Not-for-profits must adapt tax plans for remote work

Today’s workforce looks very different than it did five years ago. Cloud-based technology and pandemic adaptations ushered in a new level of remote and hybrid work that was previously unthinkable. In that time, many of the laws governing taxation and compliance haven’t changed. In fact, many of the federal, state, and local tax rules that govern payroll tax and state taxation allocation were developed in the 1940s through the 1980s.

As a result, tax and compliance professionals in the not-for-profit sector might feel challenged to apply old rules to the new reality of remote or hybrid workers. How can they balance the tension between modern workforce demands and rules that are decades old?

Reimbursement of travel expenses 

As more organizations adopt a hybrid and remote work environment, it’s become common for employers to reimburse employees for expenses incurred to travel to the employer’s office. This may include flights, meals and lodging. While many organizations have been treating these expenses as a nontaxable business expense reimbursement to employees, these expenses may in fact be considered taxable to the employee, depending on the facts and circumstances.

In Commissioner v. Flowers, 326 U.S. 465 (1946), a taxpayer who was a remote employee attempted to deduct travel expenses when traveling on occasion to their employer. The Supreme Court disallowed the deduction for travel expenses, ruling that the expense must be incurred in the pursuit of business, specifically, the employer’s business. The court concluded that the employer “gained nothing” from the taxpayer’s decision to reside in a different location and, as a result, the employee’s expenses to travel to the employer’s office were irrelevant to carrying on the business of the employer.

So, in cases where workers are working remotely completely for the employee’s own benefit (during which the organization gains nothing from the employee working in the employee’s chosen location), the expenses may be non-deductible — in other words, taxable to the employee if reimbursed.

This clearly creates a challenge for organizations trying to operate in this new business environment. Employers should be aware of these rules and strategize on how to create policies or work practices that mitigate these risks. 

Payroll taxes

Fifty states mean fifty sets of non-uniform tax laws. Before the pandemic, the plethora of state tax laws often was not a significant concern for many nonprofits, as employees generally were concentrated in one or a few jurisdictions. Those employees had a simple and stable relationship to the home office: employees commuted to work, sometimes across a state line, but often not.

Today, employees might turn a vacation destination into a new temporary workplace or move unpredictably between an organization’s offices in one state and their residence or residences in other states. This creates tremendous challenges and burdens for organizations to understand where their employees are working and the related tax consequences.

Below are some of the high-level considerations employers should contemplate given the realities of remote and hybrid work environments.

State payroll taxes — unemployment tax

The unemployment tax might be the simplest of the payroll taxes to administer because states generally follow the same set of rules. Employers within a state are generally covered by the state’s unemployment insurance program if they meet the requirements for coverage under the Federal Unemployment Tax Act. When employees perform services all in one state, the employer generally pays unemployment taxes to that state. 

Unemployment insurance becomes more complex when employees work in more than one state, or if the employee is a remote employee. There are four factors (frequently referred to as the four-pronged test) that employers may use when determining which state an employee should be allocated for unemployment insurance tax purposes. This assessment requires an understanding of where an employer is localized, the employee’s base of operations, place of direction and control, and state of residence.  

The first test is localization: where does the employee spend most of their time? While not specifically addressed in applicable guidance, many practitioners use a high-level test that if an employee performs at least 80% of their work in a state, then that state collects the employee’s unemployment tax. If the localization test doesn’t resolve the issue, entities should apply a base of operations test. “Usually, in the not-for-profit setting, that means: Where is the office of that employee?” explained Grant Thornton Tax Senior Manager Albert Arazi.

In Arazi’s experience, this determines where unemployment tax is paid in the vast majority of cases. However, he noted that it’s important for employers to understand where employees are located and when they’ve changed their work locations.

If there is no clear base of operations, the next test to consider is where the employee receives their direction and control, which is often interpreted as where the employee’s supervisor reports to physically work. Lastly, if there is no clear place of direction or control, the allocation defaults to the employee’s state of residence.

Additionally, 501(c)(3) nonprofit organizations may not be required to register or pay unemployment in certain jurisdictions until there are at least four employees in the state.

It is important that employers at nonprofit organizations understand where employees are performing services, and set policies around hybrid and remote working that allow the organization to manage these issues appropriately.

State payroll taxes — state income taxes

State income taxes are consequential because of the amount of money involved. Unlike unemployment taxes, which are shaped by federal guidelines, state income taxes are determined by each state.

One general principle and four common variations have emerged from the myriad state approaches. The general principle is that employees pay state taxes where they work — specifically the location in which the employee is physically present when they are providing services. Of course, determining this location has become more complicated as workers shift where they work with a fluidity unforeseen less than a decade ago. The following are four of the most common variations to the general principle above:

1. Nine states currently don't have state income taxes.
2. Many states have reciprocal agreements with neighboring states. These are most common in contiguous Mid-Atlantic and Midwestern states (notably, New York State does not have such an arrangement with its neighbors). Such arrangements can simplify payroll tax withholding for not-for-profits. Under a reciprocal agreement, an employer only withholds income tax to the state in which the employee is a resident, even though the employee is working in the employer’s office located in the “reciprocal” state. However, reciprocal agreements don’t apply to every situation, and they require documentation and attestation which can be easily overlooked.
3. Non-resident withholding varies among states. If an employee performs work in a state for as little as one day, that state may subject the employee to tax. In many cases, doing so will require the employee to file a nonresident tax return to retrieve a refund of the tax, and/or complicate the employee’s resident tax return by applying for a credit for taxes paid to other states to avoid double taxation. Some states recognize the administrative difficulties associated with this policy and impose minimums of either time spent in the state or the value of the work performed. However, many states require withholding after a single day spent working in the state. In addition to informing employees about what can happen from an income tax perspective when working in other states, organizations may need to update their time tracking and payroll systems to account for this important issue.
4. There is a controversial “convenience of the employer” rule followed by a handful of states, most notably New York. Arazi sketched out this contemporary scenario: “If your primary office is in New York, and you're working from home in New Jersey for your own convenience, even if it's only done part of the time, New York is going to treat that as if you're physically performing services in New York for that day. As you can imagine, that creates a lot of challenges if, for example, you currently have employees who are spending three days in the New York office and two days in New Jersey.”

The convenience of the employer rules have become increasingly challenging for employers in recent times, especially those who are headquartered in states that have them, like New York.

The variations to the general principle regarding how to withhold state income taxes require employers to fully understand where their employees are working and implement processes and procedures to effectively manage this issue and mitigate this risk. With payroll often being a large portion of a not-for-profit’s expenses, it is important to seek the right advice and work with tax professionals who truly understand this space.

Other jurisdictions 

It should be noted that the complexity surrounding payroll taxes is not limited to states. Local and international taxes are intricate in their own right. Across the country, there are thousands of local jurisdictions each with the power to impose payroll taxes along with associated withholding, registration, and reporting requirements. By the same token, as remote work can extend beyond the borders of the United States, questions will arise with respect to how employers should withhold taxes on employees who work in international locales, because of a work assignment, an extended vacation, or even a temporary move. Nonprofits will need to be concerned about potential tax exposures and requirements even if only one employee decides to work in a place with a local taxing jurisdiction, or leaves the United States for any appreciable length of time.

Crafting a response

Tax concerns are only a part of the discussion around remote and hybrid work. HR professionals will want to evaluate how important such flexibility is to an organization’s employees. Legal, finance, and operations specialists will need to consider any implications of remote or hybrid work arrangements within their area of expertise. It’s vital to weigh remote work arrangements with communication across all operational divisions of the business.

Nonprofits might understand that broad communication is necessary in this area when they are required to respond to isolated employee situations resulting from a remote or hybrid work arrangement. Ultimately, however, they need a more proactive, consistent, and holistic approach. That begins with questions like these: