Daily Tax Report: State provides authoritative coverage of state and local tax developments across the 50 U.S. states and the District of Columbia, tracking legislative and regulatory updates,...
By Richard Ferrari, Peter Berard and Francis Cannataro
Richard Ferrari is an indirect tax partner for financial services , Peter Berard is a senior manager with employment tax advisory services, and Francis Cannataro is staff with employment tax advisory services in Ernst & Young's New York City office.
New York State (NYS) continues to serve as a global capital for finance, innovation and multinational corporate headquarters. As such, business travel continues to rise, and NYS is the beneficiary of many executives visiting for business purposes. It has also become the leading state in the country in pursuing withholding tax audit examinations, holding employers responsible to withhold, at source, income taxes on earnings associated with services performed while in NYS.
As a result, Ernst & Young LLP (EY) has seen a significant increase over the past three years in both business travel and nonresident income tax enforcement in NYS. Evidencing this trend is the state's publication of withholding tax audit guidelines intended to streamline and standardize the audit examination process for its employment tax auditors. These guidelines are lengthy and specific, and they provide detailed instructions for various procedural aspects layered into audit examinations.
In particular, we have recently observed a heightened focus by the New York State Department of Taxation and Finance (NYSDTF or the department) on the financial services sector as well as other key industries. Despite the frequency at which the NYSDTF initiates examinations and the volume of current audits, there is no indication that the department has turned its attention away from pursuing other businesses that are currently free from scrutiny. In addition, we have noticed that employers who were previously under examination are just as susceptible to renewed audit attention as other previously audit-free businesses. Considering the dollars at stake, there is little to suggest that the NYSDTF will soften its strict approach, and the current audit cycle trend will likely continue into the foreseeable future.1
Employers are no longer asking whether they should comply with NYS withholding tax rules. Instead, businesses are seeking support to overcome significant challenges associated with bringing their internal policies into compliance with NYS's complex tax regime.
The withholding tax audit process relies on the mechanical operation of New York tax law, regulations, technical documents,2 audit guidelines and historical audit precedence. In particular, it focuses on an employer's obligation to withhold NYS tax owed by its employees.
Generally, NYS tax law requires employers maintaining an office or transacting business within NYS to deduct and withhold NYS personal income tax from taxable wages paid to a resident or nonresident individual.3 Specifically, employers must withhold NYS income tax from all wages paid to NYS residents, regardless of where services are performed. However, for nonresidents, only wages paid for services performed within NYS are subject to withholding tax. In this context, wages are payments typically considered wages for federal income tax withholding purposes.4 As a result, an employer must withhold tax on a broad spectrum of compensation, including regular wages, trailing compensation (e.g., stock options, restricted stock or deferred compensation), bonuses and severance payments.
Although nonresidents are typically only taxed on wages earned from services performed within NYS, exceptions exist. NYS is one of only a handful of states in the country to incorporate a “convenience of the employer” test into its withholding tax architecture.5 This “telecommuter rule” generally requires that any nonresident individual assigned to a primary work location within NYS must have 100 percent of wages sourced to NYS if the services rendered outside of NYS were for the employee's convenience and not for the necessity of the employer, and the employee performs some amount of services within NYS during the year at issue. The rule does contemplate an exception for work performed at a bona fide employer's office, but satisfaction of the requirements needed for a bona fide employer office to exist occurs only in the narrowest of circumstances. Consequently, the reach of NYS withholding tax law extends further than what most employers perceive it to be.
Primarily, business travelers remain the key focus of the NYSDTF. The majority of employment tax non-compliance issues arise from the complexity associated with withholding, remitting and reporting the correct amount of tax from wages paid to nonresident employees who are not assigned to a NYS office. The rigidity of some modern payroll systems underscores this difficulty, as many employers are simply unable to track multistate travel or withhold tax from wages and report such withholding to multiple states.
A typical withholding tax audit begins with the NYSDTF sending an employer a formal audit notification letter that identifies tax periods under scrutiny and specifies information required for the auditor to conduct the examination. Included in the information request is generally a demand to review books and records, a power of attorney form,6 and a questionnaire tailored to identify an employer's landscape, develop an audit plan, and spot potential gaps in an employer's withholding process, controls and compliance.
As part of its information request, the NYSDTF will require an employer to provide an electronic file summarizing all domestic wages paid to employees across all U.S. states and taxes withheld for the calendar year(s) under examination. The NYSDTF also seeks key elements of information such as business traveler policies and travel expense reimbursement records. These requests may appear overly broad to an employer, but are essential to the NYSDTF in achieving its aim of accurately determining the identity and frequency of employees traveling to NYS throughout the period in question.
During examinations, the department looks to specific key areas where an employer may be non-compliant. Audit guidelines prescribe approximately 20 different tests, or “reports,” relating to separate areas of potential compliance issues.
For instance, Report 7 relates to all employees with a NYS zip code, address or resident state code and zero NYS withholding. If applicable, the existence of such employees could indicate that the employer paid wages to individuals on which withholding was required but no withholding occurred. Additionally, Report 20-2 pertains to Form 1099-MISC recipients who were not employees in the current year but were classified by the employer as employees in at least one of the prior five years. Such data assists the auditors in their review of whether workers were properly classified as independent contractors.
As shown in these examples, each report is narrowly focused, but in the aggregate they serve the NYSDTF's broader purpose—namely, an analysis of whether an employer is compliant in specific key areas. The following represents areas of attention featured prominently during an examination.
Typically, employers based outside of NYS are unaware that they may have an income tax withholding obligation. However, as mentioned earlier, NYS mandates that employers must withhold tax from nonresident employees who earn NYS source wages.7
This mandate means employers are responsible for accurately monitoring when employees travel to NYS and how much tax to withhold from a nonresident's wages. As a result, businesses employing individuals who travel frequently are at risk. This is especially relevant in high-paying industries. A significant tax liability can accumulate quickly, even without the employee spending significant time in the state.
Many employers and practitioners are familiar with the NYS 14-day de minimis withholding threshold, which states that, if a nonresident employee is not reasonably expected to surpass 14 days of service in NYS in a given calendar year, then the employer is not required to withhold NYS taxes. While the department will not penalize an employer for failing to withhold tax on wages during these first 14 days based on a reasonable expectation, the obligation to report an employee's wages in Box 16 of Form W-2 still exists for the employer. Additionally, depending on the amount of income attributable to New York for a nonresident employer, an individual income tax return reporting obligation may still exist. Further complicating the rule, withholding relief is not available to employers who expect the traveling employee to work in NYS for more than 14 days in a calendar year.8
The NYSDTF understands this reality and puts substantial effort focusing on whether an employer allocated and withheld the appropriate tax on the wages of its nonresident employees. This necessarily includes withholding correctly on compensation not considered regular wages because employers cannot avail themselves of the 14-day rule's protection when paying trailing compensation to its employees.
Payments to employees of stock options, deferred compensation, and other income earned in a prior year and paid in a later year are subject to considerable scrutiny by audit examiners. Not only can wages resulting from the exercise of trailing compensation be material (and in some cases may reach tens of millions of dollars), but rules governing its taxability are more complicated.
Employers are obligated to withhold tax on the portion of trailing compensation which is considered NYS source income. The method by which this tax is calculated for NYS nonresidents is similar in some respects to wages subject to nonresident withholding. However, the time frame an employer must use to allocate the income is distinct. No longer is it simply time spent in NYS within a single year, but rather, an employer must calculate the total time an employee performed services in NYS during the period in which the trailing compensation was earned. In such circumstances, the compensable period may extend to more than 10 years.
Moreover, the 14-day exception to withholding does not apply. An employer is obligated to withhold from the first day trailing compensation is earned in NYS.9
The resulting demands on the employer to comply with the law and related rules are thus great. Employee work location and travel must be tracked with records preserved. Employers must also understand the nuances between various trailing compensation payments (e.g., restricted stock units, restricted stock awards and non-statutory stock options). NYS delineates rules for each type of equity payment and the time period in which the compensation is considered earned (i.e., the allocation period). Therefore, an employer must comply independently with each rule governing a specific compensation type and cannot assume that each type is taxed in the same manner
Authors' Comment: NYS is unique in its approach. This can result in confusion for employers since the withholding tax methodology employed by NYS for trailing compensation is not consistent with that used by most other states.
Furthermore, an employer must still withhold NYS tax on trailing compensation earned in NYS regardless of whether the employee moved out of the state in a prior year or no longer works in the state during the year in which the taxable event occurred. NYS withholding tax is owed on all trailing compensation earned in NYS without concern to the employee's work location or residence in the year in which it is paid.
Consequently, non-compliance issues related to these types of compensation frequently occur. Employers may be unaware or unprepared to comply with these requirements and, as a result, are left vulnerable to substantial consequences, especially from a vigilant NYSDTF.
Employers must also be cognizant that the NYSDTF focuses on whether tax is properly withheld for employees that come into or leave the state due to a work assignment. Typically, employees performing services within NYS on assignment are identified by auditors by the address of the employee and from a discrepancy between the wages reported to the department and the NYS tax that is withheld on those wages.
For instance, the NYSDTF closely examines whether an employer properly complied with the “accrual rule” for employees leaving or entering the state on a work assignment.10 Application of the rule is dependent on the type of compensation earned and the period in which it is earned, resulting in compliance complexity that can become significant.
Without maintaining a substantive policy preserving adequate documentation of the employer's withholding procedure, an employer is at significant risk. For instance, an employee's assignment letter/contract and Form IT-2104.1, New York State, City of New York, and City of Yonkers Certificate of Nonresidence and Allocation of Withholding Tax, delineate the time period in which an employee performs work in NYS and showcase an employee's good faith estimate of the tax that the employer should withhold. Documents such as these can prove invaluable for an employer to overcome its burden in validating its withholding decisions under examination. However, the employer will also be required to show a similar good faith effort in reviewing other information to determine whether the estimate given by the employees at issue is accurate.
Another frequent area of emphasis by the NYSDTF is determining whether an employer utilized correct withholding tables for a given tax year. Withholding tables are reissued yearly and describe the taxable rates associated with given income thresholds. Simple withholding errors are common and can occur, for instance, when employees are paid supplemental wages such as bonuses where the proper withholding rate changes.
Employers can contribute to such mistakes by failing to properly preserve or utilize an employee's Federal Form W-4, Employee's Withholding Allowance Certificate, or NYS Form IT-2104, Employee's Withholding Allowance Certificate. Completed by the employee, these forms instruct the employer how to calculate the NYS tax to be withheld from the employee's pay. The employer should retain a copy of Form W-4 or Form IT-2104 on file for inspection in the event of a request by the NYSDTF for inspection or an audit.11
In addition, if an employee selects more than 14 withholding allowances, the employer must send a copy of the paper form to the NYSDTF for review and approval and must retain proof of such forms to the department. Circumstances triggering this responsibility arise frequently, especially in select industries, and can result in significant audit consequences. Employers are ultimately accountable for any withholding tax liability as a result of failing to maintain Form IT-2104 in their records and for failing to provide the department with notice of an employee's request for more than 14 withholding allowances.
Audit Reports allow the NYSDTF to complete a comprehensive field audit assessment. Any compliance gaps existing within an employer's withholding procedures can, in turn, mean significant tax, interest and penalties assessed against the employer. And ultimately, employers remain financially responsible for all assessments, including under-withheld tax.
If state income tax was not withheld from the employee, the individual is technically obligated to pay the appropriate state tax on his or her individual income tax returns. Although such an action would relieve the employer from owing the under-withheld portion of the tax to the NYSDTF, the reality is that employees not having state income tax withheld from wages will often fail to file a state income tax return. Consequently, employers may be saddled with the additional burden of paying the under-withheld tax, as well as the additional interest and penalties associated with its initial failure to report and timely remit it to the state.
Considering the frequency with which employers are ultimately held responsible for the under-withheld amount and the substantial financial consequence resulting from this failure, employers should factor this into a compliance program's analysis and treat it as an essential part of an overall risk assessment. It is incumbent upon employers to review internal policies and procedures to assess whether scenarios exist in which reporting gaps could expose the employer to additional tax, interest and penalties if ever under examination. NYS is attentive and knows where to look. Employers should react accordingly and develop proper internal governance in an effort to avoid preventable audit assessments.
There are multiple remedies employers can use to self-correct gaps in their overall employment tax reporting and governance model. For instance, some employers may believe that risk exists that may warrant proactively coming forward under NYS's Voluntary Disclosure and Compliance program to remediate historical under-withholding. Under the program, the employer sets forth the facts and parameters of the disclosure to the state with the ultimate goal to satisfy its liabilities. If successful, the employer can limit its exposure, be relieved from penalties and maintain confidentiality.
Alternatively, an employer may wish to undertake the rigor of their own internal audit review akin to a NYS withholding tax audit examination to assess risks and compliance gaps. As part of this process, an employer can look at its current withholding policies and determine whether to refresh and update its procedures or implement a more comprehensive plan to strengthen its overall level of compliance.
Regardless of any choices made by an employer and despite the challenges associated with maintaining compliance or facing an audit examination, employers should always be positive and take steps to evaluate current risks and potential future liability. A precise road map is situation- and employer-dependent, but ultimately, action can prove invaluable.
Disclaimer: The views expressed in this article are strictly those of the authors and do not necessarily reflect any official policy or position of Ernst & Young LLP.
2 The department issues a range of informational guidance, including advisory opinions, technical memoranda and tax bulletins. While accurate on the date on which a publication is issued, any subsequent change in the law, regulations, judicial decisions or changes in department policies could affect the validity of the information presented in such guidance.
5 20 N.Y.C.R.R. §132.18; Technical Memorandum TSB-M-06(5)I; Huckaby v. New York State Division of Tax Appeals, 2005 N.Y. LEXIS 497 (2005); Zelinsky v. Tax Appeals Tribunal, 1 N.Y.3d 85, 801 N.E.2d 840, 769 N.Y.S.2d 464 (2003).
6 Due to extensive audit procedures and potential consequences of a negative audit assessment, the NYSDTF provides the employer with a power of attorney form so the taxpayer can appoint a qualified representative to discuss the case.
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