Even without considering the ramifications of the 2018 Wayfair decision, the taxability of software-as-a-service (SaaS) products is complicated. With Wayfair thrown in, it just gets worse.
But why is it so complicated? More importantly, how are SaaS companies supposed to be able to comply with tax laws when they can barely keep on top of them?
A large portion of it comes down to irregularities in SaaS definitions between states, in addition to little uniformity when it comes to SaaS tax legislation. The very nature of the product (is it “software” or “service”) adds to complexity. Over 20 states now assess sales tax on the SaaS revenue stream, but for different reasons.
Why Are SaaS Taxes So Complicated?
In addition to occasionally differing definitions, the laws built on top of those definitions are also different state to state. For example, in New York, all canned or prewritten computer software is considered tangible personal property, and is thus taxable. In others, like Nevada, SaaS is taxable, but only when used for business purposes. Texas classifies SaaS as information services and assesses tax on 80% of the cost (rather than 100%).
SaaS companies who have customers in a number of different states have to deal with these irregularities and keep up with evolving legislation. For companies based in states that do not tax SaaS, such as our home state of California, they can often be lulled into a false state of security and disregard SaaS taxes all together. Clients often tell us that they didn’t realize SaaS was taxable anywhere else because California is usually so aggressive, and if they don’t tax it, others likely don’t either. Unfortunately, that’s not correct. Further, the concept of taxing “the cloud” is also not necessarily intuitive to people who are used to dealing with tangible items you can hold in your hand!
Previously, many of our clients had physical presence in only a handful of states. Now, due to Wayfair, economic nexus can kick in (which is different state to state and is typically dependent on sales and transactions thresholds) and require these companies to collect and remit sales tax on their SaaS products in states where they do not have physical presence.
Additionally, many states with major technology hubs, such as Washington, Texas, Massachusetts and Pennsylvania, do impose sales tax on SaaS, often catching companies by surprise.
How Does Economic Nexus Specifically Impact SaaS Companies?
Beyond requiring SaaS companies to collect and remit sales tax for sales in states where they meet nexus thresholds, economic nexus often hits these companies particularly hard due the monthly subscription fee model, which is popular within the industry. Many states have an “either/or” threshold for creating nexus with a minimum dollar threshold OR a limit of just 200 transactions before economic nexus kicks in, meaning SaaS companies only need 16 customers in a single state before they hit the annual transaction threshold.
For larger companies, which offer SaaS products on an enterprise scale, just one sale can be enough to hit gross sales thresholds (often around $100,000) and trigger economic nexus.
What Happens When Economic Nexus Is Triggered?
It’s easy to see how quickly SaaS companies can find themselves in sticky tax situations due to the interplay between SaaS and economic nexus. While sales tax is a pass-through tax and is not paid for by the seller, it does become a liability if the seller fails to collect. We often remind potential clients that it’s not their tax liability, but the obligation to collect it falls on a seller who has created nexus in the state. So, if a SaaS company suspects they have triggered economic nexus, what do they need to do about it?
The first step is to determine where nexus has been triggered, how long it’s been in effect and the dollar amount of potential exposure for sales tax. At Miles Consulting, this is something we typically do for clients as they look to determine any retroactive liabilities. Often these issues come up as part of a first-time financial statement audit, a cash infusion by investors or an M&A transaction. These issues are generally discovered as part of due diligence work. However, we recommend that companies examine these issues BEFORE a due diligence because then they have more time to resolve them – before quick deadlines cloud the issue.
Next, we help companies with voluntary disclosure agreements, which allow companies to come forward and pay outstanding liabilities before they are identified for an audit by the state. Proper handling of voluntary disclosures often reduces penalties and limits the lookback period to three or four years.
We can also assist SaaS companies by following up with past customers about possible retroactive collection. The most important function of SaaS taxability compliance is to catch liabilities quickly, which is our specialty. We can then help the companies to move forward in the most effective way possible
Do You Have Questions About SaaS Tax Compliance?
If you are curious about SaaS tax compliance, or have other tax questions, please contact us today. We’re happy to clarify any multi-state tax issues you’re trying to navigate.
For more information regarding SaaS taxability in specific states, please follow the links below:
What You Need to Know About the Taxability of SaaS in 9 Western States
What You Need to Know About the Taxability of SaaS in 9 Eastern States
What You Need To Know About the Taxability of SaaS in 6 More States
