Convenience of the Employer Test: What It Is & How It Impacts Workers
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Telecommuting is becoming a more popular and a more permanent solution for the future of employment across the United States. While this has a lot of advantages for both employer and employee, it also presents new challenges regarding wage and taxation compliance.
Since employees' physical presence isn't required in the primary office of the employer anymore, taxation is becoming more difficult in the states where the employees are located.
What is the Convenience of the Employer Rule?
TheConvenience of the Employer rule regulates sourcing income obtained by nonresidents of some states who work for in-state employers on locations that do not fall within the state's limits.
It is called the Convenience of the Employer rule because the taxation and sourcing of the remote employee's income will depend on whether the employee is working remotely because of necessity for the employer or their own convenience. The rule and the convenience test accompanying it have been explained in detail in a memorandum issued by the Department of Taxation and Finance. The memorandum TSB-M-06 published in May 2006 by the New York DTF explains what this rule is and why it was introduced.
Here's the gist of it:
For example, a nonresident that commutes to work in New York City must pay New York State taxes on all income earned from employers based in this state. If this employee works outside of the state of New York (i.e., from home) for a New York employer, the employee will be subject to New York tax as well as their local tax.
This tax policy essentially introduces double taxation in cases where the employee's home office is outside of the state in which their employer resides. In these situations, the employee will need to pay state tax for both the state they reside in and the state their employer is located in.
This rule also allows telecommuters to deduct their business expenses (such as setting up a remote workspace or buying the necessary equipment) from their taxes, but only if they meet certain criteria. In case they do not meet the criteria, remote workers cannot deduct the expenses from the taxes.
Which states apply the rule?
There are quite a few states that utilize this rule and require nonresident employees to pass the Convenience of the Employer test. These are Arkansas, Delaware, Nebraska, New York, and Pennsylvania.
In addition to these, two more states apply a variation of the rule to employees working for employers registered in their states. These states are Connecticut and Massachusetts. Connecticut requires employees in their state to pass the COE test only if the state the taxpayer is working in has similar tax laws in place.
Massachusetts, which normally taxes nonresident employees only the income they make while working in the state, has introduced a regulation that temporarily follows the COE rule but only for employees who telework as a result of the COVID-19 pandemic. Thus, any nonresident employees of businesses based in Massachusetts that work from home due to pandemic-related reasons are susceptible to double taxation.
Finally, New Jersey applies the COE rule on audit, even though it has no formal statutes or tax laws regarding it.
While not all states agree to the rule, most of them are doing nothing and waiting to see what's going to come out of this. Some US states, such as New Hampshire, are taking legal action to ensure the Convenience of the Employer Rule doesn't damage the tax apportionment between states.
New Hampshire has gone so far as to take its southern neighbor, the state of Massachusetts, to court over what the state of NH claims is an "unconstitutional extraterritorial assertion of taxing power". Since this is a dispute between two states, the Supreme Court of the US will need to make the call.
Does California have a Convenience of the Employer Rule?
Along with most other states, California doesn't use the COE rule. Nonresidents working for employers based in California get their personal income tax withheld by their employers. The employers must also report wages paid to employees working outside of the state for services they provided within California. Wages earned in California are solely subject to California state tax. The state of California prevents employers from charging their employees with any business operating expenses. This goes so far as to prohibit employers from charging the employees even with the cost of internet service. So, if an employee working from home requires the internet to perform their daily business activities, they can get a reimbursement from their employer for it.
Why is the rule in place?
The rule's main purpose is to make managing remote workers and teams more beneficial for employers. Additionally, the rule and the test were implemented to discourage and completely prevent tax evasion.
Another purpose of the rule is to decrease the costs of providing equipment like office space, computers, or whatever is necessary to have a normal and productive workday. If employees are getting the equipment themselves because of necessity, they can file their home office expenses for a deduction on their tax return.
What is the Convenience of the Employer Test?
The COE test says that any and all employee expenses paid by the employer need to be for the convenience of the employer. If they are not, these expenses are not a part of the employee's income.
The Convenience of the Employer test is detailed in IRS Publication 587: Business Use of Your Home, along with some examples. The IRS states that a home office may be used "for more than one business activity, but you cannot use it for any nonbusiness (i.e., personal) activities."
This test consists of several requirements that the employee should pass in order to prove that they work from a remote location as a result of necessity and not choice or convenience.
The COE test concerns the tax liability of all the expenses the employer paid and the deduction of unreimbursed expenses the employees paid themselves.
What are the requirements of the test?
For their home office to be considered an exception to the convenience of employer rule, a nonresident employee must establish that their home office represents a "bona fide employer office." An employee's home office can be considered a "bona fide employer office" if it meets either the primary factor or 4 of the 6 secondary factors and 3 out of 10 other factors.
The primary factor for the test is that the home office contains specialized facilities required for a normal workday or is close to them.
For example, the employee needs access to a large clear area far away from residential areas in order to test various combustion accelerants as part of their job. The employer can't provide this, but there is one such area in the vicinity of the employee's home. The employee can perform his work activities from his home office, which will be considered a "bona fide employer office".
Secondary factors for the convenience of the employer test are:
- A home office is necessary or a condition of employment.
- The employer had a bona fide business purpose for using the employee's home office
- The employee conducts their code duties in their home office or uses it as a primary office for the convenience of their employer.
- The employee interacts with clients regularly and continuously at their home office location.
- The employee is not provided with a dedicated office space or other work accommodations by the employer at one of their business locations.
- The amount of reimbursement the employer provides to the employee regarding the expenses for setting up a home office (80% is the norm).
Other factors are:
- The employer maintains a separate telephone line and listing for the home office.
- The employee's home office address and phone number is listed on the business letterhead and/or business cards of the employer.
- The employee uses a designated area of their home exclusively to conduct the business of the employer that is separate from the living area. The home office will not meet this factor if the area is used for both business and personal purposes.
- The employer's business is selling products at wholesale or retail, and the employee keeps an inventory of the products or product samples in the home office for use in the employer's business.
- The employer's business records are stored at the employee's home office.
- The home office location has a sign indicating a place of business of the employer.
- Advertising for the employer shows the employee's home office as one of the employer's places of business.
- The home office is covered by a business insurance policy or by a business rider to the employee's homeowner insurance policy.
- The employee is entitled to and actually claims a deduction for home office expenses for federal income tax purposes.
- The employee is not an officer of the company.
The implications of the Convenience of the Employer rule
While there are a lot of benefits of telecommuting that should be considered, this type of remote work presents a lot of challenges for employers.
Since numerous employees are forced to work from home during these times, either because of government-mandated regulations or employer policies, the constitutionality of the convenience of the employer rule has been put in question. This is because the COE rule allows state taxation outside of their usual taxing jurisdiction and state borders. Furthermore, these states are allowed to tax and source income from both nonresident employees and businesses operating within state borders.
For example, an employee based out of a New York office working from a home office in Massachusetts is subject to New York state tax on any income received from the employer while working from home. Thus, the employer must withhold New York taxes from the employee's paycheck.
In addition to this, the state of Massachusetts, which is the employee's home state, will treat the employee's income as subject to the local state tax. This results in double taxation for the employee.
Some states, like Connecticut, will reduce their residents' taxation by offering an income tax credit for taxes paid in other states. Even though these policies remove double taxation for their residents working in other states it isn't a perfect solution. The main problems are:
- The employees will receive credit based on their state's tax rate, which can be lower than the tax rate from the state in which their employer is based.
- The state giving credit to its residents effectively wavers its taxation in favor of the state that the employer is based in. This can create substantial differences in income between states.
While the number of states implementing the convenience of the employer rule is slowly growing, nothing is certain yet, and the Department of Taxation and Finance isn't going to make the rule mandatory any time soon.
However, with the need for regulating remote work increasing with its popularity, the chances of seeing similar forms of legislation are very high.