the business statutes are designed to tax BigCo on its income derived from the Oklahoma customer. Sam is just in the middle. The customer is not paying Sam directly.

So, why the focus on pushing for source-based income tax of visiting employees (beyond a particular threshold) rather than residency-based? H.R. 1864 already exempts employees, such as entertainers, who can easily attribute income to their in-state activities (the concert they played in the state). Although again, when the entertainer is an employee, seems that the state should be more interested in being sure the employer's income from the concert gets taxed in the state.

What makes sense for the modern workforce and tax system? In terms of simplicity, imposing income tax on employees only in their state of residence seems best. Yes, a few employees might not have a home, but rules can be created for these few. In terms of overall tax design, I think the best arguments are for having individuals pay income tax to the state where they get the bulk of their government benefits funded by income tax - education, roads, courts, property protection, etc.

What do you think?

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