How Remote Workforce Programs Trigger Myriad Tax Problems—Part One
What’s triggered? How about fringe benefits, federal and state tax withholding, and information-reporting issues?

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Editor’s note: Given the complexity of this topic, this will be a two-part article. This first part addresses fringe benefits, federal and state tax withholding, and information reporting. The second part, which will appear in the May-June issue of Tax Executive, will address 1) tax reporting and withholding under remote-work programs for foreign employees (which can result in US workers traveling overseas and foreign employees traveling to the United States) and 2) federal and state nexus issues that affect corporate income tax deductions.

The coronavirus pandemic created an explosion in remote workforce programs, some only temporary but others indefinite or even permanent. These programs have generated enormously complex federal, state, and foreign tax questions from employers and employees, but surprisingly little responsive guidance from tax authorities. Employers must pay close attention to all of these tax issues—relating to the design and taxation of employee benefits, changes in foreign and state income tax withholding (and possibly in state unemployment, workers’ compensation, and family leave taxes), and, at the corporate level, the potential creation of foreign and state nexus and apportionment issues. These challenges need to be addressed now to mitigate problems (and, where possible, minimize taxes), since these work-from-home and work-from-anywhere programs promise to generate federal, state, and foreign tax audits for years to come.

Work-From-Home Benefits and Reimbursements: Income Exclusions and Deductions

Alternative Exclusions During the Pandemic

In the case of work-from-home programs, questions arise not just about reimbursements for in-home expenses and commuting expenses but also about the design of benefits intended to attract employees back to the office, ranging from free food to loan forgiveness, enhanced dependent care assistance, wellness benefits, athletic facilities, leave-sharing, and charitable donations.1

In the first two years of the pandemic (while the presidentially declared “national disaster” was in effect), many of these benefits were eligible for alternative exclusion rules, which in turn had different impacts on corporate tax deductions, that is, the “working condition fringe” exclusion under Internal Revenue Code Section 132(a)(3) and (d) for business-related deductible expenses and the “qualified disaster assistance” exclusion under Code Section 139.

Working Condition Exclusion for Work-From-Home Benefits

For the working condition fringe benefit exclusion to apply, employee recipients must have a business purpose for receiving the property or service that must be sufficiently substantiated through record-keeping—in some instances detailed record-keeping under Code Section 274, applicable to cars, planes, and all travel and entertainment expenses, but in other cases merely proof of “primary business use” (for example, for cell phones, computers, and office supplies).2

An employer’s payment for services, therefore, can be tested for business use on a current-year basis under Section 162; and the same is true for office supplies that normally have useful lives of less than a year. Notably, however, in the case of depreciable assets, confirmation of business use should be collected during each year of the property’s useful life, since the working condition fringe benefit exclusion requires the showing of deductibility under Section 167, which would apply to each year of use.3 For employees whose employers require them to work primarily (or exclusively) from home, it seems reasonable to assume that the “primary business use” test would continue to be met. But for employees under elective remote-work policies, and those who are required to work primarily in their offices, extra care will be needed for employers to determine whether property and services provided for home use continue to meet the “primary business use” test.

Special Valuation Rule Changes

During the pandemic the Internal Revenue Service announced special changes applicable to company-provided cars and to flights on company aircraft. The relief for car valuations, provided in Notice 2021-7, 2021-3 IRB 482 (January 4, 2021), allowed employers to value the use of company-provided cars under the cents-per-mile method, which yields a dramatically smaller value than the annual lease value (ALV) method for cars with minimal business use. For employees with limited ability to drive their cars for business during the pandemic, this cents-per-mile valuation reflected the “value” of an employee’s personal use of the car much more accurately. (Notice 2021-7 also allows, but does not require, employers to revert to the ALV rule for 2021.) Unfortunately, the valuation relief for company-provided cars announced in Notice 2021-7 did not extend to employers’ cash reimbursements for employee-owned cars under so-called fixed and variable rate allowance (FAVR) programs, which pay (at least quarterly) a fixed dollar amount plus an additional cents-per-mile reimbursement. A limit imposed on FAVR programs is that the car mileage must be at least 6,250 business miles per year.4 Because this test was hard for many employees to meet in 2020 and 2021, employers had to either stop their FAVR programs altogether or convert their FAVR programs into one that met the general “accountable plan” rules of Treasury Regulations Section 1.62-2. These rules require that employees be taxed on the fixed portion of any monthly or quarterly advance, to the extent the advance, plus any variable mileage payments, exceeds what would have been paid under a simple cents-per-mile allowance.5

Separate relief was provided under the “safe harbor” valuation rules applicable to personal flights on employer-provided aircraft, which are based upon US Department of Transportation–issued standard industry fare level (SIFL) statistics, which vary with the identity of the passenger, the weight of the aircraft, and the length of the flight. When these valuation rules were initially designed, they were generally higher than first-class airfares, although the SIFL values had declined over the years to slightly below first-class fares.6 The pandemic-created problem arose late in 2020, when the DOT first published three different SIFL rates, providing adjustments to the normal SIFL measurement (which equals airline industry expenses divided by seat miles), to account for massive federal grants and loans to the airline industry. Taxpayers were initially very concerned that the new SIFL base rate (before applying either of the proposed alternatives) substantially exceeded any SIFL rate the IRS had ever announced previously. Helpfully, on April 19, 2022, the IRS provided in Revenue Ruling 2022-9, 2022-18 IRB, that taxpayers “may use any of the three rates when determining the value on noncommercial flights of employer-provided aircraft under [S]ection 1.61-21(g),” and it has continued to permit employers to switch among the SIFL valuation alternatives, as the DOT has continued to make its semiannual adjustments in SIFL rates.7

“Commuting” Expenses Versus Reimbursable Business Expenses

IRS Definition of “Commuting”

Commuting, generally defined as “daily transportation expenses between a taxpayer’s residence and any regular place of business,” has long been a nondeductible personal expense, even when the employee works during the trip.⁸

Before the mid-1990s, the IRS generally assumed that a “commute” was the distance between an employee’s residence and the normal office (or, alternately, as the “first trip of the day and last trip of the night”). Under these longstanding rules, if the taxpayer took a business trip between home and a location that was farther from home than the regular office was, it was possible to deduct the incrementally larger mileage expenses. In 1999, however, the IRS issued a new definition of “commuting,” Revenue Ruling 99-7, under which the distance between an employee’s home and any “regular place of business” is deemed a nondeductible personal expense.9 (For this purpose, a “regular place” of business is any location where an employee repeatedly performs services for more than a year and performs services for more than thirty-five workdays [or partial workdays] during the calendar year.10) However, this harsh rule, which denies a deduction for long commutes between home and a “regular place of business,” is counterbalanced by two separate additional rules, also contained in Revenue Ruling 99-7, the first allowing a deduction for commutes between home and any temporary business location, even if the distance is identical to that between home and the regular place of business,11 and the second allow-
ing a deduction for all trips if the taxpayer has a “home office” that satisfies the requirements of Section 280A.

This definition of “commuting” has confused taxpayers for years, but the IRS has refused to issue additional guidance, and instead, in 1999, declared it a “no rule” area. Clarification is much needed, particularly concerning employers’ myriad “remote work” policies, which create even more questions about the definition of “commuting.” Interestingly, in its own 2021 guidance for remote-work employees, the IRS reverted to the pre-1990 test (deeming a “personal commute” to equal only the distance between home and a single assigned office).12 Public-sector employers do not have the luxury to ignore IRS guidance. But certainly many critical questions arise for “remote-work” programs, because of ambiguities over definitions of “tax home,” “home office,” and “regular place of business,” which in turn affect the application of the “commuting expense disallowance” under Section 274(l). All these issues are discussed below.

Definition of “Tax Home”

  • Since COVID drastically limited the use of corporate offices (or even closed them), many employees have chosen to work in “shelter locations” that may be hundreds or thousands of miles from their pre-pandemic regular offices. Now that remote working programs are proliferating and extending beyond the pandemic period, there are sound legal arguments that many employees have effectively changed their tax home from their employer’s business office to the employee’s own residence. Under the IRS’ longstanding rulings used to determine an employee’s tax home (or “principal place of business”), the IRS requires analysis of the following factors:
  • total time the employee ordinarily spends at every business location;
  • the employee’s degree of business activity at each business location;
  • whether the financial return with respect to each business location is significant or insignificant;
  • whether employment at a particular location is expected (or known) to be only temporary; and
  • whether the employee might have multiple regular places of business during a single year.13

Certainly, for employees who work from home all or nearly all days in a year, it would appear that their residence may have become their tax home. This argument is further supported by the IRS’ interpretation of the Section 162(a) blocker of deductions where any taxpayer has traveled (or expects to travel) to a particular single geographic location for more than a year. The IRS explained these rules in Revenue Ruling 93-86, 1993-2, CB 71, but has concluded generally that where any taxpayer is blocked from deductions by this “twelve-month rule,” the taxpayer has effectively “changed the tax home.” The Office of Personnel Management Guidelines, released in November 2021, reached the same conclusion, recognizing that a remote-working employee’s residence may be an “official work site.”14

If an employee’s residence has become the tax home, then any overnight trips away from the tax home would be deductible. Further, even day trips between the shelter location and the employer’s office would not qualify as “commutes” if that office is visited fewer than thirty-six days a year, because the employee has a “regular place of business” at home and does not visit any other office more than thirty-five days a year (and thus even the day trips would be “business trips” under Revenue Ruling 99-7).

Difficulties of Proving Existence of a Section 280A “Home Office”

As explained above, if employees have a “home office,” then under Revenue Ruling 99-7 they never have personal commutes. However, this test can be hard to meet, since Section 280A (enacted in 1976 but amended thereafter) has long allowed an income tax deduction only for any portion of a dwelling unit used “exclusively” and on a “regular basis” for business. In addition, a portion of a personal residence will only qualify as a Section 280A home office if:

  • the home office is the taxpayer’s principal place of business;
  • there is “no other fixed business location of such trade or business where the [taxpayer] conducts substantial administrative or management activities of such trade or business”; and
  • with respect to employees, the use of the residence for business is for the “convenience of the [employee’s] employer,” and not the convenience of the employee.15

Unfortunately for many—perhaps most—employees, the remote-work programs offered to employees on an elective basis likely violate the third test above. Furthermore, even if the employer requires the employee to work at home (to meet the third test), if the employee still comes to the employer’s offices for significant periods (more than thirty-five days a year—which is the IRS’ test for “regular place of business”), the second test likely is failed. Finally, even if all three tests are met, many employees simply do not have dedicated space in their homes that is used “exclusively” for business. Instead, they conduct business using their personal computers and cell phones in a living room, bedroom, dining room, or kitchen.

Importantly, the definition of a “home office” has not been considered a significant issue for the employees who have clamored to join remote work programs, simply because employees generally expect to have all their remote work expenses reimbursed. Certainly, employees cannot claim deductions for any non-reimbursed remote work expenses, since no employee can claim an itemized deduction on Form 1040 for a home office for the years between 2018 and 2025, due to the suspension by the Tax Cuts and Jobs Act (TCJA) of such employee-itemized deductions. However, the definition of a “home office” remains important for employers, because it affects 1) whether personal commuting expenses should ever be reimbursed; 2) whether reimbursements for commuting expenses must be treated as taxable wages; and 3) whether such commuting expenses are deductible by the employer.

Lodging During Certain Employee Trips Back to the Office

For employees who work at a “regular office” for as little as one day each week (and who don’t have a Section 280A home office), the IRS in a payroll tax audit likely would contend that all day trips between the employee’s home and office are “nondeductible commutes” (pursuant to Revenue Ruling 99-7). In contrast, in the case of overnight trips, any lodging arguably should be deductible (as a “trip away from the tax home”)—although IRS auditors may nevertheless contend that the regular office has remained the employee’s tax home because: 1) it is a regular place of business, and 2) it is where the employee’s earnings come from (even if the employee had not been back to that office since before the pandemic for more than thirty-five days a year). However, such assertions might be countered by the special regulatory exception for “local lodging,” although this exception admittedly does not cover travel or meal expenses.

Specifically, Treasury Regulations Sections 1.162-31 and 1.262-1(b)(5) (which update the rules in Notice 2007-47, 2007-1 CB 1393), create a special limited exclusion for local and “not-lavish” lodging in the area of the worker’s tax home, provided to employees or independent contractors for periods that do not exceed five days and do not occur more frequently than once per quarter, where the individual needs lodging to attend business meetings or be available for other bona fide business functions. (In the case of employees, the employer must have required an employee to stay at the business function overnight.)

Commuting Deduction Disallowance Rules

TCJA Commuting Deduction Disallowance

The TCJA included a special provision, namely Section 274(l), disallowing commuting deductions:

No deduction shall be allowed under this chapter for any expense incurred for providing any transportation, or any payment or reimbursement, to an employee of the taxpayer in connection with travel between the employee’s residence and place of employment, except as necessary for ensuring the safety of the employee.

Both the legislative history of this change16 and the IRS’ regulations (in Treasury Regulations Section 1.274-14(b)) provide that the deduction is disallowed, even if the commute is taxed to the employee. By contrast, in the case of all other deduction disallowance rules provided in Section 274, applicable to a wide range of benefits from food to entertainment to spousal travel, if the recipient is taxed on the benefit, then pursuant to Section 274(e)(2) and (e)(9), the employer or provider of the benefit can claim a deduction.17 However, Congress took a different approach with commuting deductions and decided to disallow the deduction, even if the value of the commute is taxed to the employee.18 Very importantly, however, Treasury’s regulations implementing this Section 274(l) deduction disallowance do not apply the disallowance to both the fixed and variable costs of all commuting trips—unlike the disallowance rules under Treasury Regulations Section 1.274-10 that apply to “entertainment flights” on aircraft. Thus, for example, in the case of commuting flights on company aircraft, it appears that the disallowance applies to the “incremental costs” of the commuting flight—not the “fixed costs” disallowed for entertainment flights. Similarly, in the case of commuting in company limousines, the cost of the commuting trip might be limited to the gasoline (and possibly the chauffeur’s hourly wage).

Application Only to “Day Trip” Commutes?

Section 274(l) and its legislative history do not define “commute.” Treasury Regulations Section 1.274-14 warns that a commute is any “travel [by any mode of transportation] between the employee’s residence [not limited to the principal residence] and place of employment [excluding temporary or occasional places of employment].” The regulations do not specifically address the definition of “commute” in Revenue Ruling 99-7. However, as noted, and tracking Revenue Ruling 99-7, the regulations do except trips between home and a temporary place of employment. And, more important, Treasury Regulations Section 1.274-14(a) specifically provides that the “rules in [S]ection 274(l) and this section do not apply to business expenses under [S]ection 162(a)(2) paid or incurred while traveling away from home.” Thus, it appears that if the taxpayer’s residence has become the tax home under a work-from-home program, then any “overnight trips” between home and even a “regular place of employment” would be exempt from the deduction disallowance under Code Section 274(l). But, here again, the IRS does not provide specific or helpful guidance on this point.

Exception for “Safety Commutes”

An important exception to this new deduction disallowance provision, provided in the above-quoted statutory provision, applies to commuting trips “necessary for ensuring the safety of the employee.” The original proposed regulations implementing this deduction disallowance provision proposed to limit this “safety” exception to the security risks described in Treasury Regulations Section 1.132-5(m). The proposed rules would have covered many top executives, but were burdensome to apply to employees generally.19 Predictably, the public comments on the proposed regulations criticized this exception as being unduly narrow. In the final regulations, the IRS conceded that the originally proposed basis for the exclusion was “too narrow” and should be “expanded to apply beyond the business-oriented security concern in [Section] 1.132-5(m).” As amended, final Treasury Regulations Section 1.274-14(b), released December 15, 2020, provides:

Exception. The disallowance for the deduction for expenses incurred for providing any transportation or commuting in paragraph (a) of this section does not apply if the transportation or commuting expense is necessary for ensuring the safety of the employee. The transportation or commuting expense is necessary for ensuring the safety of the employee if unsafe conditions, as described in §1.61-21(k)(5), exist for the employee.

The first sentence quoted above (like the statute itself) certainly protects all commuting, whether or not the conditions of Treasury Regulations Section 1.132-5(m) are met. Given that the preamble of the final regulations indicates that the reference to Treasury Regulations Section 1.61-21(k)(5) was intended to “expand” the conditions under which commuting reimbursements would be deductible, it appears that this exception will apply not only to the security protections covered by Treasury Regulations Section 1.61-21(k), covering transportation for relatively low-paid nonexempt (hourly-wage) employees who either live or work in areas with histories of crime,20 but also any other situations where the employer provides commuting trips “to ensure the safety of the employee.”21 It is possible, since the commuting disallowance regulations no longer cross-reference Treasury Regulations Section 1.132-5(m), that the exclusion might exist even if the “security risk” and “security study” conditions are not met, but most companies have continued to obtain these studies, not only to ensure deductions for commuting expenses but also to ensure the exclusions from wages provided for “security protections” by the “working condition fringe.”

No Special Exemption From Deduction-Disallowance for Commutes Excludable Under Code Section 139?

The fact that the disallowance under Section 274(l) does not contain any exception where commutes are treated as taxable wages likely affects the deductibility of commuting that Section 139 provided tax-free. Treasury has not provided guidance on this issue, but the legislative history of Section 139, which confirms that even though substantiation is required for disaster-relief expenses, suggests that Congress intended for a deduction to apply “as if” the benefit had been taxed. More specifically, the legislative history from the Technical Explanation of the “Victims of Terrorism Tax Relief Act of 2001” (JCX-93-01) provides that:

No change from present law is intended as to the deductibility of qualified disaster relief payments, made by an employer or otherwise, merely because the payments are excludable by the recipients. Thus, it is intended that payments excludable from income under the provision are deductible to the same extent they would be if they were includable in income.

This legislative history supports the deductibility of most disaster relief payments, even if they were excluded from income under Section 139, because Sections 274(e)(2) and 274(e)(9) permit deduction for disallowance items, provided the benefit is treated as taxable income. Thus, since this legislative history indicates that Section 139 expenses are deductible “to the same extent they would be if they were includable in income,” it appears that a full deduction applies to entertainment, and food items provided for reasons related to COVID-19, while the “national disaster” is in place. However, since the disallowance for commuting expenses applies irrespective of whether commuting is taxable to the employee, it appears that commuting expenses may still be nondeductible.

State Income Taxation of Employees Working in Multiple States and Employer Withholding Obligations

Long before the pandemic, companies with peripatetic workforces have faced special problems due to myriad state laws governing the taxation of residents and nonresidents. Thus, if employees, directors, and contractors move while working among many different states, either in a single year or over the course of the vesting period for bonuses, stock options, restricted stock, or other equity compensation, the companies technically were required to allocate state income taxes (and collect withholdings) among many different states. These rules became even more complicated when the compensation payable in one year related to many prior years of work—such as for bonuses, severance pay, stock options, restricted stock, or other equity compensation.

Work-from-home programs have exacerbated these complicated problems with state-level withholding and reporting for four reasons. First, tens of millions more employees work remotely now than before the pandemic, so the exposure for individual employers for failure to withhold has increased. Second, many (but not all) employees work at home at least half the time, and the rules are unclear concerning the taxability of many types of reimbursements, in addition to being complicated by the myriad state triggers for income tax withholding. Third, state rules governing the trigger points for withholding (and state payroll audit practices) change with surprising frequency. Fourth, there are “federal blockers” in place protecting employees from taxation for some types of compensation, there are congressional proposals to expand those blockers, and there are pending court cases challenging the constitutionality of state income tax laws taxing persons simply because they voluntarily work at home (in another state) or because they previously worked in that state.

State Reporting and Withholding Triggers for Nonresident Travelers, and Exemptions

Some states provide thresholds before withholding is triggered, based on days worked, dollars earned, or some combination.22 Other states have “reciprocity rules,” under which each state in a reciprocity agreement agrees to waive income tax withholding where residents of one reciprocal state work in the other reciprocal state. Instead, the workers simply pay income taxes in their states of residency. In cases where there are no reciprocity rules, some states offer a withholding break to residents when 1) some or all of the employee’s services are performed in a nonresident state and 2) the nonresident state imposes a withholding obligation. The two most common types of withholding breaks are either 1) a complete waiver of withholding (applicable particularly where the employee files whatever state forms might be required to qualify for such a withholding exemption) or 2) backstop withholding only (that is, resident state withholding would be required only where it exceeds nonresident state withholding). Notably, however, credit under the backstop withholding rule is not always provided, even in states that generally allow such credits, in instances where the taxes paid to the other state are not taxes imposed by the state of residence. For example, for many years Connecticut refused to give credit for New York state income taxes that New York imposed on Connecticut residents who worked at home for their own convenience for employers based in New York.23

Important, too, for nearly all states, even those that require withholding on the first day of work in the state by any nonresident employee traveling to work in the state, for most lower-paid workers (who would be taxable only on a few days of work in the state), the amount of income allocated to the state may be less than the state’s standard deduction and a personal exemption. Accordingly, for those lower-paid, short-service workers, many employers simply decide not to report or withhold, since the reporting would only trigger a state income tax filing requirement for the employees but likely not result in an obligation to pay income taxes.

During the pandemic, many states offered special exemptions—but most of these lenient rules have expired. Instead, many states have followed New York’s longtime audit practices and are becoming much more aggressive with payroll audits. Other states have been operating “amnesty programs” or “voluntary disclosure agreements” to encourage employers to voluntarily confess their withholding/reporting errors, but not all states have those agreements, and even those that do may accept payments from employers but not promise to waive the tax obligations of affected employees.

“Convenience-of-Employer” Rules Complicate State Withholding

Connecticut, Delaware, Nebraska, Massachusetts, New York, Pennsylvania (plus New Jersey, under pending legislation likely to be enacted in 2023, and Arkansas until recently), and localities in Missouri and Ohio tax wages attributable to services performed by employees outside the state if the services could have been performed at the employer’s in-state office, unless the services were performed out-of-state due to the employer’s “necessity” (that is, there must be a direct business benefit in having employee work away from the physical office), and not for the convenience of the employee. For employers with offices in these “convenience” states, allowing employees to elect to work remotely in non-convenience states can result in potential double state income tax liability, since (as discussed above) not all states give state income tax credits for taxes paid to states that have adopted this “convenience rule.”

Accordingly, employers with offices in convenience states must adopt special provisions in their remote work programs to prove either that employees have been formally reassigned to corporate offices in non-convenience states or, when employees work remotely, that the employer has specifically instructed employees to do that remote work (for example, because the employer has reduced office space in the employees’ prior work location, or because the employees work closer to other offices or clients to whom the employees have a close connection). Documentation substantiating the necessity of any such partial remote work arrangement is critical, and so is tracking the number of days each employee works in the physical office versus remotely, so that the employee (if possible) can claim tax credits for income taxes paid to other states.

Payroll Systems Problems

Particularly given the enormous increase in participants in remote work programs, it has become extremely difficult for employer payroll systems to accommodate (or capture) multiple work locations. It used to be possible to track business travel for which employees were reimbursed. However, when employees work remotely, particularly when remote work is elective, often no “travel reimbursements” are ever paid, and employers therefore have struggled to develop separate systems to track employees’ work locations. Voluntary reporting by employees is difficult to implement, and the data is often inaccurate. However, few employers want to institute tracking systems embedded in employees’ work computers.

Moreover, when payroll departments determine that state income tax withholding should be collected from multiple states, employees often propose to submit statements to the payroll departments exempting them from state income tax withholding. Collecting and processing those statements (including prompt submission of statements to state tax authorities) is yet another burden imposed on payroll tax departments.

Finally, very few payroll departments have ever implemented systems to track the kinds of withholding taxes that may be imposed on certain types of compensation after an employee leaves the state where that compensation was earned. Some types of payments are protected from state income tax withholding by the “federal blocker” discussed below, but other payments are still subject to these so-called trailing liabilities.

Employee Complaints

Although Form W-2 includes spaces (in boxes 15–20) to report income to two different states (separated by a broken line), there is room only for two states. The IRS instructions for Form W-2 say, “If you need to report information for more than two states or localities, prepare a second Form W-2.” However, employees invariably complain not only about the reporting of their wages to more than one state, but also about receipt of more than one Form W-2. In addition, employees who have any fraction of their income subject to New York income tax withholding object, because New York requires the reporting to New York of 100 percent of the employee’s wage income (that is, the amount reported in box 16 equals the amount reported in box 1), and employees complain that New York initiates individual income tax audits, particularly for very highly compensated employees, even with very low amounts of New York wage withholding.

Employee complaints about state income taxes have been further compounded by the TCJA’s elimination of all but $10,000 in state tax deductions, because employees often must pay far more in nondeductible state income taxes than they expected. These complaints are extremely common in instances where the employees have changed their residency to a low-tax (or no-tax) state, yet still have withholding based on their former states of work (or residency).

Some employees are even asking their employer to pay them reimbursements of state income taxes, with gross-ups (like the benefits provided to international travelers), arguing that the incremental state income taxes are part of their “travel costs” either 1) when employees are required to travel for business to other states for long enough to trigger state withholding or 2) when employees work at home but return to the headquarters office for long enough to trigger state income tax withholding. In support of these requests, employees cite the special state law rules (typically those in California and Illinois, in particular) that require employers to reimburse employees for all “reasonable and necessary expenses” incurred in the course and scope of employment. These provisions have become especially important in an era when remote-work policies are being adopted, particularly in instances where remote work is either required or “strongly encouraged,” in which case home-office expenses that employees incur could fall within the course and scope of employment.

Despite such “wish list” requests by employees, so far none of these states has yet issued mandates indicating that state income taxes are covered under the “business expense reimbursement” rule. To the contrary, state income taxes have never been deductible as Section 162 business expenses and accordingly would not be considered “reasonable and necessary business expenses” incurred within the scope of employment that would be covered under any state-mandated expense reimbursement statute.

Federal Prohibition on State Source Taxation of Nonresidents’ Pensions

Since 1996, the federal government has protected certain forms of retirement income of an individual from income taxation by the state in which the services giving rise to the retirement income were performed, when the individual no longer resides in that state. Included in this protected class of retirement income are distributions from qualified retirement plans and certain forms of deferred compensation that are either provided in conjunction with a tax-qualified retirement plan (commonly referred to as “excess plan” benefits) or paid out in equal periodic installments for at least ten years or for the recipient’s life or life expectancy. Thus, not all forms of deferred compensation are protected from state source taxation. However, any benefits paid under so-called “excess benefit plans” (as defined below) would qualify for exemption from state source taxation, whereas a standard salary-deferral or bonus-deferral arrangement would not qualify, unless the ten-year payout rules were satisfied.

It has been left to individual states to take the initiative as to whether to apply state withholding taxes to such unprotected compensation when paid to employees or former employees who are no longer residents at the time of payment, but any state’s guidelines would necessarily have to comply with the US Code’s stated exemption criteria. Many states have never issued guidance applying this federal protection to compensation paid to former state residents, in part because the federal rules are not widely discussed in either state or federal tax literature.24 However, a state’s failure to issue guidelines would not override the clear-cut federal blocker imposed on states that (likely inadvertently) might try to tax former residents on post-retirement deferred compensation qualifying for exemption from state source taxation.

This federal prohibition on state source taxation of nonresidents is contained in 4 USC Section 114, which by its terms prohibits any state from imposing an income tax on any “retirement income” of an individual who does not reside in that state with respect to payments made after December 31, 1995.25 The law contains a special definition of “retirement income” that protects many types of income traditionally paid to retirees and extends to some types of termination pay of executives who leave service before retirement and move out of the state where they have been working, or who reside in one state and work in another. The two specifically protected types of income are:

  • Distributions from qualified retirement plans. The most common type of income protected from state source taxation under the federal law is all distributions from qualified retirement plans, including pensions, profit sharing, 401(k) plans, and employee stock ownership plans (ESOPs). The federal law also protects distributions from individual retirement accounts (IRAs), 403(a) and (b) annuities, simplified employee pensions (SEPs), and certain governmental deferred compensation plans defined in Sections 414(d) and 457; and
  • Nonqualified deferred compensation. Nonqualified deferred compensation arrangements, as defined in Section 3121(v)(2)(C),26 are also protected by the federal law, depending upon the type of plan and the benefit distribution schedule. First, an exemption (the “excess plan” exemption) applies to all distributions “received after termination of employment that are paid under any employment-related plan, program or arrangements that is maintained solely [emphasis supplied] for the purposes of providing retirement benefits for employees in excess of [the various listed limitations placed on qualified retirement plans (including the Code [S]ection 415 and 401(a)(17) limits on maximum benefits under qualified retirement plans, and the annual contribution limits under Code [S]ection 401(k) plans)].”27 A second exemption from state source taxation applies to distributions under any other type of nonqualified deferred compensation plan—again, as Section 3121(v)(2)(C) defines that term—such as employee deferrals of salary or bonus, provided that payments are made in a series of “substantially equal periodic payments” (in at least annual installments) and are made “over a period of at least ten years or for the recipient’s life or life expectancy (or the joint life or life expectancy of the employee and his other beneficiary).”28

In designing this federal blocker in 1995, Congress intended these limitations to protect only certain compensation; and states would thus be allowed to apply source taxes on nonresidents with respect to deferred compensation in the form of stock options, stock appreciation rights, deferred bonuses, vacation pay, and certain types of severance pay. The structure of the federal blocker (applying to “excess plans” and “annuity payments”) thus specifically recognized that these various benefits, which were not intended to be covered by the federal blocker, are not “excess plans” and typically are paid out either at a single point in time or certainly over less than ten years.29 Moreover, in the case of stock-based deferred compensation (such as stock options), even if the income were deferred over ten years after termination, it was believed not to be payable in “substantially equal installments,” due to unpredictable fluctuations in stock prices.

Definition of “Nonqualified Deferred Compensation”

The regulations under Section 3121(v)(2) define a “nonqualified deferred compensation plan” as “any plan or other arrangement … that is [adopted, effective, and set forth in writing] by an employer for one or more of its employees, and that provides for the deferral of compensation within the meaning of [Treasury Regulations Section 31.3121(b)(3)].”30 Treasury Regulations Section 31.3121(b)(3)(i) in turn defines “deferral of compensation” to cover any plan or arrangement such that:

if, under the terms of the plan and the relevant facts and circumstances, the employee has a legally binding right during a calendar year to compensation that has not been actually or constructively received and that, pursuant to the terms of the plan, is payable to (or on behalf of) the employee in a later year. An employee does not have a legally binding right to compensation if that compensation may be unilaterally reduced or eliminated by the employer after the services creating the right to the compensation have been performed. For this purpose, compensation is not considered subject to unilateral reduction or elimination merely because it may be reduced or eliminated by operation of the objective terms of the plan, such as the application of an objective provision creating a substantial risk of forfeiture (within the meaning of [S]ection 83). Similarly, an employee does not fail to have a legally binding right to compensation merely because the amount of compensation is determined under a formula that requires a compensation offset for benefits provided under a plan that is qualified under [S]ection 401(a), or because the employee’s promised benefits are reduced due to investment losses or, in a final average pay plan, subsequent decreases in compensation.

Treasury Regulations Section 31.3121(b)(4) further provides that, notwithstanding the definition in Treasury Regulations Section 31.3121(b)(3)(i), certain benefits cannot be considered to “result from deferral of compensation,” including “certain benefits provided in connection with impending termination [of employment].” However, as the examples illustrating this rule explain, the rule is designed to block a benefit from being retroactively subjected to FICA taxes in a year prior to the establishment of the plan (or amendment).31 Specifically, Example 3 relates to a plan established in 1984 and amended in 2001 to increase benefits for a particular employee. The example states that “the additional benefits cannot be taken into account [that is, subject to FICA taxes under the timing rules of Section 3121(v)(2)] . . . before the latest of the date on which the amendment is adopted, the date on which the amendment is effective, or the date on which the material terms of the plan, as amended, are set forth in writing.” Stated differently, the fact that a particular benefit established in connection with an employee’s termination of employment cannot be treated as “resulting from” a prior deferral of compensation for FICA tax purposes does not necessarily mean that the benefit itself cannot be itself established and operated as a “deferral of compensation” from the time of termination into later calendar years. But the existence of these regulatory exemptions from Section 3121(v)(2) for severance benefits, and for other plans adopted in connection with termination of employment, makes it unclear whether these types of benefits could be exempted from state taxes if they are paid in installments over at least ten years.

SUTA32 Tax Considerations for Remote Workers

Unlike the varying state and local income tax withholding laws, federal law requires the application of standardized tests across all states to determine which state to report state unemployment insurance (SUTA) taxes to.33 Generally, an employer will report SUTA taxes to one state, even if an employee works in two or more states on an ongoing basis. Depending on the remote work program’s structure (voluntary or employer-mandated), the work schedule of the employee (fully or partially away from any employer office), and the location of the remote work (which may occur in more than one state), there may be a requirement to change the state to which SUTA taxes are paid (which also of course would affect the state in which the employee would collect unemployment benefits in the event of a layoff).

To determine the state to which SUTA taxes should be reported, an employer should apply four tests considering all services an employee performs for the employer. The employer will start with the first test, and if it results in allocating all services to one state, no further test is used. Otherwise, the employer should continue to the next test to determine if it results in allocation of all services to one state. The four tests are:

  1. Localization of work. The first test provides that an employer may allocate all services to one state if the employee’s services are performed entirely within one state, or the services performed outside of the one state are incidental, temporary, or transitory. Incidental services are transitional in nature or occur in isolated transactions.
  2. Base of operations. If an employee’s services are not localized in any one state, the employer will next look to allocate all services to the state where the employee has their base of operations. The “base of operations” is the place, or fixed center of more or less permanent nature, from which the employee starts work and to which the employee customarily returns in order to receive instructions from the employer or communications from customers or other persons, or to replenish stocks and materials, to repair equipment, or to perform any other functions needed to exercise the individual’s trade or profession at some other point or points.34 This test will not apply if the employee has no base of operations or has more than one.
  3. Place of direction and control. If neither of the two prior tests results in allocating services to one state, an employer will next look to the place the employee’s services are directed and controlled. If the place of direction and control is in only one state where the employee performs some services, then all services are allocated to that state. The place from which an individual’s service is directed or controlled is the place where basic authority exists and from which general control emanates rather than the place where a manager or foreman directly supervises the performance of services under general instructions from the place of basic authority.35 It does not need to be the location of the principal office and can be the place that is the source of basic authority over the supervision of the employee, job assignments, instructions, and personnel and payroll records.
  4. Residence. If none of the prior tests results in allocation of services to one state, then an employer may allocate the employee’s services to the employee’s state of residence, if some services are performed in that state.


All the issues discussed above are expected to be raised in payroll tax and corporate income tax audits not only for 2020 to 2022 but also for remote-worker programs for years to come. It therefore is critical for employers to design programs that mitigate tax problems and minimize tax exposures for employers and employees alike.

Mary B. Hevener, Steven P. Johnson, Barton W. S. Bassett, and Cosimo Zavaglia are partners at Morgan, Lewis & Bockius LLP.

Acknowledgment. The authors thank Linda Kim, director, global head of tax, at Infinite Electronics, who chaired one of several programs at TEI’s 2022 Annual Conference in Scottsdale, Arizona, that focused on hybrid and remote worker programs, adding many fine suggestions to the analysis of state withholding and employment tax considerations.


  1. Many of the benefits discussed here also could be provided to company directors, partners in a partnership, or any persons providing services as independent contractors, since the definition of “employee” for purposes of the working condition fringe benefit and the de minimis fringe is not limited to common-law employees. See Treasury Regulations Section 1.132-1(b)(2) and (4). Similarly, the Section 139 disaster relief exclusion is applicable to any “individual” incurring expenses as a result of a disaster. However, for simplicity, this article refers to benefits provided to “employees.”
  2. See, for example, IRS Notice 2011-72, 2011-38 IRB 407 (September 14, 2011), concerning employer-provided cell phones. Similar rules would apply to computers, which the Tax Cuts and Jobs Act removed from classification as “listed property.”
  3. Notably, this distinction between immediately deductible and capitalizable expenses was specifically acknowledged in the Eleventh Circuit’s decision in CSX v. US, 18 F.4th 692 (11th Cir 2021), which confirmed the exclusion from RRTA taxes of certain relocation expenses.
  4. Revenue Procedure 2010-51, 2010-51 IRB 883, Section 6.02(8).
  5. The operation of such a “fixed plus variable” non-FAVR program is described in PLR 9117052 (January 30, 1991).
  6. If an executive is protected by a “security study,” the value of flights is reduced by almost fifty percent. See Treasury Regulations Section 1.132-5(m)(1)-(3), providing that the executive (plus any spouse and dependent children on the same aircraft) is eligible for the special 200 percent SIFL valuation rule, which multiplies the mileage value by only 200 percent (instead of by 300 or 400 percent), and then adds the terminal charge.
  7. Of course, when employers pick the lowest of the SIFL valuations for personal flights by top company executives, the amount of the company’s disallowance increases, per Treasury Regulations Sections 1.274-9 and 1.274-10 (although, according to the preamble of these regulations, these disallowance rules do not apply to “commuting flights”). Instead, the commuting expense disallowance rule under Code Section 274(l) presumably applies only to incremental costs (and, as discussed below, does not apply at all where flights are provided for the safety of employees).
  8. See Treasury Regulations Sections 1.162-2(e) and 1.262-1(b)(5). See also H. Rept. No. 98861 at 1025, 1984 Blue Book at 56667; Comm’r v. Flowers, 326 U.S. 465 (1946); Fillerup v. Comm’r, TC Memo. 1988103; and IRS Publication 463. Notably, even a proven health problem will not justify a business deduction (or exclusion) for commuting, although in certain very limited circumstances it may justify a medical expense deduction. See IRS Information Letter 2001-0266 (October 2, 2001), citing cases that have at times allowed, but mostly disallowed, medical deductions for commuting expenses.
  9. Revenue Ruling 99-7, 1999-1 CB 361, published January 19, 1999, and made effective back to 1990, was the third in a series of rulings attempting to change these rules.
  10. See IRS CCA 200026025 (April 30, 2000) concerning the thirty-five-day rule. For discussion of a regular work location, see INFO 2001-0156 (June 4, 2001); INFO 2004-0063 (October 20, 2003); CCA 200027047 (July 7, 2000); CCA. 200018052 (May 5, 2000); and CCA 200025052 (June 23, 2000).
  11. Note that a “regular” place of business is considered a specific location, and not (as under the 1955 ruling) the general metropolitan area of that “regular” place of business. Therefore, transportation expenses to a “temporary location” (e.g., a speech or a business meeting), may be deductible, even if the speech or business meeting is located within the same geographic area as the employee’s regular business location. The exception to this rule would be where the employee has no regular place of business.
  12. See Internal Revenue Manual Sections;; and 6.800.2 (all issued late in 2021). There is no explanation for why the IRS fails to follow its own definition of “commuting” provided in Revenue Ruling 99-7.
  13. See Revenue Ruling 54-147, 1954-1 CB 51; Revenue Ruling 93-86, 1993-2 CB 71 (November 24, 1993); CCA 200020055 (May 19, 2000); and 2000 FSA Lexis 240 (March 31, 2000).
  14. United States Office of Personnel Management, 2021 Guide to Telework and Remote Work in the Federal Government, November 2021,
  15. See Code Section 280A(c)(1)(A), which was amended in 1997 to add the last factor above, and Tokh v. Comm’r, TC Memorandum 2001-45 (citing Comm’r v. Soliman, 506 U.S. 168, 174 (1993)), which had relied on only two factors to support a Section 280A home office deduction, specifically the relative importance of the activities performed at each business location and the time spent at each location.
  16. HR Rep. No. 115-409, at 266 (2017) indicated that the correlative disallowance for “qualified transportation fringes” (including parking) was designed to apply to benefits that were excludable from income, but the discussion of the disallowance for commuting indicates that commuting expenses would be disallowed even if the commute were taxed to the employee.
  17. In the case of entertainment received by top executives (defined as “specified individuals”) the deduction for the entertainment is limited to the amount imputed to the executive. In practice, however, this special deduction disallowance rule is applicable only to company aircraft, for which there can be very large differences between the total cost of the aircraft, as allocated to the entertainment flight, and the SIFL rate imputed to the executive. Indeed, this deduction disallowance rule was enacted to override the result in Sutherland Lumber-Southwest v. Commissioner, 255 F.3d 475 (8th Cir. 2001), which had concluded that the entire aircraft expense was deductible, so long as the SIFL value was imputed as income. See Treasury Regulations Sections 1.274-9 and 1.274-10.
  18. The legislative history did not explain why this different approach was taken, but it was possibly due to the fact that commuting trips on company planes were not deemed to be “entertainment flights,” and thus were exempted from the deduction disallowance rules in Treasury Regulations Sections 1.274-9 and -10, referenced above. If Congress had allowed a deduction for commuting flights where only SIFL had been imputed, again this would have resulted in a potentially large deduction for corporate aircraft use. However, the effect of such a large disallowance for commuting trips that are taxable to employees has created a large incentive for companies to try to qualify the commuting trips for the exclusion for “safety” trips discussed below.
  19. More specifically, to exclude the value of security services as a working condition fringe under Treasury Regulations Section 1.132-5(m), an employer must demonstrate the existence of a bona fide business-oriented security concern. This showing must include a specific basis for the security concern of the employee. A generalized concern for an employee’s safety is not a bona fide business-oriented security concern, which may be established by specific threats (including death threats, kidnapping, serious harm to body or property, and a history of violent terrorist activity in an area) or receipt of threats by “similarly situated employees.” The employer remains responsible for periodically reevaluating the facts and circumstances to determine whether the bona fide business-oriented security concern still exists. In addition, for the period the security threat is present, the employer must either 1) establish an overall program providing comprehensive security protection on a twenty-four-hour basis to the employee while at work, at home, commuting, and traveling or 2) obtain from an independent third party a security study objectively assessing the facts and that the security study recommendations are applied consistently. For an employee’s spouse and dependents, no separate security study is needed unless the spouse and dependents fly or ride separately (in which case separate studies and proof for the need for security would be needed for the spouse and each dependent).
  20. See Treasury Regulations Section 1.132-6(d)(2)(iii), providing a special valuation rule (of only $1.50) for commuting transportation (including transportation in employer-provided vehicles and reimbursements for taxis or car services) that is provided in “unusual circumstances” (e.g., outside of the employee’s normal work hours) and where it would be “unsafe” for the employee to use other means of transportation. This rule by its terms does not apply to “control employees” (as defined in Treasury Regulations Section 1.61-21(f)(5) to include officers earning over $130,000, employees earning over $265,000, any director, and any one percent owner). These figures, provided for 2023 by Notice 2022-55, 2022-45 IRB 443 (October 21, 2022), are adjusted for inflation. The figures for 2022 were $120,000 and $245,000, provided in Notice 2021-61, 2021-47 IRB 738 (November 24, 2021).
  21. Somewhat confusingly, Treasury Regulations Section 1.61-21(k) does not cover the same threats as those contemplated by Treasury Regulations Section 1.132-5(m) and does not even cover a company’s executives. However, at least the statutory exception is still broad, and the preamble to the final change specifically explained that the final regulations had been “expanded” to cover “more commutes.”
  22. State-by-state variances are frustratingly inconsistent. For example, New York requires withholding once any employee works over fourteen days in New York, or on the first day of work if the employer expects that the employee will work over fourteen days in New York; Connecticut imposes withholding for over fifteen days of work; North Dakota’s threshold is twenty working days; Arizona requires withholding only if an employee works in the state for sixty or more days in a year; Georgia requires withholding either if there is work over twenty-three days in a quarter, or if Georgia-allocated wages exceed the lesser of $5,000 or five percent of the employee’s total compensation; and California requires withholding if an employee has more than $1,500 of income allocatable to California. These rules are so complex, and tracking so difficult, that federal legislation has been pending for over thirteen years that would limit states’ ability to tax travelers who spend under thirty days in a state, but it remains unclear whether or when Congress will even enact this legislation or, if it is enacted, whether it will exempt executives and other high earners.
  23. Connecticut resolved this issue by adopting its own “convenience rule,” imposing Connecticut income taxes on persons working at home in New York for their own convenience for employers based in Connecticut. New Jersey is considering similar legislation (S 3128) that requires nonresidents who work for a New Jersey company but work out of state to pay New Jersey taxes similar to a nonresident who commutes across the border.
  24. The IRS would also not issue guidance here, because this provision has no effect on federal income or FICA taxes. Indeed, the statute at issue is contained in the commerce provisions of the US Code (placed there because it addressed the movement of taxpayers from state to state).
  25. This federal statute was amended to apply to partners in partnerships, in addition to employees, by PL 109-284.
  26. Code Section 3121(v)(2) applies FICA taxes to nonqualified deferred compensation on an accrual basis, as of the time the services generating the compensation are performed or (if later) when the amounts vest. Although this Code section has been effective since 1984, it did not have practical impact until 1994 when the cap on Medicare taxes was eliminated entirely. The final regulations under Code Section 3121(v)(2) were not issued in final form until January 29, 1999 (64 Federal Register 4542), and did not become effective until January 1, 2000.
  27. 4 U.S.C. Section 114(b)(1)(ii).
  28. 4 U.S.C. Section 114(b)(1)(i). Presumably the determination of whether a stream of payments meets the “substantially equal periodic payment” rule would be determined under the Internal Revenue Code’s rules governing annuity payments, such as Treasury Regulations Section 1.402(c)-2, Q&A 5(a) (providing that the determination is made at the annuity starting date and is not affected by subsequent contingencies and modifications, such as the death of a participant) and Q&A 5(d) (specifying that distributions over ten years can be paid under a “declining balance of years” method, which pays 1/10 in year 1, 1/9 of the remainder in year 2, etc.).
  29. For example, stock options and stock appreciation rights (where compensation is received in the year of exercise), restricted stock, lump sum severance pay, vacation benefits, sick leave, disability pay, and disability benefits do not provide for the deferral of compensation for purposes of the special timing rules of Section 3121(v)(2). By contrast, phantom stock, restricted stock units, and performance stock units do qualify as deferred compensation; and technically this designation applies even if the compensation were not “deferred.” See Treasury Regulations Section 31.3121(v)(2)-1(b)(4). However, to qualify for the federal blocker applicable to “excess plans,” the compensation must be paid after termination of service.
  30. Treasury Regulations Section 31.3121(b)(1).
  31. These examples appear in Treasury Regulations Section 31.3121(b)(5).
  32. An employer’s federal unemployment insurance (FUTA) tax rate will vary depending on whether the state of SUTA taxation has repaid its outstanding federal loans from January 2021 (or of any succeeding year) that were not repaid within two years. A state’s failure to repay such loans triggers an automatic “FUTA credit reduction,” meaning that the 5.4 percent credit for state taxes that normally applies for FUTA tax purposes will be reduced at a rate of 0.3 percent per year while the loan remains unpaid, starting in the third year that the loan is outstanding, and thus the state of SUTA taxation may affect the amount of FUTA tax owed.
  33. US Department of Labor UI Program Letter 20-04, Localization of Work Provisions (May 10, 2004).
  34. US Department of Labor UI Program Letter 20-04, Localization of Work Provisions (May 10, 2004).
  35. US Department of Labor UI Program Letter 20-04, Localization of Work Provisions (May 10, 2004).

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