I recently read a very scary article in The Wall Street Journal.  It was about companies that hire out-of-state employees that telecommute.  It concluded that hiring this type of employee created a “nexus” that warrants imposing income tax on the out-of-state employer.  As far as I can tell, that means 35 states and the District of Columbia think business owners should pay income tax to every state from which they have an employee working remotely.

It may sound a bit confusing at first, but the implications of these new state rules extend beyond the here and now, so it’s an issue worthy of discussion.  For now, the solution for employers hiring out-of-state telecommuters is simple: if the worker lives in a state other than one in which the employer has a physical presence, hire the worker as an independent contractor.  This assumes, of course, that the telecommuter’s job description complies with the IRS definition of an independent contractor. 

However, the nation is expected to see a rise in telecommuting in the coming years as more and more companies move day-to-day operations to the cloud.  As a result, the impact of these new state tax rules will extend to cover more businesses.  I find three potential impacts of these new state taxation rules on business owners particularly troubling:

1) Businesses would be expected to pay income tax to every state in which they have a telecommuting employee

2) Businesses would be expected to file income tax returns in every state in which they have a telecommuting employee

3) Employers will be tempted to favor in-state candidates for telecommuting positions over out-of-state candidates

The first two potential impacts tend to catch a business owner’s attention right away.  Paying more income taxes and filing more state tax returns just creates more expenses and more record-keeping tasks.  Also, the argument that a company is “doing business” in a state just because they employ a telecommuter in that state seems unfair to most small business owners.  Most agree that paying income tax makes sense if a company solicits customers or makes sales in a state, but there is a general agreement that a company shouldn't have to pay state income tax “when the only connection to that state was that they had an employee telecommuting in that state.”

However, I find the third potential impact the most troubling.  At a time when small business owners are being asked to innovate and hire in the name of national recovery, state governments are widening the income tax net around out-of-state businesses.  I find it hard to formulate a legitimate argument for assessing income tax on a business just because it employs a telecommuter from that state.  At its most extreme, this policy could compel workers to leave their home state in favor of the employer’s state, ultimately creating a negative impact on the employee’s original home state’s tax revenues.

This policy also threatens to encourage discrimination against the best candidate for a telecommuting position based on his/her home state.  Balance Books is a cloud-based business that holds hiring the best employees, regardless of location, as a business principle precisely because of the benefits telecommuting provides to both employees and employers.  Telecommuting is already a key component of many successful small business operations, and anything that discourages companies from hiring the best available help seems counterproductive, if not discriminatory.

While these new state taxation rules may have a minimal impact on employers in the West where employees are more likely to telecommute within their home state, I worry about employers in areas of the nation where employees frequently live and work in one state for a company that conducts normal business operations in another state.  I have several clients on the East Coast with out-of-state employees that telecommute, and I can already forecast the additional time and expense it will take to comply with the new rules.  At this point, I’m hoping this issue will be addressed on the national level.  Businesses, regardless of their home state, deserve a static definition of how “doing business” in a state is defined so they can prepare for the financial and operational implications of a widening definition.  Or fight back.

If you want to read The Washington Post article, click here: http://online.wsj.com/article/SB10001424052702304066504576345782284098222.html

If you want to call your national representatives and register your opposition to these new state income tax rules, click here: http://www.usa.gov/Contact/Elected.shtml