As a business owner, you aspire to work smarter, not harder. This applies in all areas, including hiring decisions. Hiring out-of-state employees to work remotely can indeed be a smart growth strategy as it expands the potential talent pool. However, it’s not so simple when just a single employee in another state can trigger multiple obligations including payroll tax, income tax, franchise tax, local tax, and even sales tax.
Before entering into an employment agreement beyond your operating state, it’s important to know how quickly those compliance obligations can multiply. Planning is far less expensive than the cleanup of a potential tax disaster, and that’s working smarter.
Registering as an Employer in Another State
Once the employment contract of an out-of-state worker is “signed, sealed, and delivered,” you generally must register in that state as an employer. Registering as an employer triggers new obligations, such as:
- state income tax withholdings
- registering for that state’s unemployment insurance program
- filing payroll tax returns
- complying with that specific state’s labor and wage laws.
Payroll tax obligations follow where the employee performs the work, not where your business is located. Failure to register properly can lead to penalties, back taxes, interest, or scrutiny from state agencies.
Income and Franchise Tax Nexus
Even just one out-of-state hire can convert a single-state business into a multi-state filer, creating a multi-tax nexus for your business in another state.
A nexus is a connection that allows a state to tax your business. A physical presence, such as a remote employee, creates a nexus. Once nexus is established, you will be required to file state, local, income, or franchise tax returns and pay minimum franchise taxes or gross receipts taxes. That exciting new remote hire creates the risk of generating an income tax nexus, as well as perhaps a franchise tax nexus.
Additionally, you may also need to apportion income to that state. Apportionment is the process of dividing your business’s income among different states to determine exactly how much tax is owed to each one. This is particularly impactful in this cross-state-border worker scenario.
A filing requirement may still exist regardless of profitability, and some states impose minimum taxes simply for existing and taking up space.
Sales & Use Tax Nexus
Another implication is the sales tax nexus. If a business sells taxable goods or services, having a remote employee in another state creates a potential sales tax nexus, even with no property or office in that state. For businesses expanding through remote teams, this is often the most surprising consequence.
Many states now have nexus standards based on sales volume. But a physical presence, such as an employee, is still a trigger that requires registering for sales tax, collecting and remitting sales tax, and filing periodic sales tax returns, even with little or no actual sales attributed to the state.
Worker Classifications
It is tempting, and common, to want to avoid the multi-state payroll implications by taking a riskier approach and classifying a worker as an independent contractor.
This assumption is false. Worker classification rules follow federal and state standards with strict tests. Misclassification can trigger some ugly consequences, such as back payroll taxes and unemployment contributions, workers’ compensation exposure, penalties, interest, and wage claims.
Labeling a worker under your direction as a contractor will not in any way protect you from tax liability. “We’ll just make them a 1099” is only a strategy if you are looking for penalties.
State Reciprocity and Compliance
No one likes to be double-billed. A reciprocity agreement is your tax equivalent of not having to pay for the same “service” twice. Many neighboring states have these handshakes to simplify income tax withholding for employees who live in one state and work in another.
However, not all states are kind enough to have these agreements, and sometimes they are limited to specific state pairings. They also typically apply only to wage withholding and not business nexus, so when and where there is reciprocity, you may still have corporate tax obligations.
Expanding your roster to include remote employees expands your compliance burden, including registrations, new tax accounts, filings, returns, and the ongoing monitoring of income apportionment.
Conclusion: Evaluate the tax impact before you hire
Initial instinct may be that hiring remote employees across states is a smart solution to expanding the talent pool. But every combination of states results in a different outcome, and every business must perform its own situational analysis to determine if it is economical or not.
This material has been prepared for informational purposes only, and is not intended to provide or be relied upon for legal or tax advice. If you have any specific legal or tax questions regarding this content or related issues, please consult with your professional legal or tax advisor.
