What Is State Reciprocity, and Does It Impact Your Small Business?
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What Is State Reciprocity?

Here’s a tricky question: when a person lives in one state but works in another, to which state should the employee owe state income tax?

After all, both states may have a claim to the tax, but it certainly isn’t fair to tax the employee twice.

State Reciprocity

The idea of state reciprocity seeks to solve this problem. State reciprocity means that the state in which the employee works and the state in which they live have agreed to exempt the employee from one of the state taxes.

Generally, the state of residency takes precedence. Someone who works in Virginia but lives over the state line in Maryland would pay only the Maryland income tax.

Becoming exempt from a state income tax

It’s important to note that not all states have reciprocal agreements, and in that case, an employee may have to pay income taxes in both states.  However, when two states have an agreement, an employee will complete an exemption certificate and submit the form to their employer. The employer will file the paperwork with both states, and then withhold the state tax rate for the employee’s state of residence. At the end of the year, the employee will file one state income tax report for the state in which they reside.

States with reciprocal agreements

An employee who works in one of the following states may be able to file for an exemption because of reciprocity agreements with adjacent or or nearby states: Illinois, Indiana, Iowa, Kentucky, Maryland, Michigan, Minnesota, Montana, New Jersey, North Dakota, Ohio, Pennsylvania, Virginia, West Virginia, and Wisconsin. Also, any person who works in the District of Columbia but lives elsewhere can request a D.C. income tax exemption through their employer.

Some Exceptions to state reciprocity

State reciprocal agreements only cover the employee’s earned income—their salary, tips, bonuses, commissions, etc. Any income earned outside of employment may be subject to state income taxes from both states. For example, lottery winnings from a state other than the state of employment may be subject to taxes from both states. Other unearned income like interest, stock dividends, and capital gains also may be subject to multiple state income taxes.

Filing for a state income tax refund

If an employer accidentally collects state income taxes for the wrong state, the employee may have to file a state income tax form to get a refund. Standard tax return forms have provisions for such an occurrence, and employees should be able to receive a full refund for taxes that were accidentally collected.

It’s also possible to live and work in two states that do not have a reciprocal agreement by first filing a state tax return for the state in which the employee works. The state may realize that the employee is a nonresident and issue a full refund of all state income taxes collected. The employee would then file a state tax return for their state of residence, paying the refunded taxes plus any additional taxes to their home state.

In some situations, an employee may need to consult a tax professional to file the correct paperwork and make certain that they have paid all taxes to the correct states. You can also find information online on your state’s revenue or taxation website (e.g., Ohio).

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