TAX INSIDER

Is Your Client’s W-2 Correct? If You Said Yes, Think Again!

Taxpayers who work in more than one state may find that their employers do not know how to allocate the income they earned.
By Michael Feinstein, CPA

Although my experience is with professional athletes and entertainers, this situation could apply to anyone who works in one state and lives in another.

As the tax director for a business management firm, I have approximately 30 years of tax experience, with a majority of my career focused as a tax specialist in the sports and entertainment field. One of my firm's goals it to make sure that our clients' federal, state, and local tax burden is as low as possible, to the extent allowed by law. To do that for clients who work for sports teams, we must reconcile the wages reported by the teams, both in total and by each jurisdiction.

Over the years, I have learned a few things about this subject. First, not all teams prepare their payroll reports the same way, and, second, there are sometimes material errors in the way they are prepared. Some errors are inadvertent and generally can be rectified with a corrected Form W-2, Wage and Tax Statement. However, some errors occur routinely and are a bigger concern. Unfortunately, when we address one particular issue with the teams, they are generally hesitant to make changes and often do not correct the error.

The biggest flaw in team payroll reporting is for nonresident employees

A resident of a state is typically taxed on his or her worldwide income, wherever that income is derived. A nonresident of a particular state is only taxed on income that is sourced to that state. For players' or coaches' wages, the teams must allocate wages to all the other states based on the time spent in those jurisdictions. This is done by counting the total duty days for which they performed services for their wages and then allocating those wages to the nonresident states based on the duty days performed in each state.

When the team allocates wages to all of the nonresident jurisdictions, however, it allocates wages only to the states that require reporting. It does not allocate wages to states that don't require withholding, but which still impose tax (e.g., Georgia), and to states that have no state or local income taxes (e.g., Texas, Florida, Washington, D.C., if you are a nonresident, among others).

Once the teams have allocated the wages to the taxable/reporting jurisdictions outside of the state the teams are located in, many teams simply assign the balance of the reportable wages back to the team state, which is incorrect reporting. In the case of a resident, this will have no effect on what the player or coach reports to his or her resident state, since a resident should still pick up 100% of total wages (even though the resident state Form W-2 might report something less, and even though the coach or player will report some of those wages to other states and localities). Also, resident taxpayers may be able to claim a tax credit on their state returns for taxes paid to other states.

However, this incorrect reporting presents a problem for the player or coach who is not a resident of the team state and who has been allocated state wages from the team that exceed what should be reported. In these cases, the incorrect state Form W-2 has a direct effect on the amount of state income taxes the player or coach pays to the team's home state. As a result of an incorrect state Form W-2, the player or coach is often paying more than the required amount of state and local taxes.

For example, if a Florida resident played games in Georgia, Texas, and Washington, D.C., for a California team, and since Georgia, Texas, and Washington, D.C., do not require the team to report wages to those jurisdictions, by default the team will assign all of those wages back to the team state of California (and it will withhold California taxes).

Team responses

On many occasions, I have brought this mistake to the teams' attention through their payroll managers, finance officers, etc. First, I ask them to correct the state Form W-2, but the teams usually resist. Next, I request that they confer with legal counsel. Sometimes the teams listen, but more often they respond that this is how they allocate the wages and that, if we want to take a different position, we may do so by adjusting the amount on the individual state income tax return.

This approach presents a problem for a number of reasons. Typically, the state will respond with a state notice denying the treatment on the return. As representatives, we respond to the state taxing authority with an explanation of why the W-2 is incorrect.  The explanation is often rejected, and the state responds that without a corrected W-2, the adjustment will stand. Then we are left with requesting (once again) that the team correct the W-2 or, alternatively, filing an administrative appeal or taking the issue to court. This is not the end of it, though. The state tax notice will sometimes solicit a full-blown audit of the entire return or, worse, a residency audit might ensue, which presents additional (and sometimes substantial) costs to the client.

Why so many teams simply do not account for whether a player or coach is a resident or nonresident of the state the team is located in for payroll purposes is perplexing. Presumably, the teams have not been questioned enough about the issue and have fallen into the trap of just doing something a certain way.

A possible solution

Team procedures could easily be changed to account for a player's or coach's residency. Maybe, the team could accept a signed letter from the player or coach declaring his or her tax residency annually (possibly submitted each year along with the Form W-4, Employee's Withholding Allowance Certificate), and a waiver releasing the team from withholding obligations on income the player or coach believes should not be taxable to him or her by virtue of residency would suffice.

The lack of questioning by teams is disconcerting since, in my estimation, many players, coaches, and other employees who work in more than one state pay more state and local income taxes than they are required to, often completely without their knowledge. Over the years, the excess is probably substantial, especially since these practices have gone on for so long.

Those accountants who are informed about the issue end up either conceding to the team's allocation or trying to make a direct adjustment to the income tax returns. As mentioned above, if they take the latter route, this can be very costly for the client.

The errors go both ways, but more often than not, the error is detrimental to the player or coach, since in many cases, the choice of maintaining a residence outside the jurisdiction of the team's home state is tax-motivated (e.g., a player who lives in Florida, a jurisdiction with no state income tax, but plays for a California team, a jurisdiction with a high state income tax, may want to maintain his or her Florida residence as a way to minimize state income taxes).

This issue is not minor, and is a potentially large detriment to professional athletes and coaches alike. However, this issue is certainly not confined to them. Any employee who works in multiple jurisdictions for his or her employer who is not a resident of the state in which the employer is based should think twice when his or her Form W-2 comes in the mail. The state tax amounts may not be correct. In fact, I would be surprised if they are.

Mobile workforce bill

As an addendum, a bill that was introduced in the House of Representatives last year (H.R. 2315) would simplify reporting for employers that have mobile workforces. However, my clients would not benefit because the bill exempts from the definition of employee professional athletes, entertainers, and public figures who are persons of prominence. But this legislation would still go a long way to simplify matters for a large majority of other employers who have mobile workforces, and for their employees.

Congress's summary of the bill follows:

Mobile Workforce State Income Tax Simplification Act of 2015, H.R. 2315 (introduced by Rep. Mike Bishop, R-Mich., on May 14, 2015)

Prohibits the wages or other remuneration earned by an employee who performs employment duties in more than one state from being subject to income tax in any state other than: (1) the state of the employee's residence, and (2) the state within which the employee is present and performing employment duties for more than 30 days during the calendar year. Exempts employers from withholding of tax and information reporting requirements for employees not subject to income tax under this Act. Allows an employer, for purposes of determining penalties related to employer withholding or reporting requirements, to rely on an employee's annual determination of the time such employee will spend working in a state in the absence of fraud or collusion by such employee.

Exempts from the definition of "employee" for purposes of this Act professional athletes, professional entertainers, and public figures who are persons of prominence who perform services for wages or other remuneration on a per-event basis.

Michael Feinstein, CPA, MST, is the tax director of Boulevard Management in Woodland Hills, Calif., with approximately 30 years of income tax experience and has spent the latter part of his career engaged as a tax specialist in the sports and entertainment world.

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