The Quiet Risk of State and Local Payroll Tax Reporting Gaps

ARTICLE | September 22, 2026

Authored by Aprio

Summary: Many employers report state and local payroll taxes based on historical payroll configurations rather than their current workforce footprint. These discrepancies create reporting gaps that can result in tax, penalty, and interest exposure. Understanding how gaps form, what they affect, and how to address them early can help reduce risk and minimize potential penalties.

A payroll tax reporting gap may not create problems today, but it can become an expensive surprise tomorrow. Employers can face liability for taxes that should have been withheld and reported, along with penalties, interest, and potential complications during audits or due diligence reviews. These exposures often arise when tax reporting no longer accurately reflects where employees physically work and travel, or in some instances, where they live. Because unfiled returns often leave exposure open indefinitely, these issues may remain dormant until triggered by an employee inquiry, unemployment claim, state audit, or due diligence review, quietly growing in cost and complexity over time.

Why gaps form

Understanding how payroll tax gaps form is the first step toward identifying and correcting exposure before it surfaces as a serious issue. These gaps are rarely a product of carelessness or the fault of the payroll engine. Payroll providers generally process the data provided without digging for further information. If employee work locations, tax registrations, or withholding instructions are inaccurate, the payroll system will continue reporting based on those inputs.

Common areas where compliance can go wrong include:

• An employee relocates but does not update their Form W-4.
• An employee travels to perform services for the employer in a nonresident jurisdiction.
• An employee hired in a new state starts work before the employer registers for withholding or unemployment accounts.
• A business with cross border employment does not account for multiple states of work properly.
• Expansion and workforce changes alter the existing reporting footprint.

Each issue may be minor and reasonable on its own, but layered across several employees, jurisdictions, and years, these discrepancies can produce a tax reporting footprint that no longer describes where the workforce operates.

Where the gaps appear

Once a reporting gap exists, its impact can extend across several distinct payroll tax obligations.

Common areas of exposure include:

• State income tax (SIT) withholding: Failure to withhold SIT accurately and timely can result in tax shortfalls, penalties, and additional compliance obligations. Withholding obligations in most states are determined by where an employee physically works. Reciprocity agreements between neighboring states and short-term de minimis exceptions can help reduce exposure, but only when properly implemented and maintained.
• State unemployment insurance (SUI): State unemploymentcontributions are generally reported and remitted in only one state per employee, determined by a series of rules that consider where the employee works, where they are managed, and where they are based. Unfortunately, reporting wages to the wrong state does not eliminate the obligation to the correct state, and can cause significant disruptions if a former employee attempts to file and receive unemployment benefits.
• Local income tax (LIT): Local reporting and taxation issues often result from incorrect payroll system inputs and misidentified local tax filing obligations. For example, New York City resident taxes apply across all five boroughs, not just Manhattan. In addition, states such as Ohio and Pennsylvania include many local jurisdictions with their own rules, rates, and filing requirements, including, in some cases, taxes applied to nonresidents working in a particular locality.
• Paid family medical leave and disability programs: More than a dozen jurisdictions have implemented paid family leave, medical leave, and disability programs, with more programs continuing to phase in. These obligations generally follow SUI reporting rules but can be complex to administer, often requiring third-party insurance carriers to facilitate compliance.
• Dormant accounts: Registrations left open in jurisdictions where an employer no longer has employees can still carry filing obligations, and failure-to-file penalties can accrue when a required zero return is not filed.

The real cost of reporting gaps

Beyond noncompliance, payroll reporting gaps can affect cash flow, employee experience, business transactions, and an employer’s ability to resolve historical issues efficiently. The employer remains responsible for taxes that should have been withheld, remitted, and reported, even if the error originated years earlier. Add penalties and interest, and the cost of correcting a single payroll tax gap can quickly exceed the cost of complying in the first place.

Specific business impacts may involve:

• Paying the same liability twice: Money paid to the wrong state is not automatically transferred to the correct one. Employers, and sometimes employees, must often pursue a refund while paying tax, penalties, and interest to the correct jurisdiction.
• Creating employee frustration: Corrections often require corrected Forms W-2 and can create a personal return amendment or receipt of tax notices from states in which employees never expected to have a filing obligation.
• Turning a minor issue into a larger assessment: Because unfiled returns often leave the statute of limitations open, liabilities can continue to accumulate for years before anyone discovers the problem.
• Complicating audits and state inquiries: A payroll tax issue identified during an unemployment claim, employee complaint, or state review can trigger requests for additional records, amended filings, and extensive historical analysis.
• Creating transaction and diligence risk: Unresolved payroll tax exposure frequently arises during financing, investment, and acquisition discussions. Buyers and investors often view unresolved payroll tax exposure as a business liability that can result in a lower purchase price, funds being withheld at closing, additional diligence requests, or contractual obligations requiring the seller to cover future tax assessments.

Evolving rules

To make matters more complex, payroll tax compliance is not a static target. New paid leave programs, changing unemployment insurance requirements, and ever-changing legislation at the federal, state, and local levels can create compliance risks, even when a payroll process was accurate a year ago.

The number of paid family and medical leave (PFML), disability, and similar programs continue to grow with new states getting added every year. These programs vary significantly in their funding, administration, and reporting requirements. Some are employee-funded, others require employer contributions, and many have unique wage caps, employee count thresholds, and reporting obligations. State unemployment requirements are similarly dynamic, with wage bases, rates, and reporting rules changing regularly.

As employees relocate, transfer between states, or perform services across multiple jurisdictions, payroll configurations and registrations must evolve as well. Broader trends in workforce mobility and changing state requirements make payroll tax compliance increasingly complex, which is why employers should periodically reassess their payroll footprint for new risks.

Why timing matters

Payroll reporting gaps are correctable, and the cost depends largely on who identifies them first. Some states offer voluntary disclosure programs that may limit lookback periods and reduce some or all penalties for employers that come forward before being contacted. Terms vary, and eligibility generally depends on approaching the state before it initiates contact. Once a notice arrives, however, that route usually closes.

Where professional guidance can help

A knowledgeable advisor can mean the difference between limited penalties and an expensive, potentially time-consuming formal state inquiry. By identifying issues early, employers may be able to take advantage of voluntary disclosure opportunities and other remediation strategies that become unavailable once a taxing authority initiates contact.

A tax professional can help employers assess whether their payroll reporting footprint aligns with where employees work and travel. This typically includes:

• Mapping each legal entity’s reporting and remittance footprint against employee residence, primary work, and travel to work locations.
• Evaluating state income tax, local income tax, and SUI positions for employees with cross-border work arrangements.
• Reviewing paid leave and disability program compliance in jurisdictions with changing requirements.
• Identifying dormant accounts, missing reciprocity certificates, and registrations that may be required.
• Quantifying potential exposure and outlining corrections for both current and historical periods.
• Assisting with voluntary disclosures, amended returns, Forms W-2c, account registrations and closures, and state tax controversy matters, as needed.

Final thoughts

As workforces become more geographically distributed and state payroll rules continue to evolve, employers should not automatically assume their existing payroll configurations are still set up for accurate taxation. The good news is that most issues are correctable, particularly when they are identified before a taxing authority initiates contact.

Whether your organization has expanded into new jurisdictions, adopted remote work, or simply has not reviewed its payroll tax footprint in recent years, a payroll tax gap analysis can help identify potential exposure before it becomes a larger compliance issue.

Please connect with your advisor if you have any questions about this article.

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This article was written by Aprio and originally appeared on 2026-09-22. Reprinted with permission from Aprio LLP.
© 2026 Aprio LLP. All rights reserved. https://www.aprio.com/insights-events/the-quiet-risk-of-state-and-local-payroll-tax-reporting-gaps-ins-article-tax/

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