As the federal tax landscape threatens to change, the state and local tax world is constantly evolving to meet the needs of constituents plus adapting to conform or decouple from the seemingly never-ending federal modifications. The following is a brief discussion of some of the current trends in the state and local tax world. We encourage you to reach out to your state and local tax professionals to discuss how these impact your state and local tax situation.
Telecommuting
The emergency orders issued last year forced employers to have most, if not all, employees to telework. What started as two weeks at home is closely approaching two years! Some employees fled small apartments, cold climates and/or cities with high rates of infection and started moving to new locations. Many never informed their employer of their new whereabouts. The fight for talent is forcing employers to reimagine employment and hiring policies and procedures to allow for permanent teleworking, but this is not without issues for both the employer and employee.
Certain employers have always had teleworking/remote workers. Sales personnel often work from a home office and travel from state to state soliciting orders on behalf of a company. Global employers have key executives traveling from location to location. Repair, service and/or installation activity keeps employees on the go. Pre-pandemic, these mobile employees created challenges with states requiring employers to withhold wages based on where employees performed services. Numerous companies either ignored or may not have understood the potential implications of these activities on state and local taxes and, instead, withheld payroll taxes only based on the employee’s state of residency. However, one difference between then and now is there was little change of employee residency location unless the employer required the move. Today, employees are actively moving about the United States; staying days, weeks or months before moving on to the next location without their employers’ knowledge. These are not extended vacations but rather the new normal of work with travel adventure. If the employer is unaware of the movement of its employees, it may not be properly withholding taxes from the wages earned. While this may have been an issue for employers pre-pandemic, the awareness of the matter is at an all-time high.
Employees working in multiple states create payroll withholding, unemployment insurance and state tax nexus issues for the employer and employee. Failure to properly withhold and/or remit payroll taxes can come at a high price if a state imposes a penalty on the employer. If a state considers the employer’s failure to do so intentional, it may have the power to impose a penalty as high as 100% of the amount not withheld.
If payroll withholding is required in a state, be sure to check whether a reciprocity agreement exists with neighboring states. It is important to distinguish that while withholding employee wages may be required for an employee for more than one state based on where they are working, unemployment compensation insurance differs. Unemployment compensation insurance is generally reported to the state in which the employee’s services are localized. States follow “localization of work” provisions established by the U.S. Department of Labor in order to avoid duplicate coverage or no coverage when an employee works for an employer in more than one state.
In general, services are localized within a state when services are performed entirely within the state or when the services performed outside of the state are incidental to the services performed within the state. If the services are not localized in one particular state, then a hierarchy is used to determine where the employee’s base of operations is located.
Considerations must be given to employees that will transition to teleworking permanently or that have relocated during the pandemic as those work arrangements are no longer “temporary” and will most likely require a change in reporting. This, of course, assumes the employer is knowledgeable of such changes on a timely basis.
Having an employee telework in another state can create additional compliance requirements for the business it possibly did not have before. These employees can create income tax, sales and use tax, gross receipts, local occupational taxes, various excise taxes, or local license filing requirements. Only a few jurisdictions lifted their withholding and/or nexus rules for the duration of the emergency orders, which are starting to expire. Therefore, it is important to ensure all compliance considerations, in addition to payroll, are evaluated when contemplating employees in new states/jurisdictions. Do you know where your employees are working? If the answer is “no” or “unsure,” it may be time to require employees to update location with your payroll department.
The employee also needs to be mindful of where they perform services on behalf of their employer. Temporarily moving from one location to the next can create a multistate filing requirement for the employee if their wages exceed the minimum filing requirements for a nonresident. There is also the possibility of an employer overcollecting payroll withholding taxes for incorrect assigned states or localities. Potential evidence that an employee is moving about is a request to have their Form W-2 amended or corrected.
The employee’s state of residency will most likely challenge a return if filed as anything other than a full-year resident. Residency matters are complex issues, which, if not properly planned for, can cause issues years down the road, especially if the employee gets “caught” by a state and can no longer amend resident returns to claim credit for any additional taxes paid. Most states have either a three- or four-year statute of limitation for returns filed but NO statute of limitation for unfiled returns. And let us not forget, most states have a six-year statute of limitation for the underreporting of income. Therefore, it would be prudent for employees to understand their own multistate filing requirement(s).
SALT cap
Since the Tax Cuts and Jobs Act of 2017 (TCJA) limited an individual’s federal itemized state and local tax (SALT) deduction to $10,000, states have been exploring pass-through entity (PTE) tax workarounds. Fast forward to November 2020 when the IRS gave guidance regarding state tax deductions for specified income tax payments at the PTE level and opened the floodgates to states enacting PTE tax legislation in the ensuing months, with California, Illinois, Minnesota and New York being among the latest.
PTE tax workarounds permit the PTE to pay the state tax at the entity level. As the $10,000 SALT cap applies to individuals, PTE taxes are taken as a partnership or S corporation deduction, which flows through to the owners without limitation. The partners, members or shareholders of the PTE that have paid the state PTE tax either receive a credit against their state individual income tax liability or are able to deduct their distributive share of income from their adjusted gross income in determining their state income tax liability. As straightforward as it sounds, it really is far from it. Because every state has different regulations, not every PTE owner will benefit the same.
Currently, nineteen states have enacted PTE-level taxes. Five states (Connecticut, Louisiana, Oklahoma, Rhode Island and Wisconsin) were early adopters and enacted these laws effective for tax years 2018 and/or 2019. Maryland and New Jersey enacted their PTE taxes effective for tax year 2020. Seven states (Alabama, California, Idaho, Illinois, Minnesota, New York and South Carolina) are effective for tax year 2021 and the remaining states (Arizona, Arkansas, Colorado, Georgia and Oregon) for tax year 2022. All are annual elections with the exception of Connecticut, which is a mandatory tax on the PTE. Be careful, California, Illinois, Minnesota and New York are among the states for which the election is irrevocable. The mechanics of making the election as well as the timing of when to make the election varies by state. New York’s deadline for making an election for tax year 2021 was Oct. 15, 2021. For tax year 2022, a New York election is due by March 15, 2022.
These elections can cause cash-flow issues especially in the first year of making an election. For those states allowing election for tax year 2021, the PTE and/or the owners may have been required to withhold or make estimated tax payments thus far for tax year 2021. Safe harbor rules, underpayment interest and late payment penalties should be analyzed when calculating the overall benefit in the initial year. However, in order for an electing PTE to benefit, it too will need to make a tax payment by Dec. 31, 2021, in order to deduct, for federal tax purposes, the state taxes as a specified income tax payment.
Even though a PTE would expect a federal tax benefit by making the election, it is possible an individual will lose some of their tax credits, perfected state losses or other personal state tax attributes. A resident’s analysis of their credit for taxes paid to other states should also be conducted to determine the benefit. Many states that have not adopted a PTE tax have not adjusted their statutes or regulations to allow for a credit for a PTE tax paid to another state. Further, states have clarified that a credit for taxes paid can only be taken if made by or on behalf of the taxpayer. For this reason, tax paid by an electing PTE may not be an eligible credit against the personal income tax of a resident owner. The risk of losing any tax attributes should be considered by PTEs conducting business on a multistate basis prior to making a PTE tax election. Bottom line, each state with a PTE-level tax for which a company operates in needs to be analyzed separately but collectively with all other states the taxpayer files returns in.
PPP treatment
For the most part, there is widespread conformity amongst the states regarding the 2020 tax year treatment of Paycheck Protection Program (PPP) forgiven loans and deductibility of expenses paid with said proceeds, with few exceptions. The most notable exception is California. In order for PPP-loan-funded expenses to be deductible in California, the taxpayer had to have at least a 25% or more reduction in gross receipts for any calendar-year quarter in 2020 when compared to the same quarter in 2019. If the 25% threshold is not met, the expenses were not deductible. Another state with an exception is Virginia, which only allowed up to $100,000 of expenses paid with forgiven loan proceeds to be deductible.
State audit activity
Taxpayers continue to receive letters notifying them of a state’s intention to audit. These, like nexus questionnaires and notices, should be taken seriously. Notices, especially if there is an adjustment to tax, may require a response within a certain time frame. Otherwise, the opportunity to object could be lost. Therefore, when in doubt, engage the services of a tax professional or attorney to handle these situations.
For more information on this topic, contact our team.
The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely. The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.
2021 year-end tax planning
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