One of the holdovers that will likely result from COVID-19 workplace restrictions is employers allowing more employees to work remotely in a more permanent manner. This will allow many employees to work for an employer in one state while residing in another. As this shift takes place, its impact will most likely be felt in out-of-state remote employees’ income taxes—sometimes more than once. For instance, some states may require employers to withhold unemployment and state income taxes in the state where the employee is located instead of the state where the employer’s home office is located. In some situations, remote employees may be subject to income tax in both the state they reside and the state in which their employer operates.
Many states follow one of these approaches when it comes to withholding income taxes:
- “Physical presence” Rule: If your head office is in State A but your remote employee works at home in State B, under the physical presence rule you are required to withhold unemployment and state taxes in State B, even if you don’t have a physical office there.
- Reciprocity: Some states that border each other have entered into agreements related to allowing an employee who lives in one state but works in a neighboring state to have their withholding tax paid to the work state.
- Convenience rule: Some states impose tax based on the employer’s location, not the location of the employee, where the employee’s remote location is not needed by the employer but rather is for the convenience of the employee. This rule possibly subjects employees to income tax in both the state they reside and the state in which their employer operates.
After a period of uncertainty, Arkansas law will follow the “physical presence” rule approach. In the past, pursuant to Arkansas Department of Finance and Administration (DFA) Individual Income Tax Regulation 1.26-52-202(c), the State of Arkansas only required income tax on work that could reasonably be allocated to work performed in Arkansas. Based on DFA’s recent Legal Opinions No. 2020023 and No. 20150202, however, Arkansas took the convenience rule approach for a short period of time. In these opinions, the DFA opined that a Systems Analyst working remotely from Washington for an Arkansas employer and a non-resident professor working remotely for an Arkansas university were subject to Arkansas income tax on their income even though they worked out of state. For the Systems Analyst, the DFA noted that she owed income taxes to the State of Arkansas because she was employed by an Arkansas employer, her day-to-day work duties were directly tied to the maintenance of computer systems in Arkansas at her employer’s in-state location, and those duties directly impacted the ability of her employer to carry out its mission and purpose in Arkansas. See the opinion here. For the non-resident professor, the DFA noted he owed income taxes to the State of Arkansas because the professor was teaching a course in Arkansas and engaging with students in an organized manner in a classroom provided by the Arkansas school. See the opinion here. Due to the uncertainty, Senate Bill 484 was introduced during the 2020-2021 General Assembly—Regular Session. SB 484 clarifies the allocation of nonresident income for Arkansas income tax purposes and establishes that Arkansas follows the “physical presence” rule as was set out in DFA Individual Income Tax Regulation 1.26-52-202(c). SB 484 states that:
A nonresident individual who is paid a salary, lump sum payment, or any other form of payment that encompasses work performed both inside and outside of Arkansas shall pay Arkansas income tax only on the portion of the individual’s income that reasonably can be allocated to work performed in Arkansas.
See bill here. This means that only work an employee performed while physically in Arkansas would be subject to Arkansas income tax. SB 484 has passed through the House and Senate and will be signed into law by Governor Hutchinson.
Arkansas does have an exemption that differs from both the “physical presence” and convenience rules and that is a special border exemption for residents in Texarkana, Arkansas and Texas. See the exemption here. Under this exemption, Texarkana, Arkansas employers are not required to withhold Arkansas taxes on Texarkana, Texas residents who permanently reside there and the income is from that Texarkana, Arkansas employer. This does not apply to any non-Texarkana, Arkansas employers who may employ Texarkana, Texas residents, however.
As is probably obvious, these tax implications reach across the country and some states are looking for more tax uniformity. So much so that the State of New Hampshire filed a claim in the Supreme Court of the United States (SCOTUS) attempting to challenge Massachusetts’ COVID-19 policy of imposing Massachusetts income tax on New Hampshire residents who worked at offices in Massachusetts pre-pandemic but have been working remotely in New Hampshire during the pandemic. See the motion here. States like Massachusetts follow the convenience rule approach. This case could cause major implications across the country in states that subject employees to double the income tax. With states like New Jersey, Connecticut, Hawaii, and Iowa, voicing support in an amicus brief and pointing to concerns states have—such as losing significant revenue streams as a result of granting a credit for its residents against taxes paid to other states or forcing states to double-tax the remote workers’ income—this may very well be a case the SCOTUS decides to address.
For any Arkansas employers who are following the trend of establishing more permanent remote work positions, be sure to stay updated on this case, SB 484, and any new guidance released by the DFA. In addition, you’ll want to stay abreast of the income tax withholding statutes and regulations in the states where any remote employees reside.