Jan. 20, 2021 – Due to the COVID-19 pandemic, millions of Americans continue to telecommute from their homes or other locations where they decided to shelter in place, and many companies have no immediate plans to bring employees back into the office.
However, allowing employees to work from home and telecommute from states in which they do not normally work can create a host of tax issues. This article addresses a few important tax considerations for employers and employees working remotely.
Employer State Tax Considerations
Employees telecommuting from a different state than the one in which they normally work, and one in which the employer does not already do business could create what is called tax “nexus” for their employers.
In general, the term "nexus" is used in tax law to refer to the nature and frequency of contacts that an out-of-state employer must establish in a state before it becomes subject to that state’s tax laws.
Britany E. Morrison, Marquette 2014, is an attorney with O’Neil, Cannon, Hollman, Dejong & Laing S.C., Milwaukee. She focuses on helping clients effectively manage one of their most significant costs – taxes – by advising on a variety of federal, state and local, private wealth, employee benefit, real estate, tax-exempt and controversy tax matters. Reach her by email or by phone at (414) 276-5000.
Typically, if an out-of-state employer has a physical presence in the state, like property within the state, that will create enough contact with the state to establish nexus.
When a company has nexus with a state, it is generally required to register with the tax authority and pay the applicable corporate, employment, excise, and sales taxes.
Having a physical presence in a state may also include having employees located in a state, even if they are working remotely, which would result in tax nexus for the employer. In other words, the employee’s remote home could be treated as an office location, subjecting the employer to tax nexus in that state.
Unfortunately, guidance varies from state to state, if there is any guidance at all, and there is nothing close to a standard approach that has been established (even pre-COVID-19) because nexus laws vary so widely.
To further complicate matters, some states, like Wisconsin, are granting COVID-19-related exceptions for employees telecommuting from out-of-state for a given period, while some states do not provide any such exceptions.
For example, Illinois has not issued any related COVID-19 nexus guidance, but there is legal precedent in Illinois indicating that, in some circumstances, a single telecommuter working in the state could trigger sales tax nexus.1
The bottom line is that employers with employees who are temporarily telecommuting from across a state border, or who are considering making such arrangements permanent, need to do their research and stay alert.
State tax nexus guidance on COVID-19-related telecommuting is inconsistent, ambiguous, and subject to change especially considering that many states are looking for revenue-generating opportunities.
Employee State Tax Considerations
Similarly, telecommuting employees could have some new tax consequences to deal with. Individuals are generally subject to tax on all of their income by their state of residence, regardless of where that income is earned.
So, for employees that work in the same state in which they reside and file their taxes, there are likely no tax implications. But if that employee is now “working from home” in a different state than where they previously were going to work, they may be subject to income tax in the state in which they are remotely working if the state deems them a resident.
Many states define “resident” as an individual who is in the state for a reason other than a temporary or transitory purpose. While an employee may only intend on temporarily sheltering in a different state from where they reside, many states have thresholds to determine residency despite one’s intent. A common threshold to determine residency is if an individual spends more than 183 days in the state.
So, to put succinctly, those that have sheltered or telecommuted in a state for more than 183 days may be deemed a statutory resident in that state and subject to that state’s income tax. The state may even have a right to impose tax on all of a resident’s income, even portfolio income. Some states provide a credit for personal income taxes paid to another state, but this type of credit is not required under the U.S. Constitution, which could leave some telecommuting employees in a double taxation situation.
Unfortunately, there are no universal residency or credit guidelines to help employees in this situation. Therefore, it is important for employees working remotely in a state that is different from the state in which they reside to do their homework and to check with their tax advisors. If an employee determines they may be subject to taxation in a new state, not only should they determine their own personal income tax situation, but they should ensure their employers are aware and withholds and remits taxes to the appropriate jurisdictions.
Employee Home Office Deduction
Employees working from home much of this year may have purchased items like computers, desks, or other items to make their living space more conducive to working, and many may be wondering if they are allowed to take the home office tax deduction for those expenses on their 2020 federal tax return. Unfortunately, the answer to this is no. These expenses are considered employee business expenses and are treated as miscellaneous itemized deductions, which are not deductible for the 2018-2025 tax periods.
Before the Tax Cuts and Jobs Act (TCJA) in 2017, employees who itemized deductions on their federal returns were allowed to include any unreimbursed work expenses as part of their "miscellaneous" deductions and write-off any miscellaneous expenses such as fees for investment advice, tax advice, tax preparation, and union dues, in addition to any home office expenses that exceeded 2 percent of their adjusted gross income (AGI). However, the TCJA eliminated miscellaneous itemized deductions for 2018-2025. So, under current federal income tax law, an employee’s home office expenses are non-deductible.
For employees living in Alabama, Arkansas, California, Hawaii, Minnesota, New York, and Pennsylvania, though, there is good news. Employees who are residents in these seven states may be able to deduct these expenses on their state income tax returns.
Different rules regarding eligibility apply in each state so employees should be sure to check the state’s return instructions before deducting.
Though most will be ineligible to claim the home office tax deduction, there is an exception for those who are self-employed – meaning taxpayers that run their own business out of their homes, or are independent contractors or freelancers working on assignments from home. But these taxpayers must meet the following rules: (1) they may only deduct expenses for the portion of their home that is used exclusively and regularly for business; (2) their home must be their principal place of business; and (3) they may not deduct expenses related to anything that is used for both work and home life.
For a self-employed taxpayer, federal income tax home office deductions can be a major tax-saver but unfortunately, employees (i.e. those who receive a Form W-2 from an employer) are out of luck under the current rules even if they have made additional purchases or set aside a part of their home for an office.
Even though an employee might not be able to take a tax deduction for their home office expenses, they should always check with their employer regarding reimbursement for their home office expenses. As explained further below, if the IRS rules are met, the reimbursement can be tax-free, and employers can deduct the reimbursement as a business expense.
Employer Home Office Expense Reimbursement
Since employees will not get the benefit of deducting home office expenses on their federal tax returns (unless Congress changes this law), employers should prepare themselves for questions regarding reimbursement.
In many states, there is no legal requirement to reimburse employees for additional work expenses. In fact, only a handful of states (California, Pennsylvania, Illinois, Montana, Iowa, and New Hampshire) require employers to reimburse their employees for necessary job expenses paid by employees which may include home office expenses.
Nevertheless, even if reimbursement is not legally required, employers may wish to aid employees impacted by the additional expenses associated with COVID-19 by reimbursing them for any out-of-pocket home office expenses.
For this to be tax-free to the employee, the employers must reimburse employees under what the IRS calls an “accountable plan.”
To offer an accountable plan, an employer must comply with three standards: (1) the expenses must have a business connection; (2) the expenses must be substantiated within a reasonable period; and (3) the employee must return any money not spent to the employer within a reasonable period. If any of these conditions are not met, the employer must treat any reimbursements paid as employee wages subject to tax and, accordingly, include that amount as taxable gross wages on the employee’s W-2.
An accountable plan does not need to be in writing; however, as a best practice, employers should consider drafting a written document as it provides a structure to ensure that the three required elements are addressed.
Similarly, employers wishing to aid employees impacted by COVID-19 should also consider taking advantage of the Section 139 disaster relief provision by familiarizing themselves with the Section 139 qualifications and adopting a Section 139 program to help their employees through these unprecedented times.
Added to the Internal Revenue Code after the attacks on Sept. 11, 2001, Section 139 allows employers to make tax-free “qualified disaster relief payments” to help employees in the wake of a qualified disaster.
Section 139 is important because typically, under Section 102 of the Internal Revenue Code, any payment from an employer to an employee, even a “gift,” is taxed to the employee as compensation. Section 139, however, provides that any amount received as a “qualified disaster relief payment” cannot be taxed to the employee as income.
These payments are not subject to any federal withholding obligations and do not need to be reported on a Form W-2 or 1099. Significantly, any amounts paid as a “qualified disaster relief payment” are also deductible by the employer. In addition, in most cases, the exclusion will also apply for state income tax purposes.
This little-known existing tax provision just might be the best way for employers to assist their employees during these uncertain times. Employers interested in implementing an “accountable plan” for reimbursement or a Section 139 Plan for tax-free qualified payments to employees, should consult with their legal and tax advisers about the written programs, the implementation, and the timing for payments.
As employers continue to allow telecommuting due to the COVID-19 pandemic, it is important that employers are aware, recognize, and address the tax nexus compliance issues that telecommuting employees may create.
Likewise, employees working remotely outside their resident state, should familiarize themselves with the residency rules in their employer’s state or state of shelter to avoid any double state taxation issues.
And lastly, while employees may not get the benefit of a home office expense tax deduction, they should always check with their employers regarding reimbursement.
While reimbursement is not legally required in most states, employers may find ways via an “accountable plan” or Section 139 Plan to make reimbursement tax-free for employees and create an additional tax deduction for the company.
The tax issues discussed in this article are just a few among many and employers and employees alike are encouraged to consult with legal and tax counsel before making tax decisions as they relate to remote working during the COVID-19 pandemic.
1 See Illinois Department of Revenue, General Information Letter No. IT 99-0058-GIL (May 24, 1999) (implying that the taxpayer would acquire income and sales/use tax nexus in Illinois as a result of the presence of a single employee in Illinois who acted as the company’s webmaster and developer of software for internal use and sale to customers.)