State Taxation of Telecommuting

The year 2020 has brought us a new state tax issue.

To be fair, the issue is not totally new, but it has taken on importance with stay-at-home mandates.

Here is the issue: You work in one state but live in another. Which state gets to tax you when you are working from home?

Let’s start with the general rule: state taxation belongs to the state where the employee performs services, not the state where the employee resides. The concept is referred to as “sourcing,” and it is the same reason a state can tax you if you have rental real estate there.

Let’s follow that with the first exception: states can agree to not follow the general rule. Ohio, for example, has a reciprocal agreement with Kentucky. The agreement provides that an employee will be taxed by his/her state of residence, not by the state where the employee works.   A Kentucky resident working in Ohio, for example, will be taxed by Kentucky and not by Ohio.

Let’s pull away from the Cincinnati tristate area, however. That reciprocal agreement makes too much sense.

We need two other states: let’s use Iowa and Missouri.

One lives in Iowa and commutes to Missouri. Both states have an individual income tax. We have 2020, COVID and stay-at-home. An employee of a Missouri employer works from home, with home being Iowa.

Which state gets to tax?

This one is simple. Iowa.

Why?

Because both states have the same rule: the state of residence gets to tax a telecommuter.

So where is the issue in this area?

With states that are … less reasonable … than Iowa and Missouri.

Let’s go to Captain Obvious: New York.

New York has a “convenience of the employer” addendum to the above discussion. Under this rule, New York asks why the employee is working remotely: is it for the convenience of the employer, or is it for the convenience of the employee? The tax consequence varies depending on the answer.

* If for the convenience of the (New York) employer, then the employee’s state of residence has the first right to tax.

* If for the convenience of the (nonresident) employee, then New York has the first right to tax.

We for example have a Tennessee client with a New York employer who walked into this issue. He lives and works in Memphis, infrequently travelling to New York. We were able to resolve the matter, but New York initially went after him rather aggressively.

How does New York’s rule work with 2020 and COVID?

It doesn’t.

All those employees not commuting to New York were very much observing the convenience of their employer.

Clearly, this was an unacceptable answer to New York.

Let’s change the rule, said New York: the employee’s “assigned or primary” location will now control. If my accounting office was located in New York, for example, that would be my “assigned or primary” office and New York could tax me, no matter where I was.

How could I avoid that result? I would need to have my employer open a bona fide office where I lived. Some people could do that. Most could not.

Yessir.

There is no evolving tax doctrine here. This is ad hoc and reactive taxation, with much caprice, little constancy and the sense that New York will say and do whatever to lift your wallet.

There are few other states that follow this “convenience” rule: Pennsylvania, Delaware and New Jersey come to mind. It is more convenient for them to tax you than not to tax you, to reword the rule.

COVID introduced us to two more states feuding over the taxation of telecommuters: Massachusetts and New Hampshire. Massachusetts decreed that any employee who began working outside the state for “pandemic-related” circumstances would continue to be subject to Massachusetts income tax.

It is the same issue as New York, one might initially think. New Hampshire will allow a tax credit for the tax paid Massachusetts. The accounting fee goes up, but it works out in the end, right?

Nope.

Why?

New Hampshire does not tax W-2 income.

How do states like Massachusetts or New York justify their behavior?

There is an argument: Massachusetts and New York have roads, infrastructure, schools, universities, hospitals and so forth that attracted employers to locate there. Their tax is a fair and appropriate levy for providing and sustaining an environment which allows a person to be employed.

Got it.

Don’t buy it.

I grew up in Florida, which does not have an individual income tax. Somehow the state nonetheless has roads, infrastructure, schools, universities, hospitals and so forth. The only explanation must be divine intervention, it appears.

Additionally, if I lived in New Hampshire – and worked from there – I might prefer that my taxes go to New Hampshire. I after all would be using its roads, infrastructure, schools, universities, hospitals and so on, putting little – or no – demand on Massachusetts. I might in fact be quite pleased to not commute into Massachusetts regularly, if it all. It seems grotesque that Massachusetts will chase me across the fruited plains just because I need a job.

New Hampshire has filed a complaint against Massachusetts with the Supreme Court. The argument is rather simple: Massachusetts is infringing by imposing its tax on New Hampshire residents working in New Hampshire.  Interestingly, Connecticut and New Jersey have filed amicus (“friend of the court”) briefs supporting New Hampshire’s position. Their beef is with New York and not Massachusetts, but they are clearly interested in the issue.

I personally expect the expansion and growing acceptance of telecommuting to be a permanent employment change as we come out of COVID and its attendant restrictions. With that as context, the treatment of telecommuting may well be one of the “next big things” in taxation.

A Condo Association, Dogs Running Wild and An Office In Home

This time we are talking about an office-in-home. Many of us have one, but few of us can actually claim a tax deduction for it.

The office-in-home deduction has five main rules, two of which are highly specialized. The remaining three require one to:

1. Use the office exclusively and regularly as a principal place of business
2. Use the office exclusively and regularly as a place to meet or deal with patients, clients or customers in the normal course of business
3. Use the office in connection with a trade or business – but only if the office is a separate structure

If you are an employee, then you are in the trade or business of being an employee. If your office is in a separate structure, you are home-free under test (3). 

OBSERVATION: I suppose a converted, oversized shed could meet this test.   

I have a CPA friend who practices out of her basement. She would qualify under test (2), as she regularly meets with her clients there. I however almost always meet clients either at their office or mine, so I would not qualify.

That leaves us with test (1), which is an almost impossible standard to meet if one has an office elsewhere. Fortunately there was a Supreme Court decision a number of years ago (Soliman), which allowed one to consider administrative or management duties for purposes of this test.  

Soliman was an anesthesiologist, and the three hospitals where he worked did not provide him with an office. He used a spare bedroom for work-related activities, such as contacting patients and billing. The IRS had previously taken a very hard line with test (1) and denied the deduction. The IRS reasoned that Soliman’s job was to put people to sleep, and he did that job at the hospital. This meant that the hospital was his “principal” place of business.  The IRS was not going to be persuaded otherwise, at least until the Supreme Court told them to knock it off and allow Soliman his deduction.

Great. So I can do administrative work at home – such as scheduling or billing – and have my office qualify for a deduction, right?

Not so fast.

There are two more tests if one is an employee. The one that concerns us is the requirement that the office be for the convenience of the employer.

Those words sound innocuous, but they are not.

For most of us, having an office at home is for our convenience. In fact, the IRS takes this farther, arguing that – if your employer provides you with an office – then it is virtually impossible for the home office to be for the employer’s convenience.  The IRS reasons that the employer would not care if you showed up, as it had an office waiting. There are some exceptions, such as telecommuting or requiring work hours when the office is closed, but you get the idea. For the vast majority of employees, one cannot get past that convenience-of-employer test.

What if one is self-employed? Forget the convenience test. There is no employer.

Let’s look at McMillan v Commissioner. There will be a quiz at the end.

Denise McMillan had a couple of things going on, but what we are interested in is her home office. She was self-employed.

She claimed an office-in-home deduction on her 2009 return. I am not certain of her housing situation, but her office was 50% of her home. I cannot easily visualize how this is possible, especially given the requirement that the office space not be used for any other purpose. That is a lot of space that she is not using for another purpose – like living there.

She lived in a condo. She had gotten into it with the homeowners association over construction defects related to mold and noise, dogs running wild, dogs barking incessantly and leaving dog memorabilia as dogs will when running wild and barking nonstop.

The condo association would do nothing, so she sued them.

The condo association – highlighting the quality of its Board – sued her back.

Wow, send me a flyer so I can consider buying at this bus station to paradise.

All in all, she was out over $26 thousand in legal fees and expenses.

And she deducted 50% of them through her office-in-home deduction.

QUIZ: Is this a valid tax deduction?

She sued because of events which were interfering with her use and enjoyment of her property.  Had this property been exclusively her residence, the conversation would be over. But one-half of it was being used for business purposes.

She next had to show that the litigation also had an effect on her business activity.

 QUESTION: Have you decided yet?

The Court observed that she was suing over noise, animal waste and similar issues. She argued that they were affecting her ability to work. Makes sense to me.

The IRS did not challenge her argument. 

NOTE: My hunch is that the IRS was relying upon an origin-of-claim doctrine. The lawsuit originated from a personal asset – her residence – so the tax consequences therefrom should remain personal. In this case, personal means nondeductible.

Since the IRS did not challenge, the Court could not – or would not - conclude that there was no effect on her ability to work.

The IRS had not challenged the 50% percentage either.

So the Court decided that she was entitled to a tax deduction for 50% of her legal expenses.

By the way, how did you answer?

New Jersey and the Telecommuter

We are visiting state taxation today. Our trip this time will take us to New Jersey, and it will highlight how tax law can simultaneously arrive at a technically correct but bumble-headed conclusion.

Let’s say you manufacture parts in New Jersey. Would you expect to file and pay state income tax to New Jersey?

That one is easy - of course. You are doing business there – in the meaningful sense of the phrase. You have a building, you have employees. You park your car out front. You visit Chipotle for lunch. You are there.

Let’s make this more challenging. You do not manufacture parts. You do not manufacture anything. You develop software. Your offices are in Rockville, Maryland. You do not have offices in New Jersey. You do not park your car in New Jersey or visit their Chipotle for lunch. You are not there. You have an employee who moves to New Jersey. You like her. You keep her on board.

Like a Jim Croce song, you have a name.  Your name is Telebright.

Let’s have her work from her new home. She begins her workday at 9:00 a.m. by checking with her project manager, who is based in Boston. She receives daily work assignments. When done, she uploads her work and sends it to you. She is expected to work 40 hours a week. She could live on the moon, for what location matters to her work.

She does not solicit customers. She does not have sales responsibility. She does not refresh products, or stock shelves, or install, or service. She does not supervise employees. She does not have management authority. You do not even reimburse for her office-in-home. She travels twice a year to Maryland. By the way, you do not pay for the travel – rather she pays for those trips out of her own pocket.

You – being enlightened – take New Jersey withholding taxes out of her paycheck so that she has no rude April 15^th surprise.

New Jersey surfaces, somewhat like the mutant alligator in a bad Sci-Fi network movie. New Jersey says that you are doing business in the state, and it wants you to … (wait on it) … pay corporate income taxes!

The case goes before the New Jersey Tax Court. The court cites the New Jersey statute:

Every domestic or foreign corporation which is not hereafter exempted shall pay an annual franchise tax for each tax year, as hereafter provided … for the privilege of doing business , [or] employing or owning capital or property … in this state.”

The Court then reflects philosophically:

The term ‘doing business’ is used in a comprehensive sense and includes all activities which occupy the time or labor of men for profit.”

It rolls up its sleeves and grittily reviews the law (N.J.A.C. 18:7-1.9(b)):

Whether a foreign corporation is doing business in New Jersey is determined by the factors in each case. Consideration is given to such factors as:

(4) The employment in New Jersey of agents, officers and employees.”

Oh, oh. This is going to go wrong, isn’t it? Or is it possible the court will recognize that a lone employee in the state hardly amounts to a corporate beachhead?  Here is the Court:

There is no one, single controlling factor nor is there a bright line standard that determines whether a foreign corporation’s in-state activities meet the Director’s regulatory requirements for doing business. Rather, it is only by close scrutiny of all the facts of the case, taken as a whole, that a final determination can be made. ”

It then digs in like a free agent seeking a new sports contract and drives for the bright line.

It cannot be disputed that plaintiff satisfies factor 4 … by employing Ms. … in New Jersey.”

[Telebright] agreed to permit Ms. … regularly to perform her duties at her New Jersey home.”

This consistent contact with New Jersey was not sporadic, occasional or intermittent.”

But the Court pauses. Will it realize that you are being a good sport for even keeping her employed after the move? Will it acknowledge that this is not a 19^th century economy, when a county seat could not be more than a day’s travel for any resident of the county? It hesitates:

“While it is true that [Telebright] has never maintained an office in New Jersey, nor solicited business here ….”

No! Not now Tax Court of New Jersey! You are so close!

The Court shakes it off:

 … [its] daily contact with the State through its employee is sufficient to trigger application of the CBT Act.”

The mere fact that Ms. … is the only … employee in this State does not change the court’s decision.”

Yes, the court determined that Telebright was responsible for New Jersey corporate tax because it permitted an employee to work from her home in New Jersey.

Why does this upset me?

One reason is that reasoning like this would have me filing taxes with India if I hired an on-line bookkeeper there.

Another reason is that I have read court decisions like this for more than two decades now. After a while it is like watching WWE wrestling – there really isn’t much suspense about who is going to win. There was a time when a state at least tried to develop coherent doctrines and workable principles. In recent years however state tax has become more like a hijacking on a Sopranos episode.

Another reason is this is an employee-hostile decision.

I have a friend and client, for example, who lives in Kentucky and commutes to California. Yes, you read that right. He works a week here in Kentucky and a week near San Francisco. He is situated well enough at the company that he floated the idea of having an “office” here. The company turned him down. Why? Because they do not have a footprint in Kentucky and his “office” could create one. So he commutes every other week to California. I suspect he may be their only Kentucky-resident employee.

If you were Telebright, what would you do? Would you not permit your employee to work from home, never mind the reasons? Would you even keep her as an employee?

Who gains here? Tony … er, Trenton gets a few dollars from its next mark … er, taxpayer. Who loses? For now, the company loses. In the future, the loser will be the next employee who wants to work from a New Jersey residence for an out-of-state company whose tax advisor has read Telebright.