Employers with employees working across multiple states or local jurisdictions often have additional tax withholdings to consider, especially if the employee lives in one state and works in another. As such, one common multi-state taxation option is to make courtesy tax withholdings for the employee’s state income taxes.
A courtesy withholding is a voluntary payroll deduction an employer can make to help cover an employee’s state income taxes, even though it isn’t legally required.
In most cases, employers are only obligated to withhold state income taxes for the state where the employee physically performs their work. However, some states permit employers to withhold additional taxes as a courtesy to the employee’s home state or city, as long as the employer follows applicable courtesy withholding regulations.
If an employee, for instance, lives in New Jersey but works in New York, they typically only owe state income taxes to New York. Yet, if New Jersey permits courtesy withholdings, the employer could also withhold New Jersey income taxes, reducing the employee’s potential tax payment when they file their personal income tax returns with the Garden State.
Some states also allow courtesy withholdings at the local level (e.g., cities, counties, municipalities, etc.), which is particularly helpful when remote or hybrid work arrangements allow employees to regularly work in multiple cities or live in one city but work in another.
A tax nexus refers to the connection between a business and a state that obligates the business to comply with the state’s tax laws, such as withholding state income taxes from an employee’s wages. In other words, it’s what determines which state’s tax laws a business must abide by when its operations or employee residences cross state lines.
Businesses have a few ways of establishing their tax nexus within a state, such as employing workers, having a physical presence, or regularly conducting business there.
Employees have a state tax nexus as well. For most workers, it’s the state where they live, as that’s often the same state where they work. However, unless a reciprocal agreement exists, employees who work in one state while living in another can have an income tax nexus with both.
Courtesy withholdings, therefore, simplify the entire situation by ensuring taxes are collected for both states, guaranteeing employees don’t accidentally become liable for unpaid amounts when filing annual returns.
For example, if Employee A works in Illinois but lives in Missouri, their employer must collect and remit state income taxes to Illinois. To ensure their tax liabilities are covered in both states, Employee A can ask their employer to make courtesy withholdings for Missouri taxes.
If the employer agrees, the employee won’t have to worry about underpaying or not paying Missouri income taxes when filing annual tax returns. Instead, they can claim the Illinois income taxes they paid as a credit on their Missouri tax return and receive any overpaid amounts back as a tax refund.
While both affect an employee’s income taxes, reciprocal agreements and courtesy withholdings serve different interstate payroll tax purposes.
Reciprocal agreements are formal arrangements between two states that allow employees who work in one but live in the other to pay income taxes only to the state where they live instead of the state where they work. In these cases, the employee typically submits a multi-state tax exemption form to their employer to ensure taxes are withheld only for their home state, not their work state. This setup helps eliminate double taxation and simplifies state payroll taxes for workers who regularly cross state lines for their job.
Courtesy tax withholdings, conversely, aren’t an arrangement between states but something a state government allows private employers to do. Instead of deciding which state tax rates to follow, courtesy withholdings consider both by voluntarily withholding income taxes when doing so isn’t required.
For example, if an employee lives in Iowa but works in Illinois, the reciprocal agreement between the two states means the employee only has to pay Iowa state income taxes. Yet, because Illinois allows courtesy withholdings, the worker’s employer can also voluntarily withhold Illinois income taxes.
Thus, the employee’s risk of unforeseen or underpaid state tax liabilities is minimized, and the employer doesn’t have to worry about determining which state’s tax rates to apply.
Regardless, employers should always confirm policy specifics with their state agency, as applicable rules can vary.
Employers interested in pursuing courtesy tax withholdings must first confirm with their state or local government(s) if they’re allowed to do so. Not all areas permit voluntary withholdings, and those that do often have specific rules employers must follow.
In some cases, the jurisdiction may require the employer to register before any income taxes can be withheld, even if the withholding is optional. Failing to complete any preliminary steps could eventually lead to compliance issues, even if the employer intended to help employees manage their tax obligations more effectively.
Furthermore, some states have detailed rules about how and when the withheld taxes must be filed and remitted. There may also be reporting or recordkeeping requirements, especially if the employer has no other physical or economic presence in that jurisdiction.
Courtesy withholding requirements can vary by jurisdiction, so employers should thoroughly review the applicable tax guidance for each location.
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PJ joined Paylocity in 2015 as a Government Relations Specialist and earned her M.A. in Finance from Southern New Hampshire University in 2017. PJ currently leads a team of tax professionals and works with tax and payroll operations groups.
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