Withholding audits have domino effects. In addition to resulting in assertions that tax, interest and penalties are due as a result of withholding adjustments, withholding audits often result in subsequent personal income tax audits of highly compensated individuals that are identified during the audit and can result in assertions of personal liability against corporate employees and officers who are in control of withholding and reporting compliance.
Our focus in this article is identifying issues to reduce the likelihood of sustainable assessments and personal liability arising from withholding obligations. We examine the following withholding tax topics:
- Withholding Tax Liability;
- Safe Harbors;
- Deferred and Special Compensation;
- Responsible Person Liability; and
- Documentation Issues.
We provide the framework for each of these topics and identify additional points to consider.
Withholding Tax Liability
It is intuitive to distinguish between withholding for residents and withholding for non-residents. However, a state statute requiring withholding may not explicitly make such a distinction. For example, New York law provides that “every employer maintaining an office or transacting business within [New York] and making payment of any wages taxable under this article shall deduct and withhold from such wages for each payroll period a tax . . . .”1 The phrase “wages taxable under this article” in the statute captures both residents and non- residents inasmuch as New York residents are taxable on all of their income and non-residents are taxable on their New York source income.2
It makes sense that a state would require employers to withhold tax for all employees who are residents of that state because all of the income of a resident is typically subject to the taxing jurisdiction of the state. However, the rules vary from state-to-state as to when an employer must withhold for non-resident employees.
Unlike withholding for residents, states may not require withholding tax for all employees who are not residents of the taxing state. For example, New York statutes require withholding tax for non-residents that have New York source income (with some exceptions described below). By contrast, some states exempt an employer from withholding tax for a non-resident employee who works in that state (e.g., State A) if the employee’s home state (e.g., State B) has a reciprocal agreement with the state in which the employee works (e.g., State A) that exempts a similarly situated employer from a withholding requirement.3
When determining an employer’s withholding responsibilities for non-residents, some states provide safe harbor provisions. Not all states provide safe harbors, however, and the thresholds for exemption vary in those that do. For example, Arizona has a safe harbor for non-resident employees who are physically present in Arizona for less than 60 days during the taxable year.4 Connecticut and New York have safe harbors for non-resident employees who are not present in the state for more than 14 days during the taxable year.5 Although requiring an employer to withhold tax with respect to a non-resident’s de minimis physical presence may raise constitutional concerns, there is no guarantee that a safe harbor will be provided by the state.
Just as safe harbor thresholds can vary, so do the sources of authority that implement those safe harbors. The Arizona safe harbor referenced above is in a statute and the Connecticut safe harbor referenced above is contained in administrative guidance.6 These distinctions can be important because the weight of authority may affect whether: (1) the safe harbor would be respected by a court; (2) a legislative or administrative process would be required to change the safe harbor (legislative provisions are more difficult to change than administrative provisions); (3) a change in the safe harbor could have retroactive effect; and (4) a taxpayer can rely on the implementing authority to defend against penalties.
Withholding Tax Safe Harbors Versus Personal Income Tax Nexus
Importantly, although safe harbor provisions may exist in certain states for purposes of withholding tax, those same safe harbor provisions do not necessarily protect an individual from a personal income tax obligation in that state. Many states impose a personal income tax filing and payment obligation on: (1) “residents;”7 and (2) persons who derive income from sources within the state.8 Because an individual may derive income from a state without exceeding a statutory withholding threshold (e.g., a days threshold), the individual may have a personal income tax liability, yet her employer may not have a withholding obligation.
For example, assume that State X subjects a non-resident who derives taxable income from sources within State X to tax and that State X has a withholding safe harbor of 30 days (but not a personal income tax safe harbor). Now assume that during the year an individual works only 25 days in State X. On these hypothetical facts, the non-resident individual’s employer may not be required to withhold tax, but the non-resident employee may have a personal income tax reporting obligation as a result of deriving income from the 25 days of work in the state. This dichotomy of withholding liability versus individual subjectivity to tax is often overlooked and can spawn spin-off audits of individual employees.
The aforementioned dichotomy has received Congressional attention. The two major issues being debated are: (1) the number of days of presence by a non-resident that will result in a withholding requirement; and (2) whether such a number of days threshold is the appropriate measure to determine whether an individual has a personal income tax reporting requirement.
The proposed Mobile Workforce State Income Tax Simplification Act of 2013 was introduced in the House of Representatives on March 13, 2013.9 It is intended to provide uniformity of personal income tax nexus standards and the standards for an employer to withhold. Thus, except for certain persons (e.g., entertainers and athletes who can earn significant sums of money in very short periods of time in a state), non-resident personal income tax nexus and withholding requirements would only apply if a non-resident employee worked in a state for more than 30 days. It is unclear whether the bill will pass, but it certainly has the appeal of administrability as a result of the uniform number of days and a threshold that allows for the mobility of employees between states.10
What Is a Day?
Establishing a uniform number-of-days threshold is not the end of the story. Another wrinkle in filing thresholds is how state laws compute a day of presence in the state. Days of presence are important for withholding safe harbors. They are also important for personal income tax definitions of a “resident,” which are often tied to the number of days a person spends in a jurisdiction.11
Regarding what constitutes a day for residency purposes, the New York regulations provide:
In counting the number of days spent within and without New York State, presence within New York State for any part of a calendar day constitutes a day spent within New York State, except that such presence within New York State may be disregarded if such presence is solely for the purpose of boarding a plane, ship, train or bus for travel to a destination outside New York State, or while traveling through New York State to a destination outside New York State.12
Employers should understand the relevant states’ day counting rules and establish systems to help document their employees’ locations. State audits and challenges regarding a person’s days of presence in a state typically involve various aspects of daily activity including a review of passports, calendars, personal journals, credit card statements, bank statements (such as ATM withdrawal information), phone records, flight information (such as frequent flyer reports and airline tickets), hospital and medical office visit forms and utility bills.13 Furthermore, the time of arrival or departure of an airplane may be relevant in determining the day count, as was the case in a New York City administrative law judge determination that examined whether a taxpayer’s flight landed before or after midnight.14
Deferred and Special Compensation
Another issue involves the base from which to withhold taxes. States may require withholding on wages and may define “wages” by reference to the Internal Revenue Code (“IRC”). For example, Maryland defines wages as “salary, wages, or compensation for personal services of any kind as defined in [IRC] §§ 3401 and 3402(o)(2)(A)” and “includes remuneration paid for services described in § 3401(a)(5) and (6) of the [IRC].”15 North Carolina requires withholding on “wages,” but the North Carolina statutes provide that “‘[w]ages . . . has the same meaning as in section 3401 of the [IRC] except it does not include [certain specifically enumerated types of income].”16
The amount of wages withheld against may vary depending on whether the employee is a resident or a non-resident. For New York residents, employers must withhold on all wages paid to resident employees.17 For non-residents, New York requires withholding on only state source income, which leads to the question of what constitutes state source income.18 The answer may vary widely among states, especially for income such as deferred and special compensation.
How does a state determine the “source” of income with respect to deferred compensation and stock options? Some states compute the source of deferred compensation and non- statutory stock options by applying an allocation formula that attempts to represent the amount of work performed in the state over a specified period.19
For example, Minnesota administrative guidance provides that for deferred compensation, the applicable time period may be the period over which the employee gained the right to that deferred income:
Other non-statutory [not federally protected] deferred compensation is assigned to Minnesota in the ratio of days worked in Minnesota during the “allocation period” to the total number of days worked for the employer during the “allocation period.” The allocation period is the period of time during which the employee accrued the right to the deferred compensation.20
Examples in Minnesota’s administrative guidance illustrate the mechanics of the allocation period.21 Consider the following Minnesota example:
Employer maintains a supplemental retirement plan (SERP) that provides income that does not meet the criteria necessary to be preempted under federal law from state taxation when paid to a nonresident . . . .
Employee is a resident of California and works for the employer for two years in California. Employee then changes her residency to Minnesota where she works for 11 years. Upon terminating employment, Employee changes her residency to another state. Employee is entitled under the SERP to a monthly payment of $4,000 for five years.
Because Employee accrued the right to the deferred compensation throughout Employee’s 13 years of service, the allocation period is 13 years. Because the time worked in Minnesota during the allocation period is 11 out of 13 years, 85 percent or $3,385 of each monthly payment (11/13 x $4,000) is assigned to Minnesota.22
The above is just one example. State rules and types of compensation vary and, therefore, each state and type of income must be separately considered. Furthermore,inasmuch as formulas such as the foregoing may result in states attempting to tax too great a portion of such income, each such employee’s facts should be examined critically.
States may impose penalties on employers for failing to timely and properly withhold and remit taxes. New York imposes penalties on employers that non-willfully fail to withhold and pay taxes at the rate of 25% (for late filing) and 25% (for late payment) of the amount of tax that was required to have been withheld.23
It is possible that the employee’s direct payment of all personal income tax will not be a recognized defense to the assertion of penalties for failing to withhold and remit taxes. For example, the Indiana Department of Revenue took the position that a 20% penalty for failing to withhold tax when the tax had been fully paid by the individual was correct, asserting that “the issue is not whether the tax was paid, but rather whether the [withholding] taxpayer complied with Indiana laws governing withholding—a statutory mechanism designed to ensure compliance and ease of enforcement of Indiana tax laws.” 24
Responsible Person Liability
Personal liability for unpaid withholding taxes may attach to responsible persons within a corporation.25 The individuals that qualify as “responsible persons” vary by state.
For example, Ohio imposes personal liability for unpaid withholding taxes on employees of corporations having “control or supervision” over withholding tax compliance and upon corporate officers who are responsible for the “execution of the corporation’s . . . fiscal responsibilities . . . .”26 Wisconsin imposes personal liability on responsible persons when “(1) the individual had the authority to pay or direct payment of the taxes; (2) the individual had the duty to pay or direct payment of the taxes; and (3) the individual intentionally breached the duty.”27
To support a challenge against an assertion of improper withholding, documentation is important. Further, sufficient documentation is typically required. For instance, New York has issued several forms, which, if completed by an employee and relied on by a corporation, constitute sufficient documentation for demonstrating that the corporation acted properly for withholding audit purposes.28 However, New York places restrictions on such reliance. For example, the New York Withholding Tax Field Audit Guidelines state:
Employers may rely on information provided by employees regarding residence provided the information is accepted by the employer in good faith, and the employer did not have actual knowledge or reason to know the statement is inaccurate or unreliable.29
What constitutes “actual knowledge” and “reason to know”? The New York State Department of Taxation and Finance asserts that “[a]n employer cannot claim it does not have actual knowledge or reason to know if the business does not have a system in place to verify that the [withholding forms] received from employees are accurate.”30
Finally, New York State has instructed its auditors to apply additional penalties (see above) when an employer has actual knowledge or reason to know that the withholding forms submitted by employees were inaccurate.31
State tax agencies view withholding tax audits as low hanging fruit that can generate additional tax revenue, interest and penalties and identify candidates for personal income tax audits. Further, under certain circumstances, personal liability may attach to individuals in a company’s tax department. For these reasons, a state withholding tax audit can have unforeseen consequences, many of which can be avoided by careful preparation