As COVID-19 closed the physical location of many businesses and stay-at-home orders were issued, some individuals chose to shelter-in-place at vacation homes or other locations out of the state where they previously worked. Those individuals may still be continuing to work out of their “COVID homes.”
While being able to work remotely has many benefits, nexus implications for both individual and business tax clients resulting from employees working somewhere other than the employer’s or taxpayer’s home state may arise. Each state has its own set of complex rules related to filing obligations, and, given the length of the pandemic, those rules may require consideration for 2020 and potentially future tax years. Failing to advise a client about or identify potential additional filing obligations can create professional liability risk for CPA firms.
What are the implications for business tax clients?
A business with employees working in other states may establish nexus with those states, meaning sufficient contact with a particular state to create a tax filing obligation. If a client has additional filing obligations and fails to fulfill those responsibilities, the client may assert that the firm should have advised them of such. In such circumstances, the client may seek to hold the firm responsible for the client’s penalties and, in some instances, the tax.
What taxes would a client having an employee working in another state be responsible for filing? Obviously, the business may have to withhold state income tax for employees working from COVID homes, but are there other potential filing obligations?
Yes. By having a physical presence, such as the location of its employees, in other states, the business may be required to collect and remit sales tax to those states. Additionally, the business may have income, franchise, unemployment and gross receipt tax filing obligations. In some circumstances, filing income tax returns in other states may actually reduce the client’s state tax burden, providing additional incentive for the client to explore its filing obligations.
What are the implications for individual tax clients?
If the CPA firm fails to advise an individual client of its out-of-state filing obligations, individual tax clients may make assertions similar to those made by business tax clients.
Generally speaking, if an individual works in another state, an individual income tax return is required to be filed in that state and a credit for taxes paid to other states is claimed on their resident state income tax return. However, exceptions, such as reciprocity and coronavirus-specific exemptions, make the answer unclear.
While the obligation to file in another state is a nuisance, and there could be additional tax if the COVID home state has a higher tax rate than the individual’s home state, a potential for double taxation may arise. Several states have a statutory definition of a “resident” based upon the taxpayer spending a certain number of days in the state. If the COVID home is in one of these states, they may be required to file a resident return in that state in additional to their resident state, thus creating double taxation.
Similar to business clients, a client may be able to save state tax by residing in the COVID home, a possible incentive for clients to explore their filing obligations.
What risk management tips can a firm implement to mitigate its risk?
Notify clients of the potential for additional state and local filing obligations through a direct letter, newsletter, webinar or similar communication and take note of which clients receive the notification. Impose the burden on the client to contact the firm to discuss their specific situation and how the various state laws may apply to them. AICPA Tax Section members have access to its Letter to Advise Client on Teleworking Tax Impacts which can serve this purpose.Although not failsafe, such communications reduce the likelihood of a claim asserting that the CPA failed to advise the client.
While a newsletter may be sufficient for individual tax clients with whom the firm may meet annually, it may not be sufficient for clients with more frequent interaction. Consider directly communicating with these clients to discuss the issue. Always document the discussion.
If a client asks the firm to research its filing obligations, is there anything to keep in mind?
Individual and business tax clients may ask the firm to research its filing obligations, including planning opportunities for tax savings based on the client’s physical location. Although this tax consulting engagement provides CPA firms with a potential revenue opportunity, the risk must be managed. Securing a separate engagement letter for the new service is the first step in managing professional liability risk. Be sure to specifically identify the states and types of taxes the firm will be researching. CNA policyholders and AICPA Tax Section members have access to a sample Tax Consulting engagement letter to leverage.
Utilizing experts to add bench strength
Many firms have the requisite state and local tax experience and resources necessary to advise on filing obligations, but what if your firm does not? Consider referring the client to another CPA firm to provide such advice or consider engaging a state and local tax expert to work with your firm.
If the CPA firm opts to subcontract with an expert to perform the research, read Navigating Storms, and Risk, with Subcontractors for tips on how to mitigate potential professional liability risk.
If the firm makes a referral, it could be held liable for a negligent referral if the professional does not perform services competently. Therefore, it is recommended that the firm:
- Performs limited due diligence on the individuals to ensure they are properly licensed and have relevant experience;
- Provides at least three referrals in alphabetical order;
- Makes the referrals in writing; and
- Instructs the client to perform its own due diligence and disclaims any responsibility for the referred professional’s work.
Experts may be sourced from state CPA societies, the AICPA, network firms and presenters at continuing professional education events.
Anything else to keep in mind?
During the 2020 filing season, it may be obvious that a client has a filing obligation in another state. For example, an individual tax client has an out-of-state Form W-2, Wage and Tax Statement, or you note a new state on a business client’s property-by-state for apportionment purposes listing. Other times, it may not be obvious. To help identify clients with potential additional filing obligations, ask every client about their out-of-state activity during the tax year and document the client’s response. This protocol may be a good addition to your tax organizer. If additional filing obligations are noted, be sure to add them to the tax compliance engagement letter and adjust your fees accordingly.
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