Managing Federal, State, and Local Withholding Taxes
Among the duties that come within the ambit of human resources is managing employment-related tax obligations. Probably the most significant of these is withholding taxes.
Workers Work in Multiple Locations and in Multiple Taxing Jurisdictions - Federal, State, and Local
Businesses often have workers based in multiple locations, which may or may not be in their state of residence. Also, while many of these workers may work in one location, some move around between a business’s locations or its customers’ locations or other locations where they perform their duties. Examples include sales people who travel within a territory and people who perform their duties at the location of a client or customer, such as installing equipment. Businesses’ particular circumstances are as varied as there are businesses, but the theme is the same - complexity.
In addition to federal withholding taxes administered by the Internal Revenue Service, states imposing income taxes and multiple localities (counties, cities, school boards, etc.) may also impose their own taxes as well as employer withholding obligations on employees’ wages. The Kentucky Secretary of State’s website includes a list of these (http://app.sos.ky.gov/occupationaltax/). So, for example, an employee working in Shively, Kentucky would be subject to withholding for federal income tax, Kentucky income tax as well as Jefferson County (Louisville Metro) and Shively taxes.
Worker Classification Issues
When a business hires a worker as an employee, their classification is, as a practical matter, set. However, when a business retains a worker as an independent contractor, the Internal Revenue Service (or perhaps a state or local department of revenue or other state agency) could seek to reclassify the worker as an employee. The issue often arises when a worker questions whether he is indeed an independent contractor or is more appropriately classified as an employee. An employee may do this by filing IRS Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding. This oftentimes will precipitate an employment tax audit.
During an employment tax audit, one issue may be whether workers classified as independent contractors should be reclassified as employees. Classification turns on the relationship between the business and each worker as to: the control the business exerts over the worker’s behavior, e.g., instructions, training, etc.; the business’s control over financial aspects of the worker’s services, e.g., risk of profit or loss, etc.; and, the type of relationship between the business and the worker, e.g., whether it is governed by a contract (or not). IRS Publication 1779, Independent Contractor or Employee provides a general overview of factors the IRS considers to be important.
Retroactive reclassification can be onerous. When a worker who is classified as an independent contractor is reclassified as an employee retroactively, this can cause thorny logistical issues due to the nature of withholding, i.e., it is withheld from employees’ wages and paid to the IRS. Retroactive reclassification can also potentially have a collateral impact on employee benefit plans and compliance with employment laws. In states and localities with income taxes, a retroactive change in classification can potentially have an impact on state and local withholding. Fortunately, options exist to resolve reclassification issues on a go-forward basis.
Employees Residing and Working in Multiple States or Localities
Employees generally inform their employers of their states of residence. In many cases, there is no readily apparent issue regarding the state of residence claimed by an employee. But, the determination of an employee’s state of residence can be important. This is because a resident of a state is subject to their home state’s tax on all of their wages, regardless of where they are earned, and they are also subject to tax on the portion of wages earned in any state in which they are a nonresident, for which they get a credit in their state of residence. Being subject to tax on all of one’s wages versus a portion of one’s wages is an obviously important issue, when it arises.
When this happens, the determination of which state is an employee’s state of residence is generally a two-step inquiry. First, one must determine in which state the worker is domiciled. This common law test entails determining whether or not one resides in a particular state and intends to remain in the Commonwealth; it is a factually intensive inquiry especially when contacts with multiple taxing jurisdictions are involved. The second statute-based test generally turns on whether or not a person has an abode in a state and also spends approximately half the year or more in that state; if so, that person would be a resident of that state by statute. When the facts are not straight forward and involve multiple states, residency can be a complex issue.
When an employee is a resident of one state and primarily works in another with a different tax rate, this can cause an issue. For example, an Indiana resident employee working in Kentucky must pay tax on their income to both Kentucky (6%) and to Indiana (3.4%) - with a tax credit for Kentucky tax paid which would have a significant impact to the employee. State reciprocity agreements often provide an answer to this issue but there are not reciprocity agreements between all states. The Kentucky-Indiana Reciprocity Agreement is an example of a reciprocity agreement that authorizes a resident of Indiana working in Kentucky as an employee to pay tax on wages only to Indiana -- and not Kentucky, and vice versa. Reciprocity agreements are the exception, not the rule.
An employee who performs their job duties in multiple states - even for relatively short periods of time - can potentially incur obligations to report and pay income taxes in states in which the employee derives income from performing their job duties, depending on the amount of time and work performed in the involved state. Likewise, employers can incur withholding and reporting obligations. Requirements vary from state to state, and some states are more aggressive than others at attempting to enforce their tax laws on non-residents and their employers, even when an employee spends only a relatively short period of time working in the state.
States generally provide for safe harbors for employers, allowing an employee to be present in the state for up to a couple of weeks or so before subjecting the employer to a withholding obligation. There is no uniform standard, and some states provide for no safe harbor whatsoever.
Potential for Officer Liability
Federal and state statutes that require employers to withhold taxes from their employee’s wages and pay them over to the Internal Revenue Service and state departments of revenue often describe this obligation as one of trust. This can, depending on the statute, fall on an employee with responsibility for overseeing a business’s payroll and the payment of taxes withheld. Accordingly, it is incumbent upon those managing this function to ensure that income taxes that are withheld are remitted to the appropriate taxing jurisdictions. There are hefty civil and, in severe cases, criminal penalties that can apply. There are also exceptions.
Professionals managing employment taxes must deal with a national patchwork of different and non-uniform rules for withholding tax on and reporting of wages. Care and planning will aid in this.
This is a modified version of Mark A. Loyd’s regular column, Tax in the Bluegrass, “Managing Withholding Taxes” which appeared in Issue 3, 2017 of the Kentucky CPA Journal.