Telecommuters Beware of States’ Convenience of the Employer Rule

As a result of the COVID-19 pandemic, telecommuting or remote work arrangements have evolved from a growing trend to the norm at many companies. Unfortunately, a minority of states’ tax laws are out of sync with the times and subject some telecommuters to double taxation. Federal legislation could temporarily minimize the impact of these provisions.

In response to the COVID-19 pandemic, state and local governments throughout the country issued stay-at-home orders. As a result, many companies implemented remote work arrangements with employees who, in some cases, live in a state other than where the company has a taxable presence. This situation has highlighted the uncertainty surrounding the state tax treatment of telecommuters.

In response to these stay-at-home orders, many states have issued guidance offering temporary relief to telecommuters. But once this relief expires, the outlook becomes less clear.

Convenience of Employer Test

Generally, states will tax income that is earned within the state. However, a growing minority of states (currently Connecticut, New York, Pennsylvania, Arkansas, Delaware and Nebraska) utilize convenience of the employer (COE) rules to determine how nonresident remote employees should be taxed on their income. New Jersey, while not having formal statute or regulations, has also applied COE rules on audit. Many of the questions surround the applicability of the COE doctrine during these times when many employees have been forced to work from home, whether due to government mandate or office policy. However, the states have long grappled with criticism and scrutiny on the viability and fairness of these policies.

The COE rule extends the reach of a state’s taxing jurisdiction beyond its borders to include income earned by out-of-state employees of in-state businesses. The rule comes into effect if the employee works from a home in another state out of their own convenience instead of due to the employer’s necessity. Such compensation is treated as earned and taxable at the employer’s location rather than the location of the employee.

For example, an employee who is based out of an office in New York but works out of her home in Massachusetts is subject to New York state tax on any compensation earned while working from home. The employer is obligated to withhold New York taxes from that employee.

At the same time, the employee’s home state—Massachusetts—is also likely to treat that compensation as subject to Massachusetts’ withholding and taxation, resulting in double taxation to the employee.

While many states allow residents a credit for taxes paid to other states, the amount of the credit depends on many factors and typically does not result in a complete offset. In our example, the employee would receive a credit on her Massachusetts’ tax based on Massachusetts’ tax rate, which is lower than New York’s. While this would eliminate double taxation, she still would be paying tax at a higher rate than someone who lives and works in Massachusetts. Further, Massachusetts, in allowing this credit, is effectively handing tax revenue over to New York at its own expense.

Constitutional Challenges to Convenience of Employer Test

New York in particular has seen many challenges to its COE rules. Taxpayers have challenged the constitutionality of such rules in court. Many believe that such provisions violate both the Dormant Commerce Clause, which prohibits states from unduly burdening interstate commerce, and the Due Process Clause, which requires that a taxpayer have some level of minimum contacts before a state can impose tax. By subjecting compensation earned for work performed in another state to tax, the COE rules do not allow for a reasonable apportionment of income reflecting the level of economic activity that is actually conducted within the state.

Even before the pandemic, telecommuting arrangements had evolved from when many of these states first implemented COE rules. Technological improvements have allowed employees to work from home as needed with relative ease and minimal disruption. Corporate culture has also changed, with many companies encouraging employees to take advantage of flexible work arrangements, allowing them to work from home as needed. Some companies have used remote work arrangements to their competitive advantage by hiring or retaining talent who may wish to live in a different part of the country. Unfortunately, COE rules have not adapted to take these changes into consideration.

Temporary Relief for Telecommuters

In response to COVID-19, some COE states have issued guidance that an employee’s tax obligations will not change in spite of mandatory stay-at-home orders. This subverts the basic tenet of convenience of the employer as it is not merely a preference to work from home but an actual directive. Additional states may also begin adopting COE rules as a way to replenish lost revenue and in anticipation of more employees opting to continue working from home even after COVID-19 related restrictions are lifted.

Indeed, some members of Congress have recognized the pitfalls of COE rules as demonstrated in a provision under the proposed Health, Economic Assistance, Liability Protection and School (HEALS) Act. If HEALS is enacted, or if a similar provision is included in future legislation, the provision would in effect temporarily disallow states from imposing their own COE rules. Instead, for tax years 2020 through 2024, employees commuting to and working from multiple states would be subject to income tax only in their state of residence, unless the total days worked in such other state exceeds a certain threshold during the year. For the 2020 tax year, the threshold is 90 days. In tax years 2021 through 2024, the threshold is reduced to 30 days. The legislation’s attempt at reeling back the states’ authority to impose COE rules on nonresident taxpayers further supports the argument that the rules are unsound.

The Takeaway

While COE rules have always been met with controversy, COVID-19 has shined a new light on the unfairness of these rules. In lieu of any federal changes, we expect that states will continue to adapt and update their rules. While awaiting further guidance from both the federal and state governments regarding telecommuting and working from home, now is the time to start planning. We recommend reaching out to your state and local tax advisor to better understand the potential tax consequences of working from home and how to best minimize your overall tax liability.