Five Rules of Multistate Taxation

Here’s a question I get with some frequency: “One of our employees lived on one state when he/she was granted an award and then moved to another state before the award vested/paid out—what state do we have to withhold tax in?”

Every time I get this question, I think “I have some bad news for you.”  Because the answer is “It’s complicated.”

In this blog entry, I cover four rules that apply to multistate taxation and also discuss some tips for assessing your company’s risk level.

Five Fundamental Rules for State-to-State Taxation of Mobile Employees

1. Generally, the entire gain on the equity award transaction (e.g., option exercise, award payout) is subject to tax in the state where the employee resides at the time of the transaction (assuming this state imposes an income tax).

2. The transaction is also usually partially taxable in any states where the employee resided or worked during the life of the award (again, assuming these states impose an income tax). This can include permanent transfers, short-term assignments, and even business travel.

For most states, the life of the award refers to the period from grant until vest, but in some states, it is the period from grant until exercise/payout. To determine the portion of the award taxable in the nonresident state, divide the number of days the employee lived/worked in that state during the relevant award period by the total days in the award period.

3. Employees can generally claim a credit in their state of residence for taxes paid in other states.

4. State payroll taxes, such as disability insurance, unemployment insurance, workforce development, and family leave insurance, may not be subject to the same principles as state income tax. See the NASPP Blog “How State Payroll Taxes Apply to Mobile Employees” for more information.

5. Just because the employee has an obligation to pay tax in a state doesn’t mean the company has an obligation to withhold this tax. The company’s withholding obligation in a particular state can vary based on a number of factors including the laws of the state in question, whether the company has a corporate nexus in that state, whether the resident and nonresident states have a reciprocity agreement, and, in the case of remote workers who have relocated to another state, whether the state is a “convenience of the employer state.”

This is a complex area, even more so because each state determines its own tax laws and policies, so the laws can and do vary from one state to another. To learn more about state-to-state taxation, read the article "State Mobility Issues for Equity Compensation Professionals" by Marlene Zobayan of Rutlen Associates and available to all NASPP members.

Not a Do-It-Yourself Project

It’s probably clear from rule #4 that multistate taxation usually isn’t a do-it-yourself project. The laws are complex, they vary from state to state, and, as stock plan administrator, you may not have visibility into all the key facts and circumstances that can impact the company’s tax obligation. It’s best to seek the assistance of a qualified professional.

Mobility Compliance Starts with Risk Mitigation

For companies that haven’t considered this issue before, it can be challenging to go from zero to fully compliant. Most companies initially focus their compliance efforts in the areas of highest risk. Below are some key questions to answer when assessing your risk.

• How large is your mobile employee population? The more employees that are moving between states, the greater your risk.
• How high ranking is your mobile population? Higher ranking employees, particularly your C-suite, are going to be more visible to state tax authorities than lower ranking employees. A CEO who is in the news a lot might catch the attention of state auditors.
• How valuable is the equity held by mobile employees? Underwithholding penalties are typically a percentage of the taxes that should have been withheld so higher value equity awards are likely to trigger greater penalties for noncompliance (and regulators may be more aggressive about pursuing penalties on these awards).
• How high are the tax rates in the jurisdictions that employees are moving in and out of. Higher tax rates mean higher penalties for noncompliance. States with high tax rates also tend to be more aggressive about pursuing enforcement.
• How aggressive are the states employees are moving in an out of when it comes to pursuing tax liabilities from nonresidents? California and New York are notoriously aggressive in the area. States that are less aggressive about enforcement present less of a risk.

Implementing a Mobility Compliance Program

If you are faced with implementing a mobility compliance program from the ground up, you don’t have to go from zero to 100% compliance overnight. Start small and work your way up. Performing a risk analysis as described above will help you decide where to start.

For example, you might start with only your executives and roll out compliance to lower ranking employees in phases. Another approach might be to initially limit your compliance program to states with the highest tax rates or that are known to be aggressive about pursuing enforcement.

Here are some practical questions to address as you implement your compliance program:

• Which employees are mobile? What jurisdictions are they moving in an out of?
• What will be the source of address information? How will you know when employees have moved?
• What limitations exist in your payroll system? Some payroll systems may limit the number of jurisdictions taxes can be withheld in or may require state payroll taxes to be withheld in all jurisdictions where income tax is withheld.
• What education will be provided to employees?
• Will the company provide tax assistance to employees?

See our Top Ten List  on “Implementing a Compliance Program for Mobile Employees” for more tips on getting started with your compliance program.