Out-of-State Workers Owe Income Taxes
An administrative decision that likely escaped the notice of most lawmakers has quietly transformed Alabama’s taxation of nonresidents, raising constitutional questions and putting Alabama employers at a distinct disadvantage. Lawmakers did not make this change, but they can and should fix it.
Early in March, the Alabama Tax Tribunal ruled that a former Alabama resident who moved to Idaho was still required to pay Alabama income taxes, reasoning that his employment with an Alabama company constituted “transacting business in Alabama.” This is a surprising ruling that changes taxability in Alabama in a meaningful way, and while its intent is to generate additional tax revenue, such an aggressive approach could easily backfire on the state.
Although the existing statutory language is vague in application to the taxation of remote workers, the tribunal’s decision to tax employees of Alabama businesses regardless of their physical location is a departure from previous Alabama policy, in which residents who moved out of state were no longer liable for state income tax. The recent tribunal decision acknowledged that the taxpayer in question had no physical presence in the state but insisted that this was irrelevant in determining whether his income was taxable in Alabama. This change sets Alabama up as an extreme outlier among states, as it adopts the aggressive New York model of remote work taxation but with even weaker nexus requirements.
The tax tribunal’s decision essentially creates a more aggressive “convenience of the employer” rule in Alabama, which stipulates that an individual’s income is subject to tax if their office is located in the state, even if they both lived, and performed the work, elsewhere. Only five states levy convenience rules—Delaware, Nebraska, New York, and Pennsylvania, plus Connecticut, which only applies the rule retaliatorily against other states with similar rules—so Alabama joins a very short and unenviable list, without the legislature ever taking a vote.
Ordinarily, states can tax their residents’ income from all sources, and the income of nonresidents when that income is earned in the state. Every state with an income tax also provides a credit for taxes paid to other states to avoid double taxation. Under convenience rules, however, remote employees can be taxed in their employer’s state (provided they have at least minimal contacts with the state, like spending a day there) even if they perform the work elsewhere. The ruling in Alabama appears to go a step further, not requiring any physical presence in the state during the tax year. To the taxpayer’s detriment, their home state may not offer them a credit for taxes paid to Alabama (since, according to their own income-sourcing rules, the income was not actually earned in another state), yielding true double taxation.
These policies are innately unfair, but as a more practical bottom-line concern, such a rule will force businesses to make some decisions that may hurt Alabama if those firms want to offer remote and flexible work opportunities to their employees post-pandemic, and it may discourage some businesses from considering Alabama altogether.
If working remotely from another state means double taxation, a remote work benefit is not much of a benefit. Accordingly, companies that prioritize remote work may either shift some of their functions out of state (providing an out-of-state office to which they can assign out-of-state workers) or even move their operations outright. Furthermore, this action undercuts one of the underappreciated implications of remote work: it allows companies to consider more locations than they might have under conditions where all their employees must be drawn from an existing local workforce.
While states might prefer that all employees of local businesses be drawn from the resident population, the ability of a business to hire from across the country, particularly for certain specialized positions, makes it easier for a business to locate in a wider range of jurisdictions. Even if not every job is located in Alabama, many will be, and Alabamians benefit when more businesses believe the state can work for them. Making it prohibitively difficult for Alabama-based companies to employ remote workers makes it much harder for companies to operate in the state.
This is an even bigger issue in Alabama than in some other states with convenience rules. While people might put up with paying taxes in two states for a very specialized role that’s not available elsewhere (e.g., wanting to work for a company based in New York City) Alabama largely lacks those kinds of “only here” jobs. This puts in-state firms at a competitive disadvantage and places roadblocks in front of potential future firms which may be less comfortable locating in Alabama because they know they can’t rely on any remote workers from out of state.
Additionally, convenience rules and similar policies sever whatever tie exists between a tax and the government services it funds. While most taxes (unlike some fees) fund a broad array of services and cannot be understood as a strictly user-pays arrangement, there is at least some connection between the taxpayer and the expenditure of the funds. Taxpayers pay for the governance of the area where they live or work—a place from which they derive some direct benefit. Taxing people who barely ever—or never—set foot in a state, under a vague and inconsistently applied notion that they are availing themselves of the state’s market simply because their company has an office there, is bad tax policy.
Convenience rules introduce some constitutional issues that are exacerbated by Alabama’s more aggressive tax treatment. Under the Dormant Commerce Clause, taxpayers must have some level of minimum economic contacts with a state to be subject to its taxes and must in some way avail themselves of the benefits of the state’s economy. Convenience rules have survived legal challenges in the past: New York’s courts concluded that working for a New York-based company with New York offices meant that employees were availing themselves of the state’s market, and that this represented sufficient contacts to tax their income.
But New York does not, of course, tax all U.S.-based employees of firms headquartered in New York, even though all of them benefit from the parent company’s location; the state implicitly recognizes that some claims of taxable nexus with a state are too tenuous. If Alabama continues on its current path, its treatment of remote workers would be even more aggressive than that of New York—a shaky legal foundation. And the convenience rules in states like New York and Pennsylvania are increasingly under scrutiny, with the potential to be challenged in federal court or prohibited by an act of Congress.
Legislators did not choose this policy, but they can fix it. State statutes are unclear and existing regulatory language does not help, but the Tax Tribunal’s ruling overturns existing policy. If Alabama legislators don’t want to follow (or exceed) New York’s dubious lead, they can change the law.
