Taxing Matters: Multi-state Withholding – A State of Reciprocity

Every quarter we answer dozens of tax questions ranging from the simple to the complex. And lately, it seems one particular topic arises more frequently than others.

As we quickly approach the payroll tax filing deadline, it seemed fitting to focus on an issue affecting both employers AND employees. That issue? Reciprocal Agreements.

Before we jump right into what the reciprocal agreement is all about, consider this: remote workers alone now make up 2.6 percent of the American workforce. That means nearly four million Americans are working in one location and living in another. Now, if they’re simply working and living in the same state, that’s a relatively easy tax issue, but if they aren’t, well, it can get tricky.

That’s where the Reciprocal Agreement comes into play. The Reciprocal Agreement is a tax withholdings agreement some states have with others to address issues that arise when employees live and work in different states.

According to this BNA article, “Reciprocity agreements are often made between neighboring states and can make withholding easier for employees and employers because resident and nonresident taxation doesn’t have to be determined.”

From an employer standpoint, Reciprocity makes withholding taxes easier because you only have to withhold and report for one state. From an employee standpoint, it makes life easier when it comes to filing personal taxes at the end of the year because it eliminates a double tax burden the employee would face throughout the year by paying non-resident taxes to the work state and resident taxes to their home state.

However, not all states allow reciprocity. Those that do also include special rules for each state and who they allow reciprocity with. Additionally, each state/jurisdiction has its own form that must be completed and on file with an employer. For instance, New Jersey only allows reciprocity with Pennsylvania, but Pennsylvania allows reciprocity with Indiana, Maryland, New Jersey, Ohio, Virginia, and West Virginia.

To complicate matters even further, there are 9 states that do not have withholding at all. So, in a two-state scenario, the withholding defaults to the state that does have withholding tax. The 9 states without withholding tax include Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington, and Wyoming.

Multi-state taxation is never an easy matter, but by understanding how your business could benefit from Reciprocal Agreements, you could not only simplify the process of withholding, reporting, and paying taxes for employees who live and work in different states, but also reduce the administrative burden for your company, as well as the double tax burden for employees.

To help answer some common questions regarding Reciprocal Agreements, I’ve compiled a few “fast facts” below. As always, feel free to tell us what you think in the comments section.

Reciprocal Agreements Fast Facts:

  • Do Reciprocal Agreements only apply to remote employees?

No. There are many places where living in one state and working in another is common, even if employees come into the office daily. This is a common issue for businesses in cities like New York or Washington D.C. where commuters come in from New Jersey, Virginia or Maryland. You can click here for a list of which states have reciprocal agreements with one another.

  • Are there special forms employees need to fill out for the Reciprocal Agreement?

Yes. Each state has its own form that must be completed and that the ER must maintain.

  • What happens if an employee makes a mistake on the form that verifies his/her state residency?

They would be liable for any withholding tax that might be necessary upon discovery of the issue. If the employer has the form on file, the employer would be safe from action against them.

  • What do employees need to know / do at tax time?

As long as the two states have reciprocity and the employer has withheld for the appropriate state, the employee can file their taxes as normal to their home state. If taxes have been withheld for two states, employees will have to file in both states and request a refund of tax paid to the nonresident state.

  • What should an employee do if state taxes were withheld for both the state they work in and the state they live in?

This might be accurate if the states do not have a reciprocal agreement. If they do, the employee will need to file a return to both states, and claim a refund of tax paid to the non-resident state.

  • What happens if an employee’s state withholding taxes are wrong?

If the wrong tax is withheld because the employer set them up incorrectly (regardless of a reciprocal or not), it requires adjustments to correct the employee’s pay history, amendments to the returns filed with incorrect states, filings to the correct states, and possibly a W2C to correct the employee’s W2.

  • Do Reciprocal Agreements affect Federal withholding?

Not at all. Reciprocal Agreements only apply to state withholding.

  • Do Reciprocal Agreements affect any other types of withholding like Unemployment Insurance?

No. Things like Unemployment Insurance are an employer tax and have no bearing on employee income withholding.

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