What is multistate taxation?

Each state has the right to impose individual and corporate income taxes on businesses, not to mention general sales taxes, excise taxes, property taxes, license taxes, and more.

To make matters even more confounding, the nature of these different types of taxes can also vary. While most states charge a flat income tax rate anywhere from 1% to 10%, some use a progressive marginal tax, and others have a state alternative minimum tax.

Furthermore, taxable income liability state-by-state may differ from the total income tax on the federal level. You also need to apportion taxable income and deductions to the correct state based on the amount of business done in that state.

Confused yet?

You’re not alone! 48% of employers cite multistate payroll taxes as a significant or growing concern for their organization. The process of accurately calculating and paying taxes to multiple states while remaining in compliance with different laws and regulations can be complicated and time-consuming. This includes understanding the various tax rates, filing requirements, and payment deadlines.

Another significant wrinkle: What constitutes doing business in a given state?

Previously on this blog, we have discussed the concept of “nexus,” used by states to determine when an out-of-state entity has a sufficient financial connection to their state to trigger the application of state tax laws.

Suppose you sell goods or services to customers across state lines, such as through an e-commerce business, out-of-state vendor, or other entity like a corporation or partnership connected to another taxing jurisdiction. In that case, you must understand nexus if you want to avoid being audited by other states or territories — so take a look at our article on the subject for a deeper dive.

How do you manage multistate taxation?

The key question (which is by no means simple to answer) you should ask is this:

How much do I owe in each state?

The first step in answering this question is critical for any complex tax return: diligent record-keeping and top-notch organization.

Can you be taxed in multiple states on the same income?

In many states, you must pay tax on all income earned during the tax year — from all sources. Generally, however, you get a tax credit for taxes paid to other states. Putting it another way: if you receive income from your business operations in a state where you don’t live, you may have to pay taxes in both states, but your home state will give you a tax credit toward the tax you paid in the other state.

We’ll touch on this point again shortly, but first, there is a key concept you need to understand: reciprocity.

What is a reciprocal tax agreement between states?

state reciprocal agreement, or reciprocity, is an agreement in which two states allow a resident of one state only to pay taxes where they live while requesting an exemption from tax withholding in the other (reciprocal) state — for example, a state where they work.

For example, if you live in North Dakota but work in Montana (two states with reciprocity), you can request that your employer stop withholding Montana taxes. Then, you would only have to file a North Dakota return due to the reciprocal agreement.

For those who live in one state but work in another, this can save you the significant inconvenience of filing returns in multiple states.

The following states have reciprocal tax agreements:

  • District of Columbia: Nonresidents are not required to file a DC return. Residents of DC are not required to file a return for the state of:
    • Maryland if the only source of Maryland-source income is from wages.
    • Virginia, if they do not have an actual place of abode in Virginia and the only Virginia-source income is from salaries and wages.
  • Illinois: Iowa, Kentucky, Michigan, and Wisconsin residents are required to file only if they received Illinois-source income other than wages or request a refund of Illinois taxes withheld. Illinois residents working in these states report compensation on their Illinois return.
  • Indiana: Full-year residents of Kentucky, Michigan, Ohio, Pennsylvania, or Wisconsin, whose only income from Indiana is from wages, salaries, tips, or commissions, must file Form IT-40RNR, Reciprocal Nonresident Indiana Individual Income Tax Return. They will not be subject to Indiana state income tax but may owe county tax which is calculated on Form IT-40RNR.
  • Iowa: Iowa residents with Illinois wage income are only subject to tax in Iowa. Illinois residents with Iowa wage income are only subject to tax in Illinois.
  • Kentucky: Taxpayers of Illinois, Indiana, Michigan, Ohio, Virginia, West Virginia, or Wisconsin are taxed by their state of residence on income covered by the agreement and not by the state where income is earned. Individuals who live in Kentucky for 183 days or more during the year are taxed as residents, and reciprocity does not apply.
  • Maryland: Residents of the District of Columbia, Virginia, and West Virginia are not required to file a Maryland return if their only Maryland income is from wages and salaries. This also applies to Pennsylvania residents residing in local jurisdictions that do not impose an income or earnings tax against Maryland residents.
  • Michigan: Residents of Illinois, Indiana, Kentucky, Minnesota, Ohio, and Wisconsin are only required to file a Michigan return if Michigan income from sources other than wages is received or to request a refund of Michigan withholding.
  • Minnesota: Minnesota has reciprocal agreements with Michigan and North Dakota. Residents of those states are not subject to Minnesota income tax if:
    • The taxpayer was a full-year resident of Michigan or North Dakota who returned to their home state at least once a month, and
    • The taxpayer’s only Minnesota income was from the performance of personal services (wages, salaries, tips, commissions, bonuses).
  • Montana: Residents of North Dakota are not required to file a Montana return if the only source of Montana income is wages.
  • New Jersey: Compensation paid to Pennsylvania residents employed in New Jersey is not subject to New Jersey income tax.
  • North Dakota: North Dakota has reciprocal agreements with Minnesota and Montana. Minnesota residents are not required to file a North Dakota return if the only North Dakota source of income is compensation and the taxpayer maintains a home in Minnesota and returns to the house at least once each month. Montana residents are not required to file a North Dakota return if the only North Dakota source of income is wages.
  • Ohio: A full-year nonresident living in the border states of Indiana, Kentucky, West Virginia, Michigan, or Pennsylvania does not need to file an Ohio return if the nonresident’s only Ohio-source income is from wages.
  • Pennsylvania: Pennsylvania has agreements with Indiana, Maryland, New Jersey, Ohio, Virginia, and West Virginia. Generally, one state will not tax a resident of the other state on compensation that is subject to employer withholding.
  • Virginia: Taxpayers who meet the reciprocity criteria below do not need to file a Virginia return and are not subject to Virginia income tax.

Further considerations and criteria, including for states mentioned above, follow.

  • Kentucky and the District of Columbia: Residents of Kentucky or the District of Columbia who commute daily to work in Virginia are not required to file a return if all of the following apply.
    • The taxpayer had no actual place of abode in Virginia at any time during the year,
    • Salaries and wages are the taxpayer’s only Virginia-source income, and
    • The salaries and wages are subject to income taxation by Kentucky or the District of Columbia.
  • Maryland, Pennsylvania, and West Virginia: Residents of Maryland, Pennsylvania, and West Virginia are not required to file a Virginia return if the only income from Virginia sources is salaries and wages, the taxpayer was present in Virginia for 183 days or less during the tax year, and salaries and wages are subject to taxation by the resident state.
    • West Virginia: Full-year residents of Kentucky, Maryland, Ohio, Pennsylvania, or Virginia, whose only source of West Virginia income is from wages and salaries can claim a refund for tax withheld from wages.
    • Wisconsin: Wisconsin does not tax wages and other personal service income of residents of Illinois, Indiana, Kentucky, or Michigan. A resident of one of these states whose only income from Wisconsin is wages is only required to file a return if the return is to claim a refund for tax withheld in error.

What if a state doesn’t have a reciprocity agreement?

Bottom line: You may need to file two state tax returns in two states: a resident tax return for your state and a nonresident tax return for the state where you work.

Here’s the good news: thanks to a 2015 Supreme Court ruling, you won’t end up paying double tax in this situation. Upholding a Maryland Court of Appeals ruling, the high court ruled a Maryland “double taxation” law unconstitutional, setting a key precedent.

That means that if you need to file two state returns, the state where you live should provide a way to reduce your tax liability by the same amount you paid in the other state. For example, they may provide an equivalent tax credit to offset your liability.

Regardless of reciprocity, tax credits, and other considerations, multistate taxation is confusing and complex. However, with the right strategies and expert guidance, employers and employees can simplify the process and ensure that all taxes are paid in full and on time.

Would you like some help?

If you are a client and would like to book a consultation, call us at +1 (212) 382-3939 or contact us here to set up a time.

If you aren’t a client, why not? We can take care of your accounting, bookkeeping, tax, and CFO needs so that you don’t have to worry about any of them. Interested? Contact us here to set up a no-obligation consultation.

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