Nexus and State Reciprocity

Nexus and state reciprocity are important topics for business owners and employees, as they can have tax implications for both parties. These topics might seem confusing until you understand the context in which they apply, so let’s break them down for a closer look.

Having nexus means that a business is connected to a state in some way. When a business has nexus in a state, it can trigger the need for the business to register to collect and pay taxes there. But whether a business has nexus is not always clear, as there’s no common definition of what nexus is or what having it means.

State reciprocity refers to agreements between some states that allow residents to pay income tax only to the state in which they live instead of to both their home state and their work state.  If there’s no reciprocity, an employee who works for a company that’s located in another state would have to file state income tax returns in both the state where they live and the one where the business is located.

Let’s explore each of these topics in greater depth so you can be clear on how your business must comply with tax regulations and how employees and employers can benefit from reciprocity with another state.

What is Nexus?

You’ve read what nexus is, and that it can be hard to figure out if a business has it. In addition to the lack of a single definition for nexus, states often change their rules regarding it. That puts the onus on business owners to keep up with any changes to ensure they remain in compliance with state laws.

A business is generally considered to have nexus in another state under any of these circumstances:

• There are employees working in a state other than where the business is registered.
• The business has a physical presence, such as a retail shop, office, or warehouse, in another state.
• The business generates a certain level of economic activity or income in another state. Generally, this is considered as more than 200 sales transactions or $100,000 in sales within the state in one year. If a company meets those numbers, it’s thought to have nexus and must pay sales tax to the state.

A business that has employees in a state other than the one in which the business is registered should assume it has nexus in the employees’ state.

Let’s look at an example of having nexus in another state:

• Your business is based in Texas.
• You have several full-time employees on your payroll who live in Arkansas on your payroll.
• You probably have nexus in Arkansas.
• And if that’s the case, you’ll need to register for payroll in Arkansas.
• You’ll need to apply for foreign qualification in Arkansas.
• You’ll also need to find a registered agent there, as many state agencies only consent to send documents to a physical address within state boundaries.

What is Foreign Qualification?

Foreign qualification, as a review, is a requirement for conducting business in a state other than where your company was founded and is registered. To apply for foreign qualification, you must apply to register your business in the state where you have employees. You normally send your application to the Secretary of State, although the name of the agency varies from state to state. When you foreign qualify your business, you’re able to operate in another state without having to start over and form a new business entity.

If your business has nexus in another state and you don’t foreign qualify there, you could face penalties including:

• Fines
• Charges for missed filing fees
• Having to pay back taxes for when the company was doing business in the state without having obtained foreign qualification
• Having to pay interest on any fees and taxes incurred during the period during which the company lacked foreign qualification
• Being unable to file any lawsuits in the state

Nexus and Out-of-State Taxes

If you have employees in another state and you qualify for nexus there, you’ll need to set up payroll tax accounts in each state and comply with each state’s rules.

Here are some important details to remember about taxes:

• Payroll taxes include federal and state taxes that employers must deposit and report for their employees.
• Payroll taxes can include federal income taxes, state taxes if imposed by a state, and local taxes if imposed by a county or city.
• Payroll taxes also include:
  • FICA taxes, which are Social Security and Medicare taxes paid by both employers and employees.
  • FUTA taxes, which are federal unemployment taxes paid by the employer and used to help workers who have lost their jobs.
  • Many states also collect unemployment tax from employers under the State Unemployment Tax Act (SUTA).
• If you are responsible for withholding, paying, and reporting state income tax for an out-of-state employee, you’ll also have to apply for a State Tax Identification number.
• If you have employees working in a state that levies SUTA taxes, you’ll need to register for a State Unemployment Tax Act account there.

Because tax regulations vary significantly from state to state, it’s important that you research and understand all the laws that apply to each state where you have employees. Failure to comply can result in fines and other penalties.

What is State Reciprocity?

While employers are required to withhold federal income tax from the wages of all employees, state and local taxes will vary depending on where the business is located and where its employees reside. Generally, if an income tax is imposed by the state, an employee must pay income tax to the state in which they reside.

Here are some important points to keep in mind about varying state laws:

• Nine states have no state income tax. These include Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington, and Wyoming.
• New Hampshire levies a tax on interest and dividends.
• Washington taxes some long-term capital gains.
• Employees may also have to pay income tax to the county or city in which they reside.

If an employee lives in one state but works either on-site or remotely for a company that’s located in another state, they may have to pay income tax to both states. A federal law forbids double taxation, so employees cannot be taxed twice on the same money. They may, however, need to file tax returns in both states, usually receiving a tax credit from their home state (but in some cases from their work state) at tax time to avoid double taxation.

To streamline filing and offer relief to taxpayers in that situation, some states enter into agreements with other states to let those employees pay tax only to the state where they live, not the one where they work. These agreements are known as state reciprocal tax agreements.

If the state where an employee lives has a reciprocal agreement with the state in which their employer is based, the employee can request a withholding exemption or non-residency certificate from their state’s tax agency. The form must be submitted to the employer, who will only withhold and submit taxes to the employee’s home state, but not both states.

Let’s look at an example of state reciprocity:

• Gina lives in Rockton, Illinois, located just a couple of miles from the Wisconsin border.
• On most days, she drives to her job at a college in Beloit, Wisconsin, a commute that takes about 10 minutes.
• Illinois and Wisconsin both have state income tax.
• If the states did not have a reciprocal agreement, Gina would have to file two tax returns—one to Illinois and one to Wisconsin.
• She wouldn’t ultimately pay income tax to both states, as the U.S. Supreme Court ruled in 2015 that double taxation on the same income is illegal.
• She would, however, need to take the time and trouble to complete and file two forms and confirm that she received a tax credit from either her home state or her work state.
• However, because Illinois and Wisconsin have reciprocity, Gina must only file a tax return with her home state.
• Gina should fill out a Form W-220 and give it to her employer, indicating that she does not want taxes withheld in her work state.
• Gina’s employer must continue to withhold taxes for Gina’s resident state or she could face penalties for underpayment at tax time.

Currently, 16 states and the District of Columbia have reciprocal agreements with at least one other state, and some states have agreements with five or more states.

• Arizona, with California, Indiana, Oregon, and Virginia
• Illinois, with Iowa, Kentucky, Michigan, and Wisconsin
• Indiana, with Kentucky, Michigan, Ohio, Pennsylvania, and Wisconsin
• Iowa, with Illinois
• Kentucky, with Illinois, Indiana, Michigan, Ohio, Virginia, West Virginia, and Wisconsin
• Maryland, with Pennsylvania, Virginia, Washington, D.C., and West Virginia
• Michigan, with Illinois, Indiana, Kentucky, Minnesota, Ohio, and Wisconsin
• Minnesota, with Michigan and North Dakota
• Montana, with North Dakota
• New Jersey, with Pennsylvania
• North Dakota, with Minnesota and Montana
• Ohio, with Indiana, Kentucky, Michigan, Pennsylvania, and West Virginia
• Pennsylvania, with Indiana, Maryland, New Jersey, Ohio, Virginia, and West Virginia
• Virginia, with Kentucky, Maryland, Pennsylvania, Washington, DC, and West Virginia
• Washington, D.C., with Maryland and Virginia
• West Virginia, with Kentucky, Maryland, Ohio, Pennsylvania, and Virginia
• Wisconsin, with Illinois, Indiana, Kentucky, and Michigan

Frequently Asked Questions

What does it mean for a business to have nexus?

A business that is in some way connected to a state has nexus and is subject to collecting and/or paying taxes there. Generally, a business that has employees working in another state is considered to have nexus there.

What must a business do to remain in compliance in a state where it has nexus?

A business with nexus in another state will need to register for payroll there, apply for foreign qualification, and locate a registered agent to receive official documents and other correspondence.

What is a reciprocal tax agreement?

A reciprocal tax agreement is a contract between two states that allows an employee to live in one state and work in another without having to pay state income taxes to both states.

How does state reciprocity affect an employer?

An employer whose out-of-state employee provides a state tax exemption form needs to withhold state taxes for just one jurisdiction instead of two.

How does state reciprocity affect an employee?

Employees who live in one state and work in another will need to file one tax return instead of two, cutting down on time and effort. And if the tax rate in the employee’s home state is lower than in their work state, they’ll pay less in state taxes.

How does an employee apply for tax reciprocity in another state?

Employees normally must notify their employer to claim an exemption from withholding in their work state and submit a state-issued exemption certificate, which the employer will provide, or employees can access online.

Does reciprocity affect my federal income taxes?

No. The IRS doesn’t consider what state you live in or where you earn your income when imposing income taxes.

Who establishes state reciprocal tax agreements?

Generally, a state’s Commissioner of Revenue or equivalent agency establishes state reciprocal agreements and determines what the agreement will look like. Some states only allow agreements with bordering states, while others allow them with any state that extends a similar agreement.

Keep Learning

• What is Payroll?
• Payroll Taxes 101
• When Do You Have Nexus in a State?
• Virtual Companies and Nexus: What Small Businesses Need to Know
• Legal Requirements for Hiring Out-of-State Employees