From brick and mortar to virtual, one state to many, small business operations vary.
Whether operating from home, a professional services building, retail store, or online, calculating payroll and filing taxes is a critical responsibility—and one that can be a bit more complex when paying employees across state lines.
A small business owner generally pays state taxes in the state(s) where the employee works. Seems simple enough—until you realize states govern payroll responsibilities with different rules.
Enter state reciprocity agreements.
Read on for more information about how state reciprocity agreements impact small business tax filings and payroll calculations, and employee tax filing.
What Is a State Reciprocity Agreement?
The U.S. Supreme Court ruled in 2015 that two states are prohibited from taxing the same income.
That means employees who live and work in different states, and file more than one state tax return, will only pay income taxes on some wages to one state.
Generally known as state reciprocity, the agreements between select states allow employees who work outside of the state in which they live to only pay taxes to their state of residency. That means depending on where your employee lives, they may be able to file just one annual tax return.
State Reciprocity Agreement Benefits
State reciprocity agreements simplify the withholding tax process for employers with employees who live in one state and work in another. The agreements—whether between two states or several states—mean the employer only needs to withhold state and local taxes for the employee’s state of residence. The agreements also help expand the talent pool and hiring opportunities, and simplify remote hiring.
For employees, reciprocity agreements make it easier to file state income tax returns if they work in one state but live in another. This helps prevent double taxation.
The agreements also may help high earners benefit if their state of residence has a lower maximum rate than the state where they work.
Which States Support Reciprocity?
Several states and the District of Columbia currently support reciprocity agreements. The agreements rely on mutual benefits for the states involved, and generally simplify tax processes and administrative challenges for both the taxpayer and state taxing authorities.
State reciprocity agreements vary by state, so it’s important you understand the parameters of each agreement.
The following chart shows where reciprocity agreements exist, plus what non-resident certificate a small business owner should have on file. Filing a non-resident certificate will ensure that the residency state tax is withheld at employee home state rates instead of the work state rates.
State Reciprocity and State Unemployment
It's important to note that reciprocity and non-resident certificate eligibility is determined by home address and pertains to income tax withholding.
Conversely, unemployment liability is usually based upon an employee’s work address. Prior to filing for state unemployment, an employee should consult an accountant, financial advisor, or the corresponding state agency to determine the correct unemployment liability.
Learn more about state payroll, state taxes and state unemployment.
What Happens When There is No State Reciprocity?
State reciprocity only works if the state where the employees works and lives has a reciprocal agreement, which is when neighboring states agree that people who work in nearby states can pay income tax to the state they live in.
That means reciprocity isn’t as simple as one state being next to another.
For instance, Pennsylvania and New Jersey have a reciprocity agreement, yet New York and New Jersey do not. That means if you live in New Jersey and work in New York, you will pay New York income taxes as a non-resident and New Jersey income taxes as a resident.
Some small business owners offer a courtesy withholding to help employees in these situations. It’s also helpful to know that some states for where there is no reciprocity grant a tax credit to the employee.
The Role of Small Business Owners
A small business owner should take time to mention during the hiring process if a new hire is covered by a state reciprocity agreement since it impacts their compensation. This conversation is also a great time to mention if the business plans to offer a courtesy withholding from their paycheck.
Withholding the proper taxes based on employee state of residency is key for a small business owner. This is just one reason how an automated payroll platform is a time-saver for small business owners.
It’s also important to remember that a business owner may need to register the business with both the employee’s work and home states.
Final Thoughts
If you’re concerned about manually tracking and processing the correct state taxes for each of your employees based on residence and reciprocity eligibility, you might want to consider a payroll service that will allow you to record each individual employee’s details and withhold the correct tax rates based on the information provided.
This content is for educational purposes only, is not intended to provide specific legal advice, and should not be used as a substitute for the legal advice of a qualified attorney or other professional. The information may not reflect the most current legal developments, may be changed without notice and is not guaranteed to be complete, correct, or up to date.
