Snow Bound Musings: The Tax Implications of Telecommuting

Like most people in the Mid-Atlantic states, I spent most of last week stuck at home as a virtual prisoner of the snow storms that pounded our area beginning on February 5.   During this period, the “busy season” for accountants and tax preparers, these lost work days could have been disastrous.  Fortunately, by using computer technology, most of the professionals in my firm were able to remain productive and work remotely from home. 

With the proliferation of computer technology and high speed internet connectivity over the past 20 years, telecommuting has become a more significant and pervasive movement in our economy.  Working from home or telecommuting has become routine for many workers.  For employers this technology can reduce costs for office space and aid in the recruitment and retention of quality personnel.  Likewise for employees, the use of telecommuting can not only aid in the balance of work and life, but also greatly expand the potential market for their services.

As the roads were finally cleared and I returned to the office, I was greeted by the February edition of The Tax Adviser which contained an excellent article by Ilya Lipin, discussing some of the tax ramifications of telecommuting.  Given my recent, albeit temporary foray into the virtual workplace, I was inspired to share some of the excellent information provided by Mr. Lipin as well as a few thoughts of my own regarding the tax ramifications of telecommuting.

Telecommuting and Nonresident Income

The Due Process and Commerce clauses of the United States Constitution restrict the taxing authority of states to remain within their borders requiring at least some minimum connection between the state and the income earned by the taxpayer before a state can tax that income.  As such, income is typically taxed in the state where the worker is physically located when the work is done.  This allocation requirement also applies to telecommuting.

For example, let’s say that you are a computer programmer.  You are employed by a company located in California but you work mostly from home traveling to work out of your employer’s offices only ten weeks out of the year.  In this example, approximately 80 percent of your taxable compensation would be allocable to Virginia and the remaining 20 percent would be taxable by California as nonresident income.  As a resident of Virginia, as in most states imposing a tax on earned income, all of your wages would be taxable to Virginia with a credit for the taxes paid for the California income available for a credit to eliminate the effect of double taxation.  This physical method of allocation is used by 36 of the 50 states.

In this example, if we changed the home state to one of the 9 states that currently do not have a state income tax, then you would only be subject to state income tax on the California nonresident income.

As Mr. Ilya points out in his article, the method of allocation utilized by the remaining five states – Delaware, Nebraska, New jersey, New York and Pennsylvania – is the convenience versus necessity test.  In a nutshell, these states assert that the work of nonresident telecommuters is derived from the resident employer and thus taxable in the state of the employer unless it can be demonstrated that it is the nature of the work or the needs of the employer that necessitate the employee to work from home rather than merely convenience.  The constitutionality of the convenience versus necessity test has been tested numerous time in court and has by and large survived as valid.

In certain instances, the application of this method can result in double taxation.  As I mentioned earlier, most states allow a credit for nonresident income taxes paid on income that is also taxed to a resident taxpayer.  In many states, this credit is only available where the tax paid to the nonresident state is connected with income earned in other jurisdictions.  Although a convenience and necessity state considers all the income earned in their state, the resident state utilizing a physical presence method may consider all or a portion of the telecommuting income earned in the home state.  The credit for the nonresident tax paid will not be available for income earned in the home state.

Nexus and Apportionment

The tax issues related to telecommuting are not limited to the taxation of telecommuting employee’s compensation.  Companies utilizing the services of telecommuting employees may also have to consider nexus issue to determine the calculation of apportionment formulas for their income.  When a taxpayer does business in multiple jurisdictions, the income must be divided or apportioned.  Typically, a three pronged formula based on the source of revenue, location of property and equipment and location of employees is utilized to determine the appropriate percentage on income taxable by each state.

In determining the source of revenue earned, a business utilizing telecommuting employees must be careful to consider how its income is earned.  For most service based business, the employees providing the work are conducting the income producing activity.