New Ruling Regarding Sourcing of Income for “Remote” Workers

By Bruce P. Ely & William T. Thistle, II

From time to time, we’ll get a question from a client that’s looking to hire a new employee. It goes something like this – “This candidate is just what we’ve been looking for. We’ve been trying to fill this position for months. Her experience is perfect. [Etc. Etc.] She wants to work remotely in [neighboring] State X, which we’re fine with, and she wants us to withhold State X income taxes. Can we do that? If we do, will we have to start filing corporate income tax returns in State X? Oh. Really?!?! Can we just withhold Alabama taxes from her paycheck instead? Or maybe treat her as an independent contractor?”1

Most employees live and work in the same state. But, that’s increasingly not the case. The conversation above underscores the fact that most states2 historically took the position that where an employee performed services determined the state to which withholdings should be remitted, although, individuals are generally subject to tax on 100% of their income (regardless of where it was earned) in their state of residence.

A recently-published ruling by the Alabama Tax Tribunal directly confronts that general rule of thumb and could impact your employer-clients who had one or more of their workers move to another state in light of COVID – and who remained as remote workers. See Bollinger v. Alabama Department of Revenue, Dkt. No. INC. 22390-LP (March 8, 2023).

In Bollinger, the taxpayer worked for BBVA/ Compass during early 2020 and reported to its Homewood, Alabama office. During COVID, many offices were ordered to close and this individual was forced to work remotely from his apartment. With BBVA’s permission, he relocated to Idaho, where his family lives. He continued to work for BBVA until October 2021 and was still living in Idaho at the time of the Tribunal hearing earlier this year.

The taxpayer moved to Idaho with the stated intent of residing there permanently, and even voted in Idaho, but alas, he didn’t relinquish his Alabama driver’s license, simply because it hadn’t expired. The biggest problem, however, was that BBVA issued a Form W-2 for that year, care of his former Alabama address.

The Department of Revenue first asserted that he hadn’t abandoned his Alabama domicile and was taxable by Alabama on all income he earned in 2020. Not surprisingly, however, the Tax Tribunal ruled in the taxpayer’s favor on the change of residency issue.

In the alternative, the Department argued that even if he was an Idaho resident for most of 2020, his entire salary was nevertheless taxable to Alabama because of its source. The Tax Tribunal agreed with the Department’s sourcing argument, citing Ala. Code § 40-18-2(7), providing that “every non-resident individual receiving income from property owned or business transacted in Alabama” is subject to Alabama income tax.

Although the statute doesn’t mention salary or wages, the Department’s rule addressing the gross income of nonresidents does, specifically stating that “[t]he gross income of a nonresident includes compensation for personal services only to the extent that the services were rendered in this State.” See ADOR Rule 810-3-14-.05(1)(a). That rule further provides that “[c]ompensation for personal services rendered by a nonresident outside of [Alabama] and not connected with the management or conduct of a business in [Alabama] is excluded from gross income even if payment is made from a point within this State. . . .” ADOR Rule 810-3-14-.05(1)(b). Additionally, the rule states that “the test of physical presence is used to determine the situs of the rendition of the services” if payment is made for services performed partially within and partially outside Alabama.

The Tribunal addressed that regulation head on, as well as a 2013 Administrative Law Division ruling in favor of the taxpayer in similar circumstances based on the regulation. The Tribunal admitted the case seemed analogous, but concluded that the Tax Tribunal isn’t bound by decisions of the former Administrative Law Division and overruled the decision.

The Tribunal then focused on the statutory phrase “business transacted in Alabama,” ultimately concluding that “the Taxpayer was clearly engaged in business, i.e., a regular and legal employment with BBVA, which was in Alabama.” Moreover, “because of the availability of remote work…, the Taxpayer’s physical presence in Alabama was not needed in order for him to maintain his employment in Alabama [emphasis ours].” The Judge pointed out that the taxpayer continued to work remotely post-COVID and “reported to the same Alabama supervisors to whom he had reported while working physically in Alabama.” Therefore, the taxpayer owed Alabama income tax on his salary even though part of that income accrued while he was working in and a resident of Idaho. It’s doubtful the taxpayer will appeal a $33.72 judgment against him. We also don’t know if he could claim a credit against his Idaho income tax obligation for the Alabama income tax withheld from his salary.

In light of this potentially landmark ruling, it may be wise to reconsider income tax withholding by employers and/or income tax filings by nonresident employees. If you have any questions about this ruling, please don’t hesitate to contact one of the authors - Bruce at bely@bradley.com or Will at wthistle@bradley.com.

1 Suffice to say, this scenario isn’t a good one for classifying the new worker as an independent contractor. For more on this issue and ways to mitigate the risk, please register for the ASCPA’s annual Beach Clusters, June 20-22 in Orange Beach, Alabama, with Bruce Ely as discussion leader.

2 A number of states have reciprocal arrangements with certain other neighboring states that allow for withholdings to be based on residency.