State Reciprocity Agreements: Employer Withholding

Reciprocal agreements relieve employees who work and live in different states from the double burden of paying taxes in both states, requiring payment only to their home state. If any of your employees are subject to reciprocal agreements, you can help them out by withholding income tax for their state of  residency.

How Reciprocal Agreements Work

Many states that impose an income tax have entered into reciprocal agreements.  For example, Kentucky has reciprocal agreements with Illinois, Indiana, Michigan, Ohio, Virginia, West Virginia and Wisconsin. Residents of any of those states working in Kentucky are exempt from Kentucky income tax, and would pay and file income tax only to the state where they live.

If these states did not have reciprocal agreements with Kentucky, employees would file a resident return in their home state and a nonresident return in Kentucky. Employees can typically take a credit on their nonresident return to get back withheld taxes paid to their work state.

Reasons to Withhold

In the presence of a reciprocal agreement, you’re not legally required to withhold income tax for the employee’s home state. But, many employers do so as a courtesy, which employees tend to appreciate. If you don’t withhold, employees must make quarterly estimated payments to their resident state or risk underpayment penalties at tax time.

Steps for Withholding

Check out the table below to determine if your state has a reciprocity agreement with another state.  Then:

1. Establish an account with the reciprocal state’s Department of Revenue to withhold that state’s income tax.
2. Determine which employees are subject to reciprocal agreements. Note that the employee should let you know whether she lives in a different state and would like taxes withheld for that state.
3. Ask the employee to fill out the appropriate exemption form, which varies by state. For example, employees who live in Kentucky and work in Indiana must complete and give you Form WH-47.
4. Withhold income tax based on the rules for the employee’s state of residency.
5. Pay and report all withheld taxes for the employee’s home state to that state’s Department of revenue, where you established the account for reciprocal withholding.
6. Provide affected employees with an annual W-2, which includes taxes withheld for their home state.

Reciprocal agreements do not affect local withholding, such as city or county taxes.

Potential Withholding Issues

You’re responsible for withholding based on the tax data the employee gives you. But, problems may arise if:

• The employee puts the wrong information on the form verifying her state of residency. In this case, she’s liable for any withholding tax owed to her home state.
• Income tax was withheld for the employee’s work state in error. Regardless of who caused the mistake, the employee can claim a refund for taxes paid to the work state on her nonresident return.
• You set up the employee’s taxes incorrectly. To fix the issue, you may need to amend returns filed with the wrong states, submit filings to the right states, adjust the employee’s payment history, and issue a W-2c to correct the employee’s W-2.

Below is a list of states where a Reciprocal Agreement exists.  Note that Alaska, Florida, New Hampshire, Nevada, South Dakota, Tennessee, Texas, Washington, and Wyoming are not listed as these states do not have state income tax.