United States: New York Adopts New Audit Policy On Employer Withholding For Nonresidents

On September 17, 2004, the Audit Division of the New York State Department of Taxation and Finance ("Division") issued revised withholding tax field audit guidelines ("Revised Guidelines"). The Revised Guidelines set forth, among other provisions, several new audit policies relating to an employer’s obligation to withhold New York personal income tax ("PIT") from compensation paid to nonresident employees who perform some or all of their services in New York. The Revised Guidelines are effective immediately and apply to all open tax years.

Although the Division has always had the statutory and regulatory authority to require employers to withhold PIT from nonresident employees who travel to New York on business, until now there was no formal audit policy in place to verify employer compliance and, as a practical matter, there was no enforcement program designed to audit the whereabouts of nonresident employees of corporations based outside of New York. With the issuance of the Revised Guidelines, that audit policy is now in place, and the Division appears poised to implement an enforcement program aimed at ensuring that foreign corporations that send nonresident employees to New York on business comply with the withholding tax laws.

Generally, any corporation maintaining an office or transacting business in New York and making payment of wages taxable under the PIT law is an "employer" for purposes of the withholding tax and required to withhold PIT on the wages paid to any of its employees who perform any services in New York.¹ The Revised Guidelines expressly state that whether or not a corporation is a taxpayer is not determinative of whether the corporation is an employer for withholding tax purposes. For example, a foreign corporation that has employees performing services in New York, but that is exempt from taxation pursuant to Public Law 86-272, is nevertheless an employer and thus required to withhold PIT on wages paid to those employees.

In most instances, compensation that is considered wages for federal income tax withholding purposes is considered wages for PIT withholding purposes. This includes salaries, fees, bonuses, pensions, retirement payments, remuneration paid in cash or something other than cash, such as stocks, bonds, or other forms of property, and payments for services even if an employer-employee relationship no longer exists when the payment is made. In addition, a regulation provides that the Internal Revenue Code provisions, including any applicable regulations, relating to the withholding of federal income tax apply for New York withholding tax purposes.²

The new audit policies set forth in the Revised Guidelines primarily relate to an employer’s obligation to withhold PIT on payments of ordinary wages and certain types of deferred compensation to nonresident employees whose primary work location is outside of New York, but who may occasionally travel to New York on business. First, with respect to payment of ordinary wages, the Revised Guidelines provide that if a nonresident employee’s primary work location is outside of New York and the employee performs services in New York, the employer will be required to withhold on 100% of the ordinary wages paid to such employee unless: 1) the employee provides the employer with a Form IT-2104.1, Certificate of Nonresidence and Allocation of Withholding Tax, showing the percentage of time the employee expects to work in New York during the year; 2) the employer maintains adequate records to determine the proper amount of tax to be withheld; or 3) the employer reasonably expects the employee to perform services in New York for 14 or fewer days during the tax year.

For purposes of the 14 day rule, if the employee is expected to work in New York for more than 14 days, the employer must withhold on all wages paid to the employee. If the employee is expected to work in New York for 14 or fewer days, but actually works more than 14 days in New York, the employer must withhold on wages paid to such employee starting on the 15th day.³ In addition, it should be noted that, even though the employer is not required to withhold PIT on wages paid to nonresident employees who perform services in New York for 14 or fewer days, the employee is required to report such wages as New York source income and pay PIT on such wages.

Further, an employer may rely on a Form IT-2104.1 submitted by an employee as long as the employer does not have actual knowledge, or a reason to know, that the Form is incorrect. The Revised Guidelines provide that an employer may not claim that it does not have actual knowledge or a reason to know if the employer does not have a system in place to verify that the IT-2104.1s received from employees are accurate. In addition, an employer is deemed to have reason to know that Form IT-2104.1 is incorrect if a reasonably prudent person in the position of the employer would question the claims made on Form IT-2104.1. Also, an employer is deemed to have actual knowledge or a reason to know that Form IT-2104.1 is incorrect if there has been a significant change in the employee’s work assignment or the employee gives the employer information that indicates the employee has become a New York resident. Significant changes in work assignments include promotions, change in primary work location and a change in duties. The Revised Guidelines, however, do not provide any guidance regarding whose knowledge will be imputed to the corporate employer.

Second, with respect to payments of deferred compensation or the granting of nonqualified stock options (collectively, "deferred compensation") to nonresident employees, the Revised Guidelines provide that if all or a part of an employee’s deferred compensation that is considered wages for federal income tax purposes is attributable to services performed in New York, the employer must withhold on 100% of such deferred compensation income unless: 1) the employee submits a Form IT-2104.1 for the deferred compensation reflecting the proper allocation of the income; 2) the employer has a Form IT-2104.1 on file for an employee for the current year, the employee is still performing services in New York and the deferred compensation is less than $1,000,000 for the payroll period, in which case the employer may withhold based on the Form IT-2104.1 on file for the current year; 3) the employee is no longer employed by the employer or is no longer performing services in New York and the deferred compensation income is less than $1,000,000 for the payroll period, in which case the employer may withhold based on the last Form IT-2104.1 on file for the employee; or 4) the employer has adequate records to determine the proper allocation of the deferred compensation income to New York (the "Adequate Records Method").

If an employer withholds on deferred compensation income based on the Adequate Records Method, the employer must maintain records sufficient to enable the employer to determine the percentage of services performed in New York for all of the years in which the deferred compensation income is earned. In addition, the Revised Guidelines expressly state that the 14 day rule does not apply with respect to deferred compensation income.

During any withholding tax audit under the new policies, the Division’s auditors are instructed to request that the employer provide a listing of all employees with Forms IT-2104.1 on file and a listing of each employee’s job title and work location. Moreover, as part of the new audit policies, the Division’s auditors are instructed to review the audit files relating to any prior withholding tax, corporation tax or flow-through entity audit conducted on the employer. Auditors are instructed, as part of the pre-audit analysis, to determine how the employer’s business operates, identify which functions are carried on in New York and ascertain which employees work inside and outside of New York. To develop such information, auditors are advised to review the apportionment factors on the employer’s New York corporation tax returns and to speak with auditors who have completed corporation tax audits on the employer.

Finally, the Revised Guidelines include new procedures for examining "high wage earners" from whom no PIT is withheld and who the employer claims have no nexus with New York. If the Division’s auditor believes that a highly-paid employee may be coming to New York to perform services, the Revised Guidelines provide that the auditor should select a sample period and ask the employer for documentation relating to the employee’s travel activities during the sample period. If the auditor determines that the highly-paid employee works in New York for more than 14 days a year, the auditor may recommend that a more detailed audit be performed to determine the tax that should have been withheld. The auditor may also open an individual audit case against the highly-paid employee.

The issuance of the Revised Guidelines reflects a new emphasis within the Division to verify and enforce compliance by foreign corporations with the withholding tax laws. Foreign corporations with nonresident employees who travel to New York on business are now at a much greater risk of facing a withholding tax audit, and should begin implementing procedures to accurately determine the amount of time their employees work in New York. Certainly, serious attention has to be given to highly paid individuals who regularly and consistently spend significant time in New York, and whose compensation may not have been subjected to any New York withholding.

However, strict compliance with the New York withholding tax statute and regulations may prove an administrative, and practical, impossibility. There is also an enormous and perhaps unreasonable burden associated with requiring the filing of returns by any individual who happens to visit New York on business for a few days each year.⁴ Even more importantly, consideration should be given by the Division, and by the New York City Department of Taxation, to the potential effect on the hotels, restaurants and stores, particularly in New York City, that are dependent upon the patronage of business travelers. If companies begin to feel the burden of compliance with the withholding tax laws to be too great, and institute restrictive travel policies designed to keep employees out of New York City, the local economy will suffer significantly – and such effects may significantly outweigh the small amounts of withholding tax that the new policy seeks to collect.

Footnotes

Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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