Business SALT Issues Arising From COVID-19 Travel RestrictionsJune 12, 2020
Since the middle of March, most states in the country, especially those in the Northeast, have imposed business shutdown orders and travel restrictions that prohibit individuals from traveling to work, etc. As a result, many employees who would otherwise be traveling across state lines to work are now working from home. Also, many individuals have decided to move out of more populated areas to take up residence in vacation homes, etc. that are located in other states. These factors can give rise to State and Local Tax (SALT) implications for employers and individuals. The following discussion covers the implications for businesses. The implications for individuals are discussed in a separate article.
Although imposing shutdown orders and travel restrictions may be an effective way to prevent the spread of COVID-19, it may result in some undesirable consequences such as exposing businesses and their owners to possible income and sales tax nexus where the business may not have had nexus in the past. Based on traditional nexus rules, many states will impose income and sales tax nexus on a business based on the presence of the business’ employees working remotely in that state.
To date, many states have not addressed the issue of how employees working from home due to state shutdown mandates will affect tax nexus. Thus far, Connecticut has not issued guidance as to whether employees working from home during the COVID-19 pandemic as a result of state mandates create tax nexus. Based on traditional nexus rules, compensating an employee for the use of the employee's home will create nexus.
In contrast to Connecticut, the New Jersey Division of Taxation (the “Division”) has recently implemented official guidance on this important nexus issue. The Division has stated that “as a result of COVID-19 causing people to work from home as a matter of public health, safety, and welfare, the Division will temporarily waive the impact of the legal threshold within N.J.S.A. 54:10A-2 and N.J.A.C. 18:7-1.9(a) which treats the presence of employees working from their homes in New Jersey as sufficient nexus for out-of-state corporations. In the event that employees are working from home solely as a result of closures due to the coronavirus outbreak and/or the employer’s social distancing policy, no threshold will be considered to have been met.” Accordingly, employees working remotely in New Jersey due to necessity from state-mandated shutdown orders will not create nexus in New Jersey for the employer for both income and sales tax purposes.
As of now, New York has not published official guidance as to whether employees working from home during the COVID-19 pandemic as a result of state-mandated shutdown orders create nexus. Based on traditional nexus rules, employees working remotely in New York due to necessity from state-mandated shutdown orders will create nexus in New York for the employer.
Similar to New Jersey, Pennsylvania has issued guidance on the issue of whether employees working from home during the COVID-19 pandemic as a result of state mandates creates corporate income tax nexus. Governor Tom Wolf issued a Proclamation of Disaster Emergency on March 6, 2020. Based on this Proclamation, the Pennsylvania Department of Revenue published guidance on their website in the form of Frequently Asked Questions (FAQs) addressing tax issues related to the COVID-19 pandemic. The responses to these FAQs state that “as a result of COVID-19 causing people to temporarily work from home as a matter of safety and public health, the department will not seek to impose CNIT (corporate net income tax) nexus solely on the basis of this temporary activity occurring during the duration of this emergency.” A similar statement has been published concerning sales tax. Accordingly, employees working remotely in Pennsylvania due to necessity from state-mandated shutdown orders will not create income or sales tax nexus in Pennsylvania for the employer.
The Philadelphia Department of Revenue issued guidance on April 22, 2020, which states that the Department “will temporarily waive the legal nexus threshold established under §19-2603 of the Philadelphia Code and under Section 103 of the BIRT (Business Income and Receipts Tax) Regulations, which considers the presence of employees working temporarily from home within Philadelphia as establishing sufficient nexus for out-of-Philadelphia businesses. This waiver applies if and when an employee works from home solely as a result of the COVID-19 pandemic.” Accordingly, employees working from home in Philadelphia as a result of COVID-19 shutdown orders will not create Business Income and Receipts Tax nexus for the employer in Philadelphia. Philadelphia has not provided any guidance regarding Net Profits Tax, which employs a payroll factor as part of its overall apportionment methodology.
Withholding and the “Convenience of the Employer” Test
Generally, for withholding purposes, employees’ wages for the performance of personal services are sourced to the state where the work is performed by the employee. Therefore, for employees that work remotely, generally, withholding is due to the state in which the employee is working remotely, rather than the state where the employer is located.
However, some states (i.e., Connecticut, Delaware, Nebraska, New York, Pennsylvania and the City of Philadelphia) have implemented what is referred to as the “Convenience of the Employer” test. Generally, in a state that applies this test, wages earned by a nonresident are allocated to the employer's location unless the nonresident works from an out-of-state location due to the necessity of the employer rather than the convenience of the employee. For example, pursuant to New York regulation 20 CRRNY 132.18, “if a nonresident employee performs services for his employer both within and without New York State, his income derived from New York State sources includes that proportion of his total compensation for services rendered as an employee which the total number of working days employed within New York State bears to the total number of working days employed both within and without New York State…..However, any allowance claimed for days worked outside New York State must be based upon the performance of services which of necessity, as distinguished from convenience, obligate the employee to out-of-state duties in the service of his employer.”
Based on the rule set forth above, generally, employees of a New York employer who are working remotely from their homes in other states such as New Jersey, Connecticut, etc. must be working outside of New York out of necessity in order for their wages to be sourced outside of New York for withholding and income tax purposes. Clearly, employees currently working from home due to the COVID-19 pandemic are not doing so out of convenience but out of necessity due to state-mandated shutdown orders. Therefore, wages resulting from days that the employees are working from home due to the COVID-19 pandemic should not be subject to New York State withholding or individual income tax.
Connecticut has also adopted the “Convenience of the Employer” test but in a limited scope as it applies only with respect to residents of states that have adopted their own “Convenience of the Employer” test such as New York and Pennsylvania. For example, in determining whether income earned by a New York resident individual telecommuting for a Connecticut employer will be deemed Connecticut-sourced income, Connecticut will apply the New York “Convenience of the Employer” test. Therefore, if an employee's state of residence is in New York, and the employee works for a Connecticut employer from a location in New York for their own convenience, then the Connecticut employer must include those days as days worked in Connecticut and withhold accordingly. Conversely, employees of a Connecticut employer who are currently working from home out of necessity, such as due to the COVID-19 pandemic state-mandated shutdown orders, would not be subject to Connecticut withholding or individual income tax relative to those days.
Similar to New York, Pennsylvania has also adopted the “Convenience of the Employer” test for determining where a telecommuting employee’s wages should be sourced for both withholding and individual income tax purposes. Generally, the same analysis described above for New York would apply to employees working from home for a Pennsylvania-based employer. However, the Pennsylvania Department of Revenue has published guidance on its website that states that if an employee is working from home temporarily due to the COVID-19 pandemic, the Department would not consider that as a change to the sourcing of the employee’s compensation. Accordingly, if the employee is working for a Pennsylvania-based employer, the employee’s compensation remains a Pennsylvania source, and the employer is required to withhold Pennsylvania tax on their compensation unless the state where the employee lives and is working from has a reciprocal agreement, as most states bordering Pennsylvania do (Delaware and New York do not).
Philadelphia has also adopted the “Convenience of the Employer” test in determining the sourcing of wages for employees who are telecommuting. The Philadelphia Department of Revenue has also issued guidance on this issue in the form of a Wage Tax Policy issued on May 4, 2020. The Department stated that employees of Philadelphia-based employers who are required to work outside the city (such as due to COVID-19) are exempt from the city’s wage tax for days spent fulfilling that work. However, the Department has further elaborated that “an employer may choose to continue withholding the Wage Tax from 100% of a non-resident employee's compensation. This is a business decision, not a requirement.” Accordingly, an employer may continue to withhold the Philadelphia wage tax from the nonresident telecommuting employee’s compensation but is not required to do so during the COVID-19 pandemic shutdown. Non-residents of Philadelphia who continue to have wage tax withheld from their compensation will have to file wage tax refund petitions next year.
New Jersey has not adopted the “Convenience of the Employer” test in determining the sourcing of wages for employees who are telecommuting. Generally, New Jersey’s sourcing rules state that income is sourced based on where the service or employment is performed. However, the New Jersey Division of Taxation has issued guidance on its website stating that “during the temporary period of the COVID-19 pandemic, wage income will continue to be sourced as determined by the employer in accordance with the employer’s jurisdiction. The Reciprocal Personal Income Tax Agreement between New Jersey and Pennsylvania eliminates wage sourcing issues for these employees as there is agreement to not tax the wages of a resident of the other state.” Accordingly, the wages of employees working remotely due to the COVID-19 pandemic will continue to be sourced to New Jersey for withholding and income tax purposes. Therefore, employers will not have to go through the arduous process of changing withholding in their payroll systems based on these employees working remotely.
Effects of State and City Income Tax Apportionment From COVID-19
Most states and many cities impose some sort of income tax on businesses operating or deriving income from sources within their borders. Where businesses operate in or have income from two or more states, the states are required to impose their income tax only on income that is “fairly apportioned” to them. States generally use one of two methods to apportion the taxable income or loss of a business:
- A “single sales factor” in which the percentage of total income taxed by the state is determined by dividing the gross revenues earned from sources in the state by gross revenues everywhere; or
- A “three-factor formula,” which uses an average of the business’s revenues, property and payroll in the state. Many times more weight is given to the revenue factor.
In some states, such as New York, New Jersey and Pennsylvania, either a single sales factor or a three-factor formula is used depending on the type of business. Corporations are generally subject to a single sales factor whereas partnerships employ a three-factor formula, at least with respect to non-corporate partners. Please see the chart below describing how New York, New Jersey, Connecticut and Pennsylvania apportion business income.
To make things even more interesting, the revenue or sales factor can be different depending on the entity and which state or city is involved. For instance, New York, New Jersey and Pennsylvania use “market-based” sourcing to determine which state revenue is sourced for corporate income tax purposes. For example, a New York-based architectural firm, taxed as an S corporation, that designs a building for a client in Pennsylvania will source their revenue for that engagement to Pennsylvania for New York apportionment purposes since that is where their client received the benefit of their services.
Instead of market-based sourcing, states and cities might instead use “proportional cost of performance” or “greater cost of performance” for purposes of sourcing revenues from service transactions. Under the “proportional cost” method, revenues from service transactions are apportioned to the extent that the services were actually performed in the state. Under the “greater cost” method, they are apportioned to the state where the greatest amount of time and costs were spent performing the service.
Suppose that instead of being taxed as a corporation, the New York-based architectural firm described above is taxed as a partnership. With respect to partnerships, New York is a “proportional cost of performance” state, so to the extent that the work involved in designing the building for their Pennsylvania-based client was performed in New York, the revenues from the engagement will be sourced to New York. Consequently if 80% of the time was spent in New York and 20% was spent in Pennsylvania, 80% of the revenue would be sourced to New York. Pennsylvania, however, is a “greater cost of performance state” and since the majority of the time on the engagement was spent in New York, none of the revenues would be sourced to Pennsylvania.
These situations can result in an increased or decreased overall state tax burden, depending on the factors involved. If a service business primarily operates in a state that uses a cost of performance standard and has clients in a state which uses market-based sourcing, they will wind up with at least some of the same revenues in the numerators of both state apportionment factors. If you turn things around, though, you can wind up with sources of revenue not showing up in either state’s revenue factor.
Potential Effects of COVID-19 on Apportionment
For those jurisdictions that use a single sales factor based on market-based sourcing, it is likely that their apportionment percentages will not be affected by the fact that many employees are now working from home instead of in offices located within those jurisdictions. However, for those jurisdictions that use a three-factor formula and/or apportion revenues using a cost of performance standard, the current environment may have some effects, and businesses operating or deriving revenue from sources within those states need to be aware of these issues.
First, with regard to jurisdictions with a three-factor formula, one of those factors is the payroll factor. If an employee normally works in a state that employs a three-factor formula and is now working from home in a different state, are those employees’ wages now sourced to their home state (since that’s where the work is actually being performed) or do they still get sourced to the state where they are managed or directed from? New York sources payroll to it if it is paid “in connection with business carried on or within” it. New Jersey sources payroll to it if “work is based in an office or other place of business located in New Jersey.” Pennsylvania looks to the state where the services are actually performed but has recently announced that an employer with employees who typically work in Pennsylvania but are now working in another state must still source their wages to Pennsylvania.
Consequently, with respect to an employee who lives in New Jersey and works for an employer in Pennsylvania and who is now working from home, their wages are still sourced to Pennsylvania.
Also, for those states that apportion revenues using a cost of performance standard, the fact that employees are now working from home may affect their revenue factors. If an employee who usually worked in a partnership’s New York City office is now working from home in Connecticut, the revenues derived from the employee’s services would not be sourced to New York State or New York City since they are not being performed there, and since Connecticut is a market-based sourcing state for all businesses, they wouldn’t be sourced to Connecticut either unless working for a Connecticut-based client. On the other hand, an employee working from home in New York City for a Connecticut-based employer could give rise to increased revenue and payroll factors for New York State and New York City purposes.
So far we haven’t seen any announcements from the states of New York, New Jersey or Pennsylvania on the revenue factor issue. Recently the City of Philadelphia announced that for purposes of its business taxes, service providers with offices in Philadelphia that have employees working outside of Philadelphia who would otherwise be working in Philadelphia must source the revenues derived from their services to Philadelphia.
Based on the above discussion, employers that operate in states that use a three-factor formula and/or a revenue factor based on a cost of performance standard should be monitoring the activities and locations of their employees. This can provide some tax savings or could give rise to an additional tax burden, depending on the facts.
 See Complete Auto Transit, Inc. v. Brady (430 U.S. 274 (1977))