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Special Considerations in Payroll

What If My Employees Live in Different States Than My Business's Location?

View of state map with pins. (Complete Guide to Payroll for Small Businesses - Guidant Financial.)

As you can see, state taxes, regulations, and laws play a significant role in payroll processing. Generally, your company’s withholdings and obligations are determined by the state where you do business. In many cases, your employees will also live in that state. But there are areas of the country where employees may live and commute to a workplace and live in another state.

The COVID-19 pandemic also made working from home much more common. In fact, 35 percent of workers whose jobs can be performed remotely now work from home. While this is down from the numbers who worked remotely during COVID, it’s still a big leap from the seven percent who worked from home before the pandemic.

In many cases, an employee’s state taxes, required withholdings, and any other applicable regulations and laws are determined by the state where the employee resides. As a result, if you have a multistate payroll, you must register with the Department of Labor in each state where you have an employee to obtain a state identification number. Learn more about payroll taxes for out-of-state employees here.

Remember: Your obligations in cases of multistate payroll can vary widely. If you do business in a state that doesn’t have a state personal income tax and an employee lives in a state that does, it may be sufficient for the employee simply to calculate and pay their own state income tax when they file their taxes. No corporate withholding of their state’s taxes is necessary. However, you must still know the state’s rules and regulations. For example, if the state where the employee lives requires a SUTA, that will have to be paid. Learn more here.

Determining your company’s obligations can be quite complicated, depending on the state. Fifteen states and the District of Columbia have reciprocal tax agreements with other states. (Generally, these are states with significant numbers of commuters from adjacent states.) Simply put, a reciprocal agreement means that employees are taxed in the state where they live, not in the state where they work. Employees may have to officially request to be taxed where they live in some states.

Other states, however, tax workers who live elsewhere as if they live in the state where their company’s business is done. This is known as the “convenience rule,” as it’s done for the convenience of the employer. In that case, workers are taxed as if they live where your company does business or where a central office is located, even if they work remotely from another state. Connecticut, Delaware, Nebraska, New York, and Pennsylvania are all currently “convenience rule” states.

In addition, some states may require employees who live in one state and work in another to pay nonresident or other taxes. If you have employees who live in states other than the one you do business in, ensure you have complete information on the requirements in both states.

How Are Outside Contractors or Freelancers Paid?

In general, the information in this guide pertains to salaried workers. But what happens if you hire outside contractors or freelancers who aren’t salaried? Contractors or freelancers are paid very differently than employees.

First, some contractors or freelancers are hired by agencies that contract with your company to provide those workers. If you use an agency, the agency pays the workers and handles all payroll-related tasks.

If you hire a contractor or freelancer directly, you must have a separate system from the one described here. Contractors and freelancers are generally paid by the hour or the job. Taxes are not withheld from their earnings. They are responsible for paying taxes themselves.

You’ll also need to obtain information from them using Federal Form W-9, Request for Taxpayer Identification Number, and Certification, so you can report the payments made to them accurately to the government.

If they receive payment of more than $600 from your company annually, you’ll also need to provide them with a Form 1099 each year showing their annual earnings from your company — in the same time frame as a W-2 is issued to employees. Learn more on how to pay independent contractors here.

Note that there are severe penalties for misclassifying employees as contractors rather than employees or vice versa.

The key differences that separate employees from contractors or freelancers are the amount of control and direction a company has. Companies have a right to control the final product of a job — the final result — but not precisely how or what the worker does.

In other words, if you require someone to be at work by 9 a.m. every day and to use a set of specific tools purchased by your company, the person is likely an employee, not a contractor.

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