How Does State Tax Reciprocity Work?
Everyone’s heard the saying, “you scratch my back, I’ll scratch yours.” In payroll, when these agreements happen between states, we call them reciprocal agreements. In other words, “you take my tax, I’ll take yours.”
Before we tackle the subject head on, it’s important to understand one basic rule of state taxation. While it can get complicated when an employee is moving, working in multiple states, or a professional athlete, in most cases they only pay taxes to the state they work in.
A reciprocal agreement is a special tax arrangement between two states. When two states enter the arrangement, they allow residents of one state to request exemption from tax withholding in another state. For example, if an employee lives in Ohio and works in Indiana, that employee can ask their company to not withhold Indiana state taxes. They can make that specific request with the form WH-47.
Keep in mind that the reverse is also true. If an employee lived in Indiana and worked in Ohio, they could also ask the employer to not withhold by completing the Form IT-4NR. The employee in either scenario then files one Form W-2 at tax time in their resident state.
It’s important to note that employers are not required to comply with either of the above requests. It all comes down to whether the employer has a tax ID set up in that state. For example, if the Ohio employer doesn't already do business in Indiana, they likely wouldn’t have a tax ID in that state. Without a tax ID, the employer can't remit taxes to the state. The decision of whether to set up an Indiana tax ID is at the employer’s discretion. That’s why the remittance of resident tax is sometimes called a “courtesy withholding.”
When States Don’t Play Nice
Now, just because the Buckeyes and Hoosiers play along doesn’t mean every state is that way. State reciprocal agreements are more uncommon than you might expect. As of this writing, there are only 17 states with reciprocal agreements. That's a lot of unscratched backs.
There is one important exception to the rule: the District of Columbia. If you work in D.C. and are a resident of any other state, you do not have to file a tax return in D.C. In that case, you can submit Form D-4A. Conversely, D.C. gets the same courtesy from two states: Maryland and Virginia.
There are a lot of employees who work in states that don’t have reciprocal agreements with their home state. In that case, the employee will have to file a resident tax return as well as a return in their work state. The home state should allow the employee to claim a tax credit on their resident tax return for the taxes paid to the work state. This relieves the tax burden of owing in two states.
Note that this wasn’t always the case. In the landmark case Comptroller of the Treasury of Maryland v. Wynne et ux., the U.S. Supreme Court eliminated the ability to be taxed twice on the same income. Since employees don’t have to owe taxes for both a resident and work state, reciprocity means they only need to file one return. You might call it a big Wynne for taxpayers.
Of course, there’s a lot to digest when it comes to reciprocal agreements. Employees are ultimately responsible for their own withholding requests and should seek the information to be aware of what options they have. Employers should always consult with a tax advisor if they have any questions—and we all know most tax advisors love a good back scratching.
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