Four Rules of Multistate Taxation

I’ve been getting a number of questions lately that go something like this: “An employee lived on one state when he/she was granted an award and then moved to another state before the award vested/paid out—what state do we have to withhold tax in?”

The answer to this question is “It’s complicated.”

Four Fundamental Rules

1. Generally, the entire gain on the equity award transaction (e.g., option exercise, award payout) is subject to tax in the state where the employee resides at the time of the transaction.

2. The transaction is also usually partially taxable in any states where the employee resided or worked during the life of the award. This can include permanent transfers, short-term assignments, and even business travel.

For most states, the life of the award refers to the period from grant until vest, but in some states, it is the period from grant until exercise/payout. To determine the portion of the award taxable in the nonresident state, divide the number of days the employee lived/worked in that state during the relevant award period by the total days in the award period.

3. Employees can generally claim a credit in their state of residence for taxes paid in other states.

4. Just because the employee has an obligation to pay tax in a state doesn’t mean the company has an obligation to withhold this tax. The company’s withholding obligation in a particular state can vary based on a number of factors including the laws of the state in question, whether the company has a corporate nexus in that state, whether the resident and nonresident states have a reciprocity agreement, and, in the case of remote workers who have relocated to another state, whether the state is a “convenience of the employer state.”

The COVID pandemic has added an extra layer of complexity, with some states agreeing not to tax employees temporarily residing in the state due to the shelter-in-place orders but requiring employees who would normally work in the state to continue to pay taxes there, even if they have temporarily relocated to another state.

Not a Do-It-Yourself Project

It’s probably clear from #4 that multistate taxation usually isn’t a do-it-yourself project. The laws are complex, they vary from state to state, and, as stock plan administrator, you may not have visibility into all the key facts and circumstances that can impact the company’s tax obligation. It’s best to seek the assistance of a qualified professional.

Compliance Starts with Risk Mitigation

For companies that haven’t considered this issue before, it can be challenging to go from zero to fully compliant. Most companies initially focus their compliance efforts on the areas of highest risk, such as high-profile executives and other employees, transactions involving significant amounts of income, and states that are known to more aggressively pursue tax enforcement.

More Information

Read Up: To learn more about multistate taxation, see the article "State Mobility Issues for Equity Compensation Professionals."