An introduction to sales tax on Software as a Service (SaaS) companies

Software and software as a service (SaaS) companies continue to be the fastest growing industry segment in the U.S. They’re the ones to watch – dominating top company lists from Forbes to Fast Company to the Fortune 500. Yet, knowing how to manage sales tax for a software or SaaS company can be challenging, since these companies tend to have a bigger digital footprint, and rely more on investor funding and growth through merger and acquisition (M&A) than conventional brick and mortar businesses.

These factors can be triggers for new tax requirements for your tech firm. Here are three ways that growth could change your sales tax obligations and why it might be time to upgrade your compliance practices.

The obligation to collect and remit sales or use tax in a given state comes down to whether or not the state says you have nexus within its border. Nexus was originally defined as a “substantial physical presence” by the U.S. Supreme Court in Quill v. North Dakota in 1992. More than two decades later (eons in tech time) that ruling is woefully outdated in a global economy dominated by ecommerce, mobile and cloud.

Congress has yet to act on any of the Internet taxation bills put before them. As a result, states are circumnavigating Quill with a slew of new nexus requirements aimed at remote sellers, and software and technology companies are a primary target of these new nexus laws. Not surprising given the $24 billion in uncollected ecommerce sales tax revenues they’ve missed out on to date.

More than two dozen states now have affiliate and/or click-through nexus policies in place aimed at capturing sales tax from Internet sales and online marketing activities. Furthermore, some states are introducing economic nexus rules, which base the obligation to register, collect and remit sales tax solely on sale revenue or transaction volume in that state. Three states (Alabama, Oklahoma and South Dakota) currently have economic nexus requirements and 13 other states are considering it. Under these guidelines, even a small company can have nexus in multiple states.

The untenable nature of SaaS taxability also poses a problem for software sellers. Only two states – Tennessee and Vermont – have specific statutes in place to address SaaS transactions and sales tax. Several states have ping-ponged on their decisions, the most recent being Michigan, who ultimately decided to exempt it. A recent article in The Tax Advisor covers this topic more fully, reinforcing the fact that “many jurisdictions still lack significant guidance on the taxability and proper sourcing of SaaS transactions.”

Every day, new software providers enter the market, disrupting and innovating. These “born in the cloud” start-ups, as Gartner calls them, need capital to grow and the de facto strategy is often a funding round or eventually an initial public offering (IPO) or acquisition. But investor money isn’t flowing as freely as previous years. In 2015, the majority of U.S. tech and internet companies failed to reach their valuations and IPOs were down more than 50% over the previous year, according to the Wall Street Journal. Funding activity picked up in 2016, but investors remain cautious, making due diligence more important than ever.

For any funding event (public or private), investors not only look closely at how you plan to grow the business but also how you are managing it now. This includes tax compliance. Discovery of mismanaged sales and use tax or unfavorable audit outcomes can impact valuation, jeopardize funding or even nullify deals.

Considering crowdfunding? Getting start-up capital through programs like Kickstarter is popular with entrepreneurs, but uncharted territory for state taxing authorities. Only one state, Washington, has published guidelines for addressing tax related to financing raised through crowdfunding. Just because the rules aren’t clearly spelled out, doesn’t mean you don’t have to prove compliance. Tax Advisor has a good article on crowdfunding and sales tax.

Depending on how you plan to use that financing, you may also be adding to your tax liability. Hiring remote sales staff, putting money in product development or R&D, building out affiliate programs — all of these growth activities can change or add to your sales and use tax compliance requirements.

Software and tech companies are innovators. Taxing authorities are not. Digital goods and services threw them for a loop. How do you tax the intangible? It’s the million dollar question. And few states agree on the answer. Some states, like Washington, call out digital goods and services specifically in their tax laws. Others, like Texas, rely on existing laws, grouping digital goods in with taxable tangible personal property. And still others have yet to update their laws, putting the onus on the company to make the call.

The result is a convoluted maze of rules and regulations that even the savviest tax expert would have a hard time deciphering. Currently, in the U.S., software and digital goods and services are taxed numerous different ways based on a host of distinct categories, including:

• Software-as-a-service is taxed in 17 states, partially taxed in 2 states and taxed only if the provider has a server in that state in 8 states
• Digital movies are tax-exempt in 23 states and charged at 1% in Connecticut
• Digital photography is tax-exempt in 23 states
• Digital games are taxed in 26 states
• Software training is taxed in 10 states
• Installation of hardware is taxed in 21 states
• Software maintenance contracts are taxable in 24 states and partially taxed in 1 state
• In Colorado, taxability varies by jurisdiction.

The rules are also constantly being challenged or changed. Check out What’s New with SaaS? for the latest.

But, wait, there’s more! Is the software off-the-shelf or custom? Are the user rights temporary or permanent? Are you selling user licenses? Do you offer installation, hosting services, web development or maintenance contracts? The nuances can seem endless when trying to determine whether a sale is taxable or exempt. And beware of bundling. If you provide a mix of products and services, break these items out separately on invoices. Grouping taxable and nontaxable items together can subject the entire transaction to sales tax, which causes issues with reporting, returns and audits.

The journey from start-up to tech giant often happens quickly, but rarely quietly. Idea-to-IPO success stories stud the news daily and investors, analysts, and consumers are swift to home in on the hottest innovations to hit the market. This high visibility is great for growth, but it can be a magnet for states – and state auditors -- looking to draw in more tax revenue from profitable ventures. Companies with a higher profile and higher revenues tend to be chosen for audits more often. And if you have multi-state nexus, you could be looking at multiple audits.

The borderless nature of technology product and service delivery makes taxability a challenge for every size company – start-up to enterprise. Your customers could be virtually anywhere. And so could your sales tax nexus. You can’t be a tax expert in every state and every country. You shouldn’t even try. A better alternative is to automate all the processes required for compliance.

Does your tech firm exist because someone saw a way to do something profoundly better? That’s the thinking behind Avalara AvaTax™ – it’s software that makes sales tax easier to manage. No ambiguity. No uncertainty. AvaTax has the most powerful tax engine available in the market with real-time tax rates and rules for millions of products and services and 70,000 taxing jurisdictions worldwide. Audit protection is built in and accuracy is 100% guaranteed. SaaS delivery and pre-built integrations to 500+ ERP, ecommerce and billing systems makes getting started a snap. And because Avalara is a software company that deliver products and services through a SaaS model, we are experts in that area and know first-hand how to manage the complex tax rules and compliance requirements inherent to software and SaaS companies. So you’re in good company – and good hands.

Discover what 20,000 other companies already know: AvaTax is the only way to do sales tax and be certain you’re doing it right. Check the box on compliance: you’re good to grow!