On Monday, October 19, the State of New Hampshire filed a bill of complaint in the Supreme Court of the United States asserting that its southern neighbor, Massachusetts, is violating its state sovereignty.  The suit attacks Massachusetts’s emergency regulations governing the taxation of income during the COVID-19 state of emergency. Massachusetts enacted a rule pursuant to which income earned by a nonresident of Massachusetts who worked in Massachusetts prior to the pandemic but who is working from home outside of the state remains Massachusetts-source income subject to Massachusetts income tax.  Accordingly, employers would be required to continue to withhold Massachusetts income tax on wages paid to those individuals even though the individuals are no longer working in Massachusetts.  Although the Massachusetts guidance is among the most sophisticated and detailed withholding guidance issued by the states during the pandemic, it is not alone in taking this approach.  Rhode Island issued regulations substantially similar to Massachusetts, and the Pennsylvania Department of Revenue has issued similar guidance in the form of FAQs posted on its website.  Other states have hinted at taking a similar approach, but the guidance is often vague and left open to interpretation.

In general, compensation from the performance of services is sourced based on the location where the services are performed.  Under this approach, an employee’s income earned by working from home in New Hampshire would not be subject to income tax in Massachusetts.  Under the temporary Massachusetts regulation, the employee’s income would be sourced to Massachusetts and subject to its income tax.  Conversely, the regulation also provides that the income of a Massachusetts resident earned working remotely in Massachusetts would continue to be sourced to the state in which the employee normally worked before the pandemic, provided that the other state took a similar approach.  Because New Hampshire does not have an income tax on income from employment, its residents are more adversely affected than employees who work in other neighboring states that would likely pay at least some income tax on wages earned working from home.

Employers are secondarily liable for any failures to withhold state income tax with respect to the state to which the income is sourced, assuming withholding is required.  The suit highlights the difficulties facing employers as large segments of their workforce have transitioned to working from home, particularly with respect to employees who live in a state other than the one in which they usually work.  Conflicting approaches by and guidance from the states leave employers potentially vulnerable to state employment tax audits asserting that the employer should have withheld tax in a state other than the state in which withholding occurred.  Many states, including some key states such as New York and California, have not issued any guidance related to employee withholding requirements.  Other states have explicitly indicated that they will continue to apply their standard sourcing rules.  The differing approaches also mean employees could find themselves subject to tax in two states because each state applies its own source rules in determining whether an individual is entitled to a credit for tax paid to another state.

If New Hampshire’s suit is successful, it could also threaten a sourcing model used by a handful of other states known as the “convenience of the employer” rule.  Presumably, if Massachusetts’s effort to tax wages earned by nonresidents working outside of the state is found to violate New Hampshire’s state sovereignty, the same analysis could be applied to attack the same result under the convenience of the employer rule.  Under that rule, which is arguably misnamed, the income of an employee who works remotely for the employee’s convenience rather than the employer’s necessity remains sourced to the state where the employer is located.  The rule is most well-developed in New York, which has not-yet issued any guidance regarding how it might apply the rule during the pandemic, and has historically applied the rule to tax the income in situations where the connection to New York is fairly attenuated.  Other states, including Arkansas (which recently adopted the rule in a legal opinion), Connecticut, Delaware, Nebraska, and Pennsylvania, also apply the rule.  Whether New York and other states with the rule will determine that an employee is working from home out of the employer’s necessity, rather than the employee’s convenience, during the pandemic remains an open question.  The argument for necessity seems strong, particularly during any period where the employer’s office is required to be closed.  However, New York’s history on this issue is not particularly favorable.  In 2012, the state provided more time for nonresidents to file New York returns in response to Hurricane Sandy but maintained its narrow view of when an employee working remotely was doing so out of necessity.

Print:
EmailTweetLikeLinkedIn
Photo of S. Michael Chittenden S. Michael Chittenden

Michael Chittenden practices in the areas of tax and employee benefits with a focus on the Foreign Account Tax Compliance Act (FATCA), information reporting (e.g., Forms 1095, 1096, 1098, 1099, W-2, 1042, and 1042-S) and withholding, payroll taxes, and fringe benefits. Mr. Chittenden…

Michael Chittenden practices in the areas of tax and employee benefits with a focus on the Foreign Account Tax Compliance Act (FATCA), information reporting (e.g., Forms 1095, 1096, 1098, 1099, W-2, 1042, and 1042-S) and withholding, payroll taxes, and fringe benefits. Mr. Chittenden advises companies on their obligations under FATCA and assists in the development of comprehensive FATCA and Chapter 3 (nonresident alien reporting and withholding) compliance programs.

Mr. Chittenden advises large employers on their employment tax obligations, including the special FICA and FUTA rules for nonqualified deferred compensation, the successor employer rules, the voluntary correction of employment tax mistakes, and the abatement of late deposit and information reporting penalties. In addition, he has also advised large insurance companies and employers on the Affordable Care Act reporting requirements in Sections 6055 and 6056, and advised clients on the application of section 6050W (Form 1099-K reporting), including its application to third-party payment networks.

Mr. Chittenden counsels clients on mobile workforce issues including state income tax withholding for mobile employees and expatriate and inpatriate taxation and reporting.

Mr. Chittenden is a frequent commentator on information withholding, payroll taxes, and fringe benefits and regularly gives presentations on the compliance burdens for companies.

Photo of Marianna G. Dyson Marianna G. Dyson

Marianna Dyson practices in the areas of payroll tax, fringe benefits, and information reporting, with a specific focus on perquisites provided to employees and directors, worker classification, tip reporting, cross-border compensation, backup withholding, information reporting, and penalty abatement.

Ms. Dyson advises large employers…

Marianna Dyson practices in the areas of payroll tax, fringe benefits, and information reporting, with a specific focus on perquisites provided to employees and directors, worker classification, tip reporting, cross-border compensation, backup withholding, information reporting, and penalty abatement.

Ms. Dyson advises large employers on the application of employment taxes, the special FICA tax timing rules for nonqualified deferred compensation, the voluntary correction of employment tax errors, and the abatement of late deposit and information reporting penalties for reasonable cause. On behalf of the restaurant industry, her practice provides extensive experience with tip reporting, service charges, tip agreements, and Section 45B tax credits.

She is a frequent speaker at Tax Executives Institute (TEI), the Southern Federal Tax Institute, and the National Restaurant Association.