As MSPs grow, so do communications tax complexities

It’s certainly a great time to be offering managed services.

The recent acceleration of work-from-home policies and a fast-changing IT infrastructure landscape mean managed service providers (MSPS) are in higher demand than ever. Nearly 40% are reporting annual revenue of $2.5 million, and the market is expected to grow at a CAGR of 6.3% from 2020 to 2025.

However, even in the midst of this tremendous growth, there is one potential drawback for unprepared providers.

As MSPs continue to broaden and diversify their suite of offerings, they face an increasing set of communications tax complexity, obligations, and risk.

Back in the day, communications tax was relatively straightforward. Companies had a few established options for voice and data, and states and local jurisdictions provided well-established rules on how to tax them. Then came rapid-fire innovation and convergence, unleashing new ways to communicate: wireless data, video conferencing, cloud-based Voice over IP, connected devices ... and the list goes on.

These and other advancements in communication technology have resulted in not only a growing maze of taxes and filing requirements across the United States but also less clarity as the pace of innovation has outstripped tax authorities’ ability to stay ahead.

As a result, communications tax today is a highly complex web of requirements that span the federal, state, and local levels — and in many instances, include the complications of special tax jurisdictions, too. Across the U.S., governing bodies are working to determine which services should fall under the category of “communications services,” and how to tax them accordingly. As the managed services market expands, state and local governments want to ensure they're receiving their fair shares of revenues and could legislate accordingly.

This can be particularly problematic for fast-growing MSPs, since the very nature of business is constant growth and innovation.

Many of these providers have become accustomed to calculating, collecting, and remitting tax when reselling traditional communications services such as VoIP and wireless data. But what happens when you begin to bundle them with business collaboration tools, or combine those offerings with other, newer technologies resulting from organic expansion or a merger?

In these instances and others like them, the tax implications can get particularly tricky.

Looking ahead, keeping a close watch on three key areas can go a long way in preventing expensive audit penalties and unwanted spikes in customer pricing.

For many MSPs today, a company’s greatest advantage is its pace of innovation. From a communications tax perspective, however, rapid innovation has the potential to increase tax compliance risks. Here’s why:

Across the communications and technology industries, new offerings are being introduced at astonishing speed — a new cloud technology here, a converged service there. Emerging trends are opening the door to new packages and portfolios, while mergers and acquisitions are broadening the volume of services MSPs are able to provide. As providers make the transition from traditional reseller to strategic business partner, it’s possible that some of the latest product launches could catch the attention of communications tax auditors.

For this reason, it’s imperative that a member of your tax team has a seat at the table with product and marketing teams. When these departments understand the potential tax treatments of each new service, billing becomes much more predictable and risks are much lower. In contrast, when divisions work in silos, the business could eventually find itself in a difficult situation where a new product has been selling for months before anyone is aware that collection and remittance need to take place.

As MSPs expand into new geographic service areas, communications tax considerations become more cumbersome — and audit risks can grow.

Perhaps at no time has this consideration been more important than right now. As companies move more of their services to cloud-based and virtualized environments, the opportunities for expansion increase exponentially. Whereas managed services in the past may have been limited to local or regional settings, they can now be easily expanded to hundreds or even thousands of different ZIP codes. And while sales and use tax calculations for each of those service areas is relatively straightforward, communications tax is not.

Each municipality has its own set of requirements for the taxation of voice and video services, and these can vary drastically from one jurisdiction to the next. That means each new market and merger can open your MSP to a new array of communications tax requirements.

To stay ahead of these complexities, many fast-growing MSPs are relying on communications tax specialists and software to ensure the company is staying up to date on the latest billing requirements across locations.

Bundling services is a common practice among managed service providers, for good reason. Bundled packages are often easier to sell, and they offer customers greater value.

But here again, the communications tax implications are significant. As various voice and video services converge into single-use platforms, and as different services are bundled into unified offerings, there’s an increased likelihood of communications tax complications.

The reason? Services like calling, SMS, videoconferencing, and click-to-call could each be subject to its own separate set of communications taxes, and how these are handled can vary greatly from jurisdiction to jurisdiction.

In some states, including just one communications taxable item can make the entire bundle subject to communications tax. In others, MSPs can “unbundle the bundle” when filing taxes, but will need to have extremely thorough documentation to back up calculations and inform returns filings.

If your company isn’t already maintaining timely, accurate records for all bundled services, now is the time to start. Thorough documentation of bundle pricing changes, as well as individual changes within each bundle, is a critical first step to reducing audit risk.

Wondering what your company could, or should, be doing to remain compliant? One recent survey of finance, tax, and accounting professionals offers several clues.

Among MSPs that perform well and have low audit risk, 73% use end-to-end communications tax solutions. Nearly 70% automate tax returns and filing, and most use ERPs alongside comprehensive tax solutions.

And those factors weren’t small influences.

The companies that came out on top saw seven times better performance in total cost of audits and were three times more prepared to comply with communications tax obligations.

While the complexities of communications taxation aren’t likely to ease up any time soon, having the right technology in place can help ensure your business can continue to innovate without worry.

To see how Avalara can help your managed services company stay ahead of communications tax complexities, take a look at Avalara for Communications.