Multistate Employment

April 13, 2006

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If you only do business in one state and all of your employees are residents of that state, your state income tax withholding obligations will be quite simple. However, complexities can arise once your operations expand beyond the borders of a single state.

Let's assume you have a California office where you employ five California residents. You also have a second office in Oregon, where you employ two Oregon residents. Your employees never leave their state of residence to work in the other, out-of-state office. You would have to withhold California income taxes from the wages of your five California employees and Oregon income taxes from the wages of your two Oregon employees. In other words, you'd have separate withholding obligations in each state.

A more difficult situation arises when you send your employees to other states to perform services or employ residents of other states at a single in-state site. For instance, let's change the facts from our example and assume that you have just a California office where you employ five California residents. You regularly send two of the employees into Oregon to perform services on your behalf. Must you withhold Oregon income taxes from any of the wages you pay those two employees? Or, assume instead that three California residents and two Oregon residents comprise the employees at your California office. Must you withhold Oregon income taxes from any of the wages you pay the two Oregon residents if they only perform services for you in California? How about California taxes? What if they're the employees you send when there's work to be done in Oregon or you allow them to occasionally telecommute from their Oregon homes?

These are just a sampling of the types of questions you could face. Unfortunately, they also represent the types of questions that even the most experienced tax professionals cannot always easily answer.

Before you conclude whether you have a state income tax withholding obligation with respect to a given employee, you'll need to understand the rules of both the states where you're doing business and the states whose residents you're employing. And, if you have any doubts as to the proper conclusion, seek the advice of your accountant or other tax professional. That being said, here are some general points to get you started:

Some states have entered into "reciprocal agreements" with other states. Usually under these types of agreements, state A agrees that it won't require state A employers to withhold its income tax from wages paid to residents of state B, and state B reciprocally agrees that it won't require state B employers to withhold its income tax from wages paid to residents of state A. So, if you do hire employees who are residents of other states, a good first step is to confirm whether your state has any reciprocal agreements in effect with those other states and, if so, whether the agreement relieves you of any withholding obligations. Our state income tax map includes information about the reciprocal agreements in force in each state.
Because withheld taxes are taxes the employees personally owe, you won't have to withhold a state's income tax on a given employee's wages unless the employee's income is subject to the state's tax. This usually requires that the employee be a resident of the state, or be a nonresident who derives income from sources in the state. Generally speaking, merely performing some services in a state as an employee will not alone cause the employee to be subject to the state's income tax if the employee's principal place of employment is outside the state.
A state's taxing powers reach only as far as its borders. So, unless you and your business establish some kind of physical presence in a state, the state probably can't force you to withhold its income taxes. Common examples of the types of activities that can be considered a "physical presence" include maintaining an office, store, or other business facility in the state; having employees in the state who regularly perform services, make sales, or otherwise do business on your behalf; and owning or leasing any property that is located in the state.