Reproduced with permission from Tax Management Weekly State Tax Report, WSTR 05/13/16, 05/13/2016.Copyright � 2016 by The Bureau of National Affairs, Inc. (800-372-1033) http://www.bna.com

Ta x P o l i c y

New York State continues to be the global center for finance, innovation and multina-

tional corporate headquarters, but that can come with increased scrutiny for taxpayers. In

this article, Ernst & Young’s Richard Ferrari, Peter Berard and Francis Cannataro discuss

the rise in state withholding tax audits.

New York State Employer WithholdingTax Examinations Are On the Rise

BY RICHARD FERRARI, PETER BERARD AND FRANCIS

CANNATARO

N ew York State (NYS) continues to serve as aglobal capital for finance, innovation and multina-tional corporate headquarters. As such, business

travel continues to rise, and NYS is the beneficiary ofmany executives visiting for business purposes. It hasalso become the leading state in the country in pursu-ing withholding tax audit examinations, holding em-ployers responsible to withhold, at source, income taxes

on earnings associated with services performed while inNYS.

As a result, Ernst & Young LLP (EY) has seen a sig-nificant increase over the past three years in both busi-ness travel and nonresident income tax enforcement inNYS. Evidencing this trend is the state’s publication ofwithholding tax audit guidelines intended to streamlineand standardize the audit examination process for itsemployment tax auditors. These guidelines are lengthyand specific, and they provide detailed instructions forvarious procedural aspects layered into audit examina-tions.

In particular, we have recently observed a height-ened focus by the New York State Department of Taxa-tion and Finance (NYSDTF or the department) on thefinancial services sector as well as other key industries.Despite the frequency at which the NYSDTF initiatesexaminations and the volume of current audits, there isno indication that the department has turned its atten-tion away from pursuing other businesses that are cur-

Richard Ferrari is an indirect tax partner forfinancial services , Peter Berard is a seniormanager with employment tax advisory ser-vices, and Francis Cannataro is staff withemployment tax advisory services in Ernst &Young’s New York City office.

Copyright � 2016 TAX MANAGEMENT INC., a subsidiary of The Bureau of National Affairs, Inc. ISSN 1534-1550

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Weekly State Tax Report™

rently free from scrutiny. In addition, we have noticedthat employers who were previously under examinationare just as susceptible to renewed audit attention asother previously audit-free businesses. Considering thedollars at stake, there is little to suggest that theNYSDTF will soften its strict approach, and the currentaudit cycle trend will likely continue into the foresee-able future.1

Employers are no longer asking whether they shouldcomply with NYS withholding tax rules. Instead, busi-nesses are seeking support to overcome significantchallenges associated with bringing their internal poli-cies into compliance with NYS’s complex tax regime.

BackgroundThe withholding tax audit process relies on the me-

chanical operation of New York tax law, regulations,technical documents,2 audit guidelines and historicalaudit precedence. In particular, it focuses on an em-ployer’s obligation to withhold NYS tax owed by its em-ployees.

Generally, NYS tax law requires employers main-taining an office or transacting business within NYS todeduct and withhold NYS personal income tax fromtaxable wages paid to a resident or nonresident indi-vidual.3 Specifically, employers must withhold NYS in-come tax from all wages paid to NYS residents, regard-less of where services are performed. However, for non-residents, only wages paid for services performedwithin NYS are subject to withholding tax. In this con-text, wages are payments typically considered wagesfor federal income tax withholding purposes.4 As a re-sult, an employer must withhold tax on a broad spec-trum of compensation, including regular wages, trailingcompensation (e.g., stock options, restricted stock ordeferred compensation), bonuses and severance pay-ments.

Although nonresidents are typically only taxed onwages earned from services performed within NYS, ex-ceptions exist. NYS is one of only a handful of states inthe country to incorporate a ‘‘convenience of the em-ployer’’ test into its withholding tax architecture.5 This‘‘telecommuter rule’’ generally requires that any non-resident individual assigned to a primary work locationwithin NYS must have 100 percent of wages sourced toNYS if the services rendered outside of NYS were forthe employee’s convenience and not for the necessity ofthe employer, and the employee performs some amountof services within NYS during the year at issue. Therule does contemplate an exception for work performedat a bona fide employer’s office, but satisfaction of the

requirements needed for a bona fide employer office toexist occurs only in the narrowest of circumstances.Consequently, the reach of NYS withholding tax lawextends further than what most employers perceive it tobe.

Primarily, business travelers remain the key focus ofthe NYSDTF. The majority of employment tax non-compliance issues arise from the complexity associatedwith withholding, remitting and reporting the correctamount of tax from wages paid to nonresident employ-ees who are not assigned to a NYS office. The rigidityof some modern payroll systems underscores this diffi-culty, as many employers are simply unable to trackmultistate travel or withhold tax from wages and reportsuch withholding to multiple states.

NYS Withholding TaxExamination Process

A typical withholding tax audit begins with theNYSDTF sending an employer a formal audit notifica-tion letter that identifies tax periods under scrutiny andspecifies information required for the auditor to con-duct the examination. Included in the information re-quest is generally a demand to review books and re-cords, a power of attorney form,6 and a questionnairetailored to identify an employer’s landscape, develop anaudit plan, and spot potential gaps in an employer’swithholding process, controls and compliance.

As part of its information request, the NYSDTF willrequire an employer to provide an electronic file sum-marizing all domestic wages paid to employees acrossall U.S. states and taxes withheld for the calendaryear(s) under examination. The NYSDTF also seekskey elements of information such as business travelerpolicies and travel expense reimbursement records.These requests may appear overly broad to an em-ployer, but are essential to the NYSDTF in achieving itsaim of accurately determining the identity and fre-quency of employees traveling to NYS throughout theperiod in question.

During examinations, the department looks to spe-cific key areas where an employer may be non-compliant. Audit guidelines prescribe approximately 20different tests, or ‘‘reports,’’ relating to separate areasof potential compliance issues.

For instance, Report 7 relates to all employees with aNYS zip code, address or resident state code and zeroNYS withholding. If applicable, the existence of suchemployees could indicate that the employer paid wagesto individuals on which withholding was required butno withholding occurred. Additionally, Report 20-2 per-tains to Form 1099-MISC recipients who were not em-ployees in the current year but were classified by theemployer as employees in at least one of the prior fiveyears. Such data assists the auditors in their review ofwhether workers were properly classified as indepen-dent contractors.

As shown in these examples, each report is narrowlyfocused, but in the aggregate they serve the NYSDTF’sbroader purpose—namely, an analysis of whether an

1 NYS generates tens of millions a year in revenue via with-holding tax audit examinations alone.

2 The department issues a range of informational guidance,including advisory opinions, technical memoranda and taxbulletins. While accurate on the date on which a publication isissued, any subsequent change in the law, regulations, judicialdecisions or changes in department policies could affect thevalidity of the information presented in such guidance.

3 N.Y. Tax Law §675.4 20 N.Y.C.R.R. §171.3(a)(1); IRC §3401(a).5 20 N.Y.C.R.R. §132.18; Technical Memorandum TSB-M-

06(5)I; Huckaby v. New York State Division of Tax Appeals,2005 N.Y. LEXIS 497 (2005); Zelinsky v. Tax Appeals Tribunal,1 N.Y.3d 85, 801 N.E.2d 840, 769 N.Y.S.2d 464 (2003).

6 Due to extensive audit procedures and potential conse-quences of a negative audit assessment, the NYSDTF providesthe employer with a power of attorney form so the taxpayercan appoint a qualified representative to discuss the case.

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5-13-16 Copyright � 2016 TAX MANAGEMENT INC., a subsidiary of The Bureau of National Affairs, Inc. TM-WSTR ISSN 1534-1550

employer is compliant in specific key areas. The follow-ing represents areas of attention featured prominentlyduring an examination.

Multistate Nonresident Withholding for Regular Wages.Typically, employers based outside of NYS are unawarethat they may have an income tax withholding obliga-tion. However, as mentioned earlier, NYS mandatesthat employers must withhold tax from nonresident em-ployees who earn NYS source wages.7

This mandate means employers are responsible foraccurately monitoring when employees travel to NYSand how much tax to withhold from a nonresident’swages. As a result, businesses employing individualswho travel frequently are at risk. This is especially rel-evant in high-paying industries. A significant tax liabil-ity can accumulate quickly, even without the employeespending significant time in the state.

Many employers and practitioners are familiar withthe NYS 14-day de minimis withholding threshold,which states that, if a nonresident employee is not rea-sonably expected to surpass 14 days of service in NYSin a given calendar year, then the employer is not re-quired to withhold NYS taxes. While the departmentwill not penalize an employer for failing to withhold taxon wages during these first 14 days based on a reason-able expectation, the obligation to report an employee’swages in Box 16 of Form W-2 still exists for the em-ployer. Additionally, depending on the amount of in-come attributable to New York for a nonresident em-ployer, an individual income tax return reporting obli-gation may still exist. Further complicating the rule,withholding relief is not available to employers who ex-pect the traveling employee to work in NYS for morethan 14 days in a calendar year.8

The NYSDTF understands this reality and puts sub-stantial effort focusing on whether an employer allo-cated and withheld the appropriate tax on the wages ofits nonresident employees. This necessarily includeswithholding correctly on compensation not consideredregular wages because employers cannot avail them-selves of the 14-day rule’s protection when paying trail-ing compensation to its employees.

Trailing Compensation. Payments to employees ofstock options, deferred compensation, and other in-come earned in a prior year and paid in a later year aresubject to considerable scrutiny by audit examiners.Not only can wages resulting from the exercise of trail-ing compensation be material (and in some cases mayreach tens of millions of dollars), but rules governing itstaxability are more complicated.

Employers are obligated to withhold tax on the por-tion of trailing compensation which is considered NYSsource income. The method by which this tax is calcu-lated for NYS nonresidents is similar in some respectsto wages subject to nonresident withholding. However,the time frame an employer must use to allocate the in-come is distinct. No longer is it simply time spent inNYS within a single year, but rather, an employer mustcalculate the total time an employee performed servicesin NYS during the period in which the trailing compen-

sation was earned. In such circumstances, the compen-sable period may extend to more than 10 years.

Moreover, the 14-day exception to withholding doesnot apply. An employer is obligated to withhold fromthe first day trailing compensation is earned in NYS.9

The resulting demands on the employer to complywith the law and related rules are thus great. Employeework location and travel must be tracked with recordspreserved. Employers must also understand the nu-ances between various trailing compensation payments(e.g., restricted stock units, restricted stock awards andnon-statutory stock options). NYS delineates rules foreach type of equity payment and the time period inwhich the compensation is considered earned (i.e., theallocation period). Therefore, an employer must complyindependently with each rule governing a specific com-pensation type and cannot assume that each type istaxed in the same manner

Furthermore, an employer must still withhold NYStax on trailing compensation earned in NYS regardlessof whether the employee moved out of the state in aprior year or no longer works in the state during theyear in which the taxable event occurred. NYS with-holding tax is owed on all trailing compensation earnedin NYS without concern to the employee’s work loca-tion or residence in the year in which it is paid.

Consequently, non-compliance issues related tothese types of compensation frequently occur. Employ-ers may be unaware or unprepared to comply withthese requirements and, as a result, are left vulnerableto substantial consequences, especially from a vigilantNYSDTF.

Work Assignments. Employers must also be cognizantthat the NYSDTF focuses on whether tax is properlywithheld for employees that come into or leave the statedue to a work assignment. Typically, employees per-forming services within NYS on assignment are identi-fied by auditors by the address of the employee andfrom a discrepancy between the wages reported to thedepartment and the NYS tax that is withheld on thosewages.

For instance, the NYSDTF closely examines whetheran employer properly complied with the ‘‘accrual rule’’for employees leaving or entering the state on a workassignment.10 Application of the rule is dependent onthe type of compensation earned and the period inwhich it is earned, resulting in compliance complexitythat can become significant.

Without maintaining a substantive policy preservingadequate documentation of the employer’s withholding

7 20 N.Y.C.R.R. §171.6(a).8 Technical Memorandum, TSB-M-12(5)I; Withholding Tax

Field Audit Guidelines (rev. April 5, 2005).

9 Id.10 N.Y. Tax Law §639(a).

Authors’ Comment: NYS is unique in its ap-proach. This can result in confusion for em-ployers since the withholding tax methodologyemployed by NYS for trailing compensation isnot consistent with that used by most otherstates.

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procedure, an employer is at significant risk. For in-stance, an employee’s assignment letter/contract andForm IT-2104.1, New York State, City of New York, andCity of Yonkers Certificate of Nonresidence and Alloca-tion of Withholding Tax, delineate the time period inwhich an employee performs work in NYS and show-case an employee’s good faith estimate of the tax thatthe employer should withhold. Documents such asthese can prove invaluable for an employer to overcomeits burden in validating its withholding decisions underexamination. However, the employer will also be re-quired to show a similar good faith effort in reviewingother information to determine whether the estimategiven by the employees at issue is accurate.

Withholding Tables. Another frequent area of empha-sis by the NYSDTF is determining whether an employerutilized correct withholding tables for a given tax year.Withholding tables are reissued yearly and describe thetaxable rates associated with given income thresholds.Simple withholding errors are common and can occur,for instance, when employees are paid supplementalwages such as bonuses where the proper withholdingrate changes.

Employers can contribute to such mistakes by failingto properly preserve or utilize an employee’s FederalForm W-4, Employee’s Withholding Allowance Certifi-cate, or NYS Form IT-2104, Employee’s WithholdingAllowance Certificate. Completed by the employee,these forms instruct the employer how to calculate theNYS tax to be withheld from the employee’s pay. Theemployer should retain a copy of Form W-4 or Form IT-2104 on file for inspection in the event of a request bythe NYSDTF for inspection or an audit.11

In addition, if an employee selects more than 14withholding allowances, the employer must send a copyof the paper form to the NYSDTF for review and ap-proval and must retain proof of such forms to the de-partment. Circumstances triggering this responsibilityarise frequently, especially in select industries, and canresult in significant audit consequences. Employers areultimately accountable for any withholding tax liabilityas a result of failing to maintain Form IT-2104 in theirrecords and for failing to provide the department withnotice of an employee’s request for more than 14 with-holding allowances.

Employer ObligationsAudit Reports allow the NYSDTF to complete a com-

prehensive field audit assessment. Any compliancegaps existing within an employer’s withholding proce-dures can, in turn, mean significant tax, interest andpenalties assessed against the employer. And ulti-mately, employers remain financially responsible for allassessments, including under-withheld tax.

If state income tax was not withheld from the em-ployee, the individual is technically obligated to pay theappropriate state tax on his or her individual incometax returns. Although such an action would relieve theemployer from owing the under-withheld portion of thetax to the NYSDTF, the reality is that employees nothaving state income tax withheld from wages will oftenfail to file a state income tax return. Consequently, em-ployers may be saddled with the additional burden ofpaying the under-withheld tax, as well as the additionalinterest and penalties associated with its initial failureto report and timely remit it to the state.

Considering the frequency with which employers areultimately held responsible for the under-withheldamount and the substantial financial consequence re-sulting from this failure, employers should factor thisinto a compliance program’s analysis and treat it as anessential part of an overall risk assessment. It is incum-bent upon employers to review internal policies andprocedures to assess whether scenarios exist in whichreporting gaps could expose the employer to additionaltax, interest and penalties if ever under examination.NYS is attentive and knows where to look. Employersshould react accordingly and develop proper internalgovernance in an effort to avoid preventable audit as-sessments.

What Can Employers Do?There are multiple remedies employers can use to

self-correct gaps in their overall employment tax re-porting and governance model. For instance, some em-ployers may believe that risk exists that may warrantproactively coming forward under NYS’s VoluntaryDisclosure and Compliance program to remediate his-torical under-withholding. Under the program, the em-ployer sets forth the facts and parameters of the disclo-sure to the state with the ultimate goal to satisfy its li-abilities. If successful, the employer can limit itsexposure, be relieved from penalties and maintain con-fidentiality.

Alternatively, an employer may wish to undertakethe rigor of their own internal audit review akin to aNYS withholding tax audit examination to assess risksand compliance gaps. As part of this process, an em-ployer can look at its current withholding policies anddetermine whether to refresh and update its proceduresor implement a more comprehensive plan to strengthenits overall level of compliance.

Regardless of any choices made by an employer anddespite the challenges associated with maintainingcompliance or facing an audit examination, employersshould always be positive and take steps to evaluatecurrent risks and potential future liability. A preciseroad map is situation- and employer-dependent, but ul-timately, action can prove invaluable.

Disclaimer: The views expressed in this article arestrictly those of the authors and do not necessarily reflectany official policy or position of Ernst & Young LLP.11 20 N.Y.C.R.R. §171.4.

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5-13-16 Copyright � 2016 TAX MANAGEMENT INC., a subsidiary of The Bureau of National Affairs, Inc. TM-WSTR ISSN 1534-1550