Managing payroll for multiple states can be complex and time-consuming. But proper payroll management is necessary to avoid penalties and maximize efficiency.
You must be well-informed about multi-state payroll to ensure compliance, so we’ll review the six key things you need to know. These guidelines will help you streamline the multi-state payroll process, minimize risk, and focus on growing your business.
What is multi-state payroll, and how does it work?
Multi-state payroll is the payroll process for businesses operating in multiple states. Like managing payroll for one state, it involves calculating salaries, withholding taxes and other deductions, and distributing employee payments. But it requires additional work and planning due to state-specific regulations.
Multi-state payroll applies if:
- You have multiple business locations in different states
- Your business is located near the border of two or more states, so your employees commute from other states
- You have remote employees from other states
- Your employees travel to nonresident states for temporary work assignments
The more states your business operates in, the more complex your multi-state payroll management becomes. For example, if your business operates in 20 states, you must accurately determine the taxes required to collect in each state and their amounts and withhold them for all your employees. Despite its complexity, you can handle multi-state payroll effectively with a thorough understanding of its requirements.
6 things you need to know about multi-state payroll
Multi-state payroll involves navigating different sets of laws and regulations. To ensure compliance, here are six key points to understand.
1. Source income principle
The source income principle determines which state has the right to tax an employee’s income. It asserts that the state where the income was sourced or wages were earned has the right to tax them, regardless of the employee’s residency. For example, suppose an employee works in Idaho but lives in Wyoming. In that case, Idaho is considered the source of the income, so their employer would withhold Idaho taxes and not Wyoming.
Understanding the source income principle and applying it correctly in multi-state payroll can help you comply with local tax regulations and avoid potential penalties.
A nexus is a connection between a state and a business that establishes the state’s right to tax the business. In terms of multi-state payroll, it is a business’s presence or connection with a state.
The presence can be in the form of a physical location, such as a warehouse, office, or other property. You can create the connection through activities like employee travel and sales. You can also establish it by having employees that work remotely from their state of residence or e-commerce sales activity. Determining a nexus can be complex.
If your business has established a nexus in a state, it must comply with the state’s tax laws and regulations. They can include the requirement to withhold taxes for the state if your employees reside there, even if they don’t work there.
Multi-state businesses must understand their nexus status in all states they operate in to ensure compliance.
3. Reciprocity agreements
A reciprocity agreement is a mutual agreement between two states that ensures employees living in one state and working in the other are not subject to double tax withholding. It declares that employers can only withhold taxes from their employees’ resident state. It is an exception to the source income principle.
Reciprocity agreements generally apply to neighboring states, but only some maintain them. As of January 2023, there are 17 states with reciprocity agreements. They also don’t apply to all neighboring states. For example, Illinois doesn’t have reciprocity agreements in place with Missouri and Indiana but has them with Iowa, Michigan, Wisconsin, and Kentucky.
Reciprocity agreements make things administratively easier for both the employer and employee. For example, if an employee works in Illinois but lives in Michigan, their employer can only withhold Michigan taxes instead of withholding tax for both states.
If the employee lived in Missouri, which doesn’t have a reciprocity agreement with Illinois, the employer must consider the laws and requirements of both states. Because reciprocity agreements can get complex, such as when employees work in different states throughout the year, you should consult an experienced tax expert or payroll provider.
4. Taxes to consider
States differ on the taxes they require employers to withhold and their amounts. When it comes to multi-state payroll, employers should be mindful of the taxes below:
Income tax is the tax on employee income earned within a particular state. Employers are responsible for withholding state income tax from their employees’ pay and remitting it to the state government. However, employers can’t withhold income tax for the nine states that don’t have a state income tax: Florida, Alaska, South Dakota, Washington, Wyoming, New Hampshire, Tennessee, Texas, and Nevada.
State unemployment tax
State unemployment tax is tax paid to fund the state’s unemployment program, which helps provide financial assistance to workers who have lost their jobs. In some states, employers are responsible for withholding and remitting it on behalf of their employees, while in others, it is an employer-only tax.
Disability insurance tax
Disability insurance tax is tax paid to help provide financial assistance to employees who cannot work due to a temporary disability. Employers pay it on behalf of their employees, and it is only required in a handful of states.
Paid family and medical leave
Some states, such as Massachusetts and Connecticut, require employers to withhold and remit paid family and medical leave contributions from their employees’ pay.
Withholdings vary by state, as discussed below. You must be aware of the specific tax requirements of each state you operate in and stay up to date with any changes in state tax laws to avoid penalties and ensure compliance.
5. Withholding taxes
Managing multi-state payroll taxes can be challenging. Each state’s different rules and regulations and several other factors dictate the taxes to withhold, making the process complex. Understanding these rules, regulations, and factors can make the process easier.
The guidelines below on withholding various types of taxes in a multi-state setting will help you avoid compliance issues and penalties.
Based on the source income principle, the state where your employee works determines your income tax withholding obligations. But some conditions can make it more complicated:
- If your employee works in one state and lives in another: If there are no reciprocal agreements between the two states, you withhold tax for both states. If there’s an agreement, you would only report the income to their resident state.
- When you have a nexus in another state: If your employee works in a state where you have established nexus for a period exceeding a set state threshold, you are required to withhold income taxes in that state.
- When your employee works in multiple states: If there’s no reciprocity agreement, allocate compensation to each state they worked in, and withhold income tax for each accordingly.
After determining which states you need to withhold tax for, the amount will depend on the state’s rate. Some use a tax table, and others use a flat rate. You can check each state’s rules on their tax agency’s websites.
State unemployment tax
If your business operates in Alaska, Pennsylvania, and New Jersey, you must withhold the state unemployment tax and remit it to the state. The rest of the states have the unemployment tax as an employer-only tax. If you live in the three states, you withhold unemployment taxes according to the source income principle.
Disability insurance tax
Whether you are required to withhold and remit disability taxes depends on the rules of the state you operate in. For example, you are responsible for withholding temporary disability taxes if you have business operations in Rhode Island.
Paid family and medical leave
The state you operate in determines your responsibility for withholding paid family and medical leave tax. For example, if you have operations in Massachusetts, you must withhold employee contributions and remit to the government.
6. Nonresident taxation policies
In some states, you aren’t required to withhold any taxes from employee wages until they work for more than a set threshold number of days or earn more than a certain threshold amount of wages for services performed in the states. Different states have different thresholds and other requirements in their nonresident taxation policies.
When the employee meets the threshold, you must start withholding the taxes for services performed in the state.
Improve your multi-state payroll management with Everee
Multi-state payroll involves calculating salaries, withholding taxes, and making payments to employees of businesses operating in multiple states. Effectively managing multi-state payroll can be complex because of the varying state regulations that could change every year, but it is necessary to avoid penalties and maximize efficiency.
That is why many businesses prefer using a software program or rely on professional help with multi-state payroll. A professional payroll provider has a vast knowledge of tax filings and different compliance laws across states, so they can ensure compliance as you focus on running and growing your businesses.
Need help remitting withholding taxes, filing all tax returns, and handling your year-end W2s and 1099? Get a free demo of Everee today.