Do you pay state withholding taxes where employees live or where they work?
The golden rule for paying an employee’s salary who works from home in another state is to take a location-based approach. This means you generally pay state taxes in the state(s) where your employee works.
The twist is that state tax laws are, quite literally, all over the map. That means you need to read up on the state legislation for employees working in a different state. That can be time-consuming, so another option is outsourcing to a payroll provider that handles payroll taxes for out-of-state employees.
The two types of remote workers
There are two types of workers you can hire for your business: employees and independent contractors.
- Employees: When you pay an employee, you’re responsible for withholding payroll taxes from their paycheck and paying a portion of their payroll taxes.
- Independent contractors: When you pay a contractor, you don’t withhold payroll taxes from their pay. Instead, they’re responsible for handling their own taxes, unless you’re leveraging a staffing agency who is hiring and paying contractors with W-2s.
Whether your worker is an employee or contractor isn’t entirely up to you. There are federal and state laws that dictate how each one is classified, and misclassifying an employee as a contractor could lead to some serious tax penalties.
Make sure you keep up with state laws, as they’re always changing. For example, California’s Assembly Bill 5 (AB5) made it harder for small businesses to classify workers as contractors.
Another reason why you need to know if your worker is an employee or contractor? How you pay team members for remote work will differ based on their classification.
How to pay a remote employee
First, you need to know if your employee is an in-state or out-of-state remote employee.
Two terms come in handy here:
- Nonresident state: This is any state that your worker commutes to for work or works in for a short amount of time, but it’s not their permanent home.
- Resident state: This is your worker’s permanent home. If you’re not sure where they live, check the address on their W-4.
Now that you know the basics around remote pay, ask yourself these two questions:
- Where does your employee work? Do they work from home, or do they travel to work someplace else? If the answer isn’t obvious, ask your employee directly where they perform work for your business.
- Does your employee work in the same state your business is registered? If so, they’re an in-state remote employee. If not, they’re an out-of-state remote employee.
In most cases, you’re required to withhold taxes in the state where your employee actually works, which can either be their resident or nonresident state.
So if your company is based in Michigan, but your employee works from home in Georgia, you would withhold income tax and pay state unemployment tax in Georgia.
Taxes for remote employees in your state
If your employee works in the same state your company is registered in, you’ll withhold state income taxes and pay state unemployment insurance (SUI) tax in your home state.
You may also have to withhold local income tax from their paycheck if they work in a location that requires it.
What if your employee works in your state but lives in another state? You still withhold state income taxes in your state because that’s where your employee is doing the work.
That is, unless your state has a reciprocal agreement with your employee’s home state.
Many states relaxed their tax requirements because of COVID-19 to make remote work easier on employers and employees. To understand the requirements within your state and with your employees state, check out this State-by-State Guide to Paying Employees.
Reciprocal agreements: For employees that work in your state but live in another state
Depending on where your employee lives, they may be able to withhold their income tax in their home state even if they work in another state, allowing them to file one tax return each year.
This only works if the two states have a reciprocal agreement, which is when neighboring states rally together and agree that people who work in nearby states can pay income tax to the state they live in.
For instance, Illinois has a reciprocal agreement in place. That means a person can work in Illinois but pay income tax in their home state if they live in Kentucky, Michigan, Wisconsin, or Iowa.
If there’s no reciprocal agreement between your employee’s home and work state, it’s not the end of the world. Your employee will most likely have to pay both nonresident and resident state income tax. But luckily, some states grant a tax credit to cover the pesky cost of double taxation.
Pro tip: You can help those who have to pay income tax in states without reciprocity by offering a courtesy withholding from their paycheck.
Basically, you can withhold both sets of state income taxes so employees don’t get surprised by a huge bill during tax season. Payroll software like Gusto can help you set up this type of withholding.
How to set up reciprocal withholding
Your employee needs to complete a non-residency certificate to excuse them from tax withholding in their work state. Once they’re done, they’ll send it your way for safekeeping. You won’t have to mail it in, but be sure to lock it up somewhere safe.
When you receive the certificate, let your payroll provider know that your employee has an agreement in place so they’ll withhold the correct amount in their home state.
Here’s an example of a nonresidency certificate from Kentucky. Ask your employee to contact their state’s tax agency to obtain a certificate of nonresidence for their state.
Taxes for remote employees out of your state
If your employee works from home in another state, there are three things you need to do:
1. Register with your employee’s state tax agency
Since you’ll be withholding income taxes in your employee’s home state, you’ll need to register with the state, and possibly local, tax agencies. You may also need to register with their state’s labor and unemployment agencies.
If you have multiple remote employees working in various states, you’ll need to register with the tax agency in every state.
2. Learn the state’s pay and labor laws
In addition to withholding state income taxes, you must also follow your employee’s state pay and labor laws.
Here are some laws you should know for each employee that works from home in another state:
- What’s the minimum wage in the state, city, and county where your employee works? You’ll need to pay your workers at or above the highest minimum wage, whether that’s federal, state, or county.
- Are you required to provide a pay stub? If so, what information do you need to include on your employee’s pay stub? Some states require written or printed pay stubs, while others don’t. If your employee works in a state that requires pay stubs, you need to provide one.
- Are there payday (frequency) requirements? Some states only allow semi-weekly or monthly payroll, while others also allow weekly and bi-weekly payroll. And some states have payday requirements based on the work your employee does. If your payroll frequency isn’t allowed in a remote worker’s state, you’ll need to follow the payday laws in that state.
- Are there rules about how a regular paycheck or final paycheck should be delivered? You’ll need to deliver your employee’s final paycheck within the time frame dictated by their state laws and this time frame may vary if your employee quits or is terminated.
- Do you need to withhold money for state disability insurance? Five states require employers to withhold money from their employee’s paycheck for state disability insurance. If your employee works in California, New Jersey, Rhode Island, Hawaii and New York, you’ll need to be sure you set up this type of withholding.
- How is overtime calculated? Is it different than the federal overtime calculation requirements? If the state law is different than the federal law, you’ll need to follow the law that has the greatest benefit to your employee.
- Do you need to withhold local taxes? Even if your city doesn’t have local income tax, you still need to pay local income tax if it’s required in your employee’s city or county.
- What are the labor laws regarding paid and unpaid breaks? Every state has laws about how many paid and unpaid breaks you need to provide employees. Be sure you communicate these laws to your employees and provide the mandatory break periods.
- What are the workers’ compensation insurance requirements in their state? Are you required to purchase workers’ comp for your employee? Requirements can vary by state, industry, and the size of your company.
3. Withhold income taxes and file required paperwork and payments
Every time you pay your employee, you’ll withhold state income taxes. Then, you’ll periodically file paperwork with the state reporting how much income tax you withheld and send in a payment for these withholdings.
The forms you fill out and how often you need to file your paperwork and send payments will vary based on the state.
You’ll also need to pay state unemployment taxes based on your employee’s wages. You should receive your unemployment tax rate and payment instructions when you register with the state’s tax or unemployment agency.
Some payroll providers can handle these income tax withholdings and filing requirements so you don’t have to deal with them.
How to pay a remote contractor
Paying a remote contractor is generally easier than paying a remote employee since you usually don’t have to deal with state payroll taxes.
But keep in mind that if your contractor is commuting to a nonresident state to work, you may be required to collect backup withholding taxes in the state they’re working in. Be sure to check your state rules to see whether backup withholding is required when paying nonresident contractors, and if it’s required, whether your payroll provider supports it.
Otherwise, even though you usually won’t have to withhold state payroll taxes, paying remote contractors still involves some paperwork. (If you need to support global payroll for international contractors, you can also leverage a payroll provider who will handle everything.)
1. Form 1099-NEC
Each year, you’ll file a 1099 form for every contractor you paid more than $600, if their business entity is not an S corp or C corp. Form 1099-NEC tells the government how much you paid an individual in non-employee compensation during the year. (Form 1099-MISC is no longer used for this.) It’s due by January 31st with one copy going to the Internal Revenue Service (IRS) and one copy going to the contractor. Some payroll providers can do this for you.
Note: If you paid your independent contractor with credit cards or third-party settlement platforms as payment methods. The payment settlement entity may have to file a 1099-K instead of you filing the 1099-NEC.
2. Form W-9
Before you pay a remote contractor, you’ll also need to have them fill out a W-9: Request for Taxpayer Identification Number and Certification. This informational form gives you all the details you need to complete a 1099 and also lets you know if your contractor is exempt from receiving a 1099.
If your contractor doesn’t give you a W-9 with their correct taxpayer identification number (TIN), you may be required to collect backup withholding taxes for them. (No one can avoid paying their self-employment taxes—i.e., Social Security and Medicare taxes!)
For more information on situations that require backup withholding, you can refer to the IRS guidance for 1099-NEC.
While paying a remote contractor is pretty straightforward (you just pay them the amount you owe), you still need to keep accurate records of your payments. You’ll use these records when you file your 1099s.
And that’s your definitive guide on how to pay remote workers. When you begin to unravel the map of payroll laws, paying remote employees and contractors isn’t so hard. Yes, it’s slightly more complicated than paying an employee who lives in your state, but once you understand the basics, you’ll feel much more in control.