Employer’s guide to state tax reciprocity agreements

Are you familiar with state tax reciprocity agreements? These are important to understand because state tax withholding works differently for employees who live in one state but work in another. This can pose some questions for employers. Are you supposed to withhold state taxes from wages based on the state where your business is located? Or should you withhold state taxes based on where the employee lives? To add another twist, under certain circumstances, the answer can be “yes” to both of those questions.

However, knowing what to withhold from your employee’s paycheck for state taxes becomes much easier when a reciprocal tax agreement exists between the state in which your business is located and the one in which your employee lives.

But what exactly is a reciprocal tax agreement? This guide will explain how they work, their purpose, and the states where they are currently in use.

What is a reciprocal tax agreement between states?

In a nutshell, a reciprocal tax agreement between states is an arrangement that allows an employee to work in one state and live in another without having to pay state taxes in both places. However, if the state where your employee lives does not have a reciprocal agreement with the state they work in, as the employer, you’ll be responsible for withholding state taxes for the state in which your business is located.

Let’s look at an example. Jim lives in northern Illinois, near the state line, and commutes to Wisconsin on a daily basis. Because Wisconsin and Illinois have a reciprocal tax agreement, Jim’s employer can withhold Illinois taxes rather than Wisconsin taxes from his paycheck. Without this agreement, Jim’s employer would be required to deduct Wisconsin taxes from his wages, and Jim would be responsible for paying any Illinois taxes owed.

Now that we have a better idea of what this kind of agreement is, let’s talk about what they are used for.

The role of state reciprocity agreements

State reciprocity agreements serve several purposes for both the employer and the employee.

• First, they simplify tax preparation and filing for anyone living in one state and working in another, which is common for those who live near state boundaries.
• Additionally, state tax reciprocity agreements also help to avoid double taxation on the same income for employees who work in one state but reside in another.

The takeaway is that when a reciprocity agreement exists between an employee’s home state and their work state, the employee is exempt from (and does not have to pay) state and local taxes in the state where they work. Only the employee’s home state’s state taxes must be withheld by the employer. Without this reciprocal agreement in place between the two states, the employee would have to withhold taxes for the state where the business is located.

Now that we know how they work, let’s talk about what goes on behind the scenes to make this happen.

Understanding how state reciprocal agreements work

To properly set this up, an employee is required to provide you with a state tax exemption form before you can begin withholding taxes for their home state rather than the state where your business is. Once this form is on file, you can stop withholding taxes for the business state and begin withholding state (plus any local taxes if they are required) for the employee’s home state instead.

In some cases, the employee may be required to pay quarterly taxes to their home state and file a tax return in both states to ensure that the correct amount of taxes has been paid to the appropriate agency.

For your reference, the table below includes links to each state’s tax exemption form. You can click on each state that has a reciprocal agreement (the ones that have a shade of gray) or just scroll down to the table for more information and the individual forms.

What state-by-state reciprocity agreements exist in 2024?

The table below highlights the sixteen states and the District of Columbia that currently have reciprocal agreements in place in 2024.

Are reciprocity agreements subject to change (and can new ones be introduced)?

Now that we’ve learned about each state where these agreements exist, you may be wondering if they’re permanent or subject to periodic updates. Based on circumstances, reciprocity agreements can and do change. For example, Arkansas had a rule that taxed nonresidents for working in the state, but recently repealed it.

In addition, several bills, including H.R. 5674 Mobile Workforce State Income Tax Simplification Act of 2020, have been introduced in Congress to reduce the burden of state income taxes on teleworkers and short-term business travelers, but there has been little movement on the bill in recent years.

State reciprocal tax agreements can be either

• bilateral, which is an agreement between specific states
• unilateral, which offers reciprocity to any state that offers a similar agreement to its citizens

According to the Tax Foundation, state reciprocity agreements are typically entered into by a State Commissioner of Revenue or equivalent, with each state statute determining the basis for the agreement. For example, Montana’s statute allows for the state to enter into an agreement only with neighboring states. On the other hand, states such as Minnesota, Wisconsin, and Indiana can enter into a reciprocal agreement with any state that offers a similar agreement.

The tax foundation also points out that reciprocity agreements are strictly voluntary, and in most cases, “tax administrators make the final determination, not lawmakers.” So, if more neighboring states find there are benefits for both employees and employers, there could be more reciprocal agreements in the coming decades.

How is state tax withheld in states without reciprocity agreements?

Because there’s only a total of 16 states and the District of Columbia that have active state tax reciprocity agreements in place, how does the state withholding process work in those other 34 states? If no reciprocity agreement exists, the employer would simply withhold state taxes for the state where the employee works, and the employee would be responsible for paying any taxes due in the state they live in.

To see this in practice, let’s explore an example with a fictional employee named Sarah who crosses state lines to work.

Sarah lives in northern New Mexico but works in Colorado. Because there is no reciprocal agreement between New Mexico and Colorado, Sarah’s employer withholds Colorado state taxes from her check. However, this doesn’t exempt Sarah from having to pay state taxes in New Mexico. Because the US Supreme Court ruled in 2015 against double taxation, Sarah will not have to pay taxes in both Colorado and New Mexico, but she will have to file two state returns to properly allocate the taxes withheld and at the appropriate rate.

Even if she owes no taxes in her home state, the New Mexico tax return will inform the New Mexico tax authority that Sarah already paid taxes in Colorado.

We’ve covered a lot of ground, let’s take a moment to better understand how this makes a difference for both the employer and employee.

How do employers benefit from state tax reciprocity?

The employee generally stands to benefit the most from a state tax reciprocity agreement, since that means that as an employer, you’ll be able to withhold state tax from their resident state rather than the state where your business is located. If they live in a low-tax state, they’ll likely pay less in state taxes this way.

However, there can be advantages for the employer as well, because regardless of whether a state tax reciprocity agreement is in place, you will only have to withhold state taxes for one jurisdiction:

• the employee’s home state if an agreement is in place
• or the state where your business is located if no reciprocity agreement is in place.

Remember that if there is a state tax reciprocity rule, it’s up to the employee to request that taxes for their home state be withheld by providing you with a state tax exemption form. Without it, you will need to withhold taxes based on the state where your business is — not where the employee resides.

Additionally, if a state reciprocity agreement exists, it may be wise to withhold taxes from whichever state has a lower tax rate, whether that’s the employee’s home state or work state.

Remember reciprocal tax agreement rules if hiring employees in neighboring states

Recruiting employees across state lines allows businesses to access a larger talent pool without having to search far and wide. However, employers interviewing (and hiring) candidates in neighboring states should be aware of any state tax reciprocity rules they need to follow. If you currently have (or plan) to hire employees that work in one state but live in another, understanding state tax withholding requirements and how state reciprocity agreements can impact your company’s payroll can be worth a closer look.

We wish you the best of luck as you onboard new hires that move the needle — no matter where they live!

Take a tour to see how easy payroll can be.

Jon Davis is the Sr. Content Marketing Manager at OnPay. He has over 15 years of experience writing for small and growing businesses. Jon lives and works in Atlanta.