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A payroll manager in Indianapolis hires a great candidate who happens to live in Ohio. Payroll gets set up the way it always has. Nobody stops to ask a basic question first. Which state actually gets the withholding?
That question sounds simple, but it rarely is, since where to withhold taxes for remote employees depends on a handful of interacting rules, and most employers never sit down and map out the logic. They inherit a payroll setup, add a new hire, and assume the existing process still applies. Sometimes it does. Often it doesn’t. That gap, between what feels like it should be fine and what’s actually correct, is where a lot of Midwest businesses get into trouble.
This isn’t a list of mistakes to avoid. It’s a walkthrough of how the decision actually gets made, the factors that feed into it, and the points where employers tend to talk themselves into the wrong answer.
Work Location Is the Starting Point
Employer tax withholding rules for remote workers begin with one question. Where is the employee physically performing their work? Not where they were hired. Not where the company’s headquarters sits. Where their hands are actually on the keyboard.
For most remote employees, income tax withholding is based on the state where the work is performed, not the employer’s location. If your business is based in Indianapolis and someone works full time from a home office in Michigan, Michigan generally has the right to tax those wages. Running payroll as though Indiana is the default state, simply because that’s where the company sits, is how the wrong jurisdiction ends up on file from the employee’s first paycheck.
This is the piece employers get wrong most often, and it’s also the easiest to get right. Confirm where the employee is actually working from before payroll is configured, not after a state notice arrives asking why no one registered.
Residency Adds a Second Variable
Work location tells you a lot, but it isn’t the whole story. State income tax sourcing rules, the rules that decide which state gets to tax a given dollar of wages, also account for where an employee lives, and those two things don’t always match.
Someone who lives and works in the same state is straightforward. The complications start once residency and work location split apart, which happens more often than employers expect. An employee might live in Kentucky and work from a company office in Indiana. Another might have moved mid-year without telling anyone outside their direct manager. Each of these situations calls for its own answer, and the state of residence is not automatically the deciding factor. It’s one input among several.
This is also where employee residency vs. work location rules start to matter for state unemployment insurance, which typically follows a different set of tests than income tax withholding does. Employers who only think through the income tax side sometimes discover, later, that they owe unemployment contributions to a state they never registered with.
Reciprocity Agreements Can Redirect Withholding
Some states have worked out arrangements with their neighbors specifically to handle cross-border commuting, and these reciprocity agreements change how the standard work-location rule applies. When states have reciprocity agreements in place, an employee who lives in one state and works in another can often have withholding sent entirely to their home state rather than split between the states.
Indiana has reciprocity agreements with Kentucky, Michigan, Ohio, Pennsylvania, and Wisconsin. For a company with staff in any of those states, this matters. If an employee lives in Kentucky and works in an Indiana office, the employer may be able to withhold for Kentucky alone, but only once the employee has filed the correct withholding certificate and payroll has actually acted on it.
That last part is where things fall apart. The agreement exists. The paperwork sits in a drawer. Payroll keeps withholding for the wrong state because no one has updated the record, and the employee eventually notices at tax return time when their refund doesn’t match what they expected.
The Convenience of the Employer Rule
Here’s a scenario that catches even experienced payroll teams off guard. An employee who used to work in a New York office relocates to New Jersey and keeps working for the same New York-based employer, fully remote, at their own request. Under the standard rule, New Jersey would get the withholding, since that’s where the work happens.
New York doesn’t see it that way. Along with Connecticut, Delaware, Nebraska, Oregon, and Pennsylvania, it applies what’s known as the convenience of the employer rule. If a remote arrangement exists for the employee’s own convenience rather than because the job requires it, the employer’s home state can still claim withholding, regardless of where the employee is actually working. It’s one of the clearest exceptions to the general rule that payroll taxes for remote workers follow the physical work location.
For most employers in Indiana and the Midwest, this rule rarely comes up. None of those six states border the region directly. But rarely isn’t ever. A single hire who relocated from one of them or still works for an employer headquartered there is enough to trigger it. Checking for this at the point of hire takes a few minutes. Finding it during an audit takes a lot longer.
When Remote Work Creates Tax Nexus
There’s a broader question sitting underneath all of this that has nothing to do with any single employee’s paycheck. Once a company has a remote worker performing their job in a state where the business has no office, warehouse, or other presence, that arrangement can be enough to create a tax nexus in that state.
Nexus determination doesn’t require much. Most states treat one employee working within their borders as sufficient connection to require the employer to register with the state’s Department of Revenue and open a withholding account, often before the first paycheck goes out.
Employers who hire a remote worker in a new state and simply add that person to the existing payroll without registering anywhere are creating a compliance gap that dates back to the employee’s start date, not the date anyone noticed the problem. States have gotten considerably better at detecting unregistered payroll activity from out-of-state employers, and this is where employer tax obligations for remote employees can get expensive fast. When they find it, the clock on penalties and interest runs from day one of employment.
The picture gets murkier for employees who don’t stay put. Say someone lives in Michigan but spends stretches of the year working from client sites in Illinois and Wisconsin. Nexus and withholding questions can open up in each state they touch, not just their home state, and most states source that income based on actual days worked there rather than a simple yes-or-no test. Without a habit of tracking where the work actually happened, an employer ends up guessing at the split, which is a worse position than having no answer at all.
Withholding Goes Beyond Income Tax
Even after determining which state taxes apply to a remote worker’s income, the decision isn’t over. Most employers stop at income tax once they’ve worked out the right state. That’s usually the biggest piece, but not the only one. State unemployment insurance is typically funded entirely by employers, so nothing is withheld from paychecks for it. Three states break from that pattern. Alaska, New Jersey, and Pennsylvania require employers to withhold a state unemployment contribution directly from employees’ wages, in addition to what the employer pays into the system.
A handful of states go further. California, Hawaii, New Jersey, New York, and Rhode Island require paycheck withholding for temporary disability insurance. Several others, including Colorado, Connecticut, Massachusetts, and Washington, now fund paid family and medical leave the same way. None of this shows up if an employer checks only income tax rules and calls the setup done. It’s a short list of states, but if one of them is where a remote employee lives, missing it means the withholding is wrong even though the income tax portion was handled correctly.
Contractors Aren't a Shortcut
Some businesses try to avoid multi-state withholding by classifying remote workers as independent contractors instead of employees. If the classification is accurate, this genuinely does remove the withholding obligation, since contractors handle their own tax obligations.
The trouble is that classification isn’t optional or a matter of preference. The IRS and state agencies each apply their own tests, generally focused on how much control the company exercises over the work, the tools being used, and whether the person works primarily for one organization. A remote worker who follows a set schedule, uses company equipment, and reports to a manager looks like an employee under nearly every test that matters, regardless of what the contract calls them.
Get the classification right first. The withholding decision that follows only makes sense once that foundation is solid.
Putting the Decision Process Together
None of these factors work in isolation. Determining where to withhold for a given employee means walking through the same sequence every time. Confirm the actual work location, check residency against it, look for a reciprocity agreement between the two states, rule out the convenience of the employer exception, and register with any state where nexus now exists. Skip a step, and the answer you land on might be wrong even though every individual fact was correct. This sequence is essentially what multi-state tax withholding comes down to in practice, a repeatable process rather than a one-off judgment call.
For a company with two or three states in play, this is manageable with a documented process and someone responsible for updating records when people move. Add a fourth or fifth state, or start hiring across the country, and remote workforce payroll compliance becomes a full-time function rather than a side task.
This is exactly the kind of decision logic WorkSmart’s payroll processing and tax assistance team runs through for every client with staff working outside their headquarters state. WorkSmart has been based in Indianapolis since 1998, and today supports clients with employees performing work across 47 states, which means these state-by-state decisions get made correctly and consistently, not worked out from scratch each time a new hire’s address doesn’t match the office.
For businesses expanding into neighboring states, WorkSmart’s PEO services for Indiana businesses extend into Ohio, Kentucky, Michigan, and Illinois, covering the reciprocity questions that come up most often for Midwest employers.
If you’re not fully confident in how your business determines where to withhold for remote employees, now is the time to walk through it, not after a state agency sends a letter asking why nothing was registered. WorkSmart Systems has spent over two decades helping Indiana and Midwest businesses manage exactly this kind of multi-state payroll decision. Contact WorkSmart Systems to schedule a consultation and get your remote workforce payroll set up correctly from the start.
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FAQs
How do employers decide which state taxes to withhold?
The starting point is always the state where the employee physically performs their work. From there, employers check residency, look for a reciprocity agreement between the two states, and confirm whether a convenience of the employer rule applies. The final answer depends on all three factors together, not any single one.
Do employers withhold taxes based on employee location or company location?
Generally, employee location. Where the company is headquartered matters for the business’s own corporate taxes, but it does not override another state’s right to withhold on wages earned by someone physically working there. Company location is relevant primarily under the convenience of the employer rule, which applies in a small number of states.
What state do remote employees pay taxes in?
In most cases, whichever state they’re physically working from. If they live in a different state that has a reciprocity agreement with the work state, withholding can go entirely to the state of residence instead, provided the right certificate is filed. Employees who work across more than one state during the year may owe tax in each, with credits available to prevent double taxation.
How to handle payroll taxes for remote employees in another state?
Confirm the employee’s actual work location first. If that state has an income tax, register with its Department of Revenue and open a withholding account before running payroll. Check for a reciprocity agreement with the employee’s home state, and update the setup if the employee later relocates.
How to avoid tax withholding mistakes for remote employees?
Build a process that runs the same checks for every remote hire. Confirm work location, check residency, apply any reciprocity agreement, rule out the convenience of the employer exception, and register in any state where nexus applies. Review the setup whenever an employee’s living or working situation changes, and don’t rely on assumptions carried over from before the role went remote.
Do independent contractors change how withholding works?
Yes, but only if the classification is accurate. A genuine independent contractor handles their own tax obligations, removing the employer’s withholding responsibility entirely. If the working relationship actually looks like employment, based on control, tools, and exclusivity, misclassifying the role does not remove the underlying withholding obligation, it just delays when the employer finds out about it.