Ardy Esmaeili
Trends indicate that a majority of businesses plan to fully adopt software as a service (SaaS) by 2025, and if the past is any indicator, that means state legislatures are working hard to capture revenue from this new sales stream.
As with many U.S. laws and regulations, tax laws regarding SaaS vary quite a bit and continue to evolve. Currently, some states consider SaaS to be software while others categorize it as a service. In addition, some states tax all services regardless of type, and more than 20 have a way to target SaaS. At least four states (New York, Pennsylvania, Texas and Washington) are aggressively pursuing SaaS. There’s also the issue of bundling — on its own, SaaS might not be taxed, but it will be when paired with hardware.
In the early days of a startup, there’s a tendency to think that the only tax worry would be an audit in the future, the likelihood of which is low. However, tax issues become a problem when you’re fundraising or facing due diligence for mergers and acquisitions. The party conducting due diligence will be focused on sales and use tax, as any liability could transfer to the buyer. We saw this with a new client recently — they hadn’t performed a risk assessment and the buyer identified almost $1 million dollars in tax liability. This reduced the purchase price significantly.
Startups think they’ll have lots of time to get to this point, but they actually need to focus on it right away. Any negligence, if identified, could exclude a company from any statute of limitations.
While no business is exempt from taxes, it’s critical for startups to understand when they’re liable for tax, and if offering a SaaS solution, how each set of local laws applies.
Determining your taxability
To identify which states you’ll owe sales taxes to, first establish your nexus by determining your physical or economical presence.
You can determine your physical nexus by examining which states you have employees, office, property or agents in. Are you “maintaining, occupying or using permanently or temporarily, directly or indirectly, an office, place of distribution, sales or sample room or place, warehouse, server, storage place or other place of business?” Or is there an “employee, representative, agent or salesperson working in the state under the authority of the company on a temporary or permanent basis?”
An economic nexus is established for sellers “not having physical presence in the state.” In this case, the state will collect sales tax from customers and remit if the seller meets a set level of sales or number of transactions in that state.
With broad definitions like these, it’s easy to see how complex taxes can become.
It’s critical to understand all the areas you’ll have tax liability in early to avoid fines and penalties later. In addition to sales tax, startups may also be exposed to state income tax, franchise tax, gross receipts tax and use tax.
Understanding sales tax by state
We know tax definitions and requirements vary by state. Once your nexus has been established, it’s important to review each state in which your startup is liable for taxes to understand how they tax tangible and non-tangible goods.
How do they define SaaS, and once defined, how is it taxed? For example, about 40% of states tax SaaS today, and we expect to see this number rise as more businesses move to the cloud, more SaaS solutions are developed and the effort to capture this type of revenue increases.
Here are a few categories that partly show how different states consider SaaS:
- Hardware and software bundles.
- Data processing.
- Digital goods or subscriptions.
- Information services.
- Online trainings.
- Professional services.
- Custom programming.
- Security.
- Server location.
- Storage.
- Web hosting.
- IaaS and PaaS.
- International end users.
Customer software use is typically how states track taxing destinations today. If a startup is not confident that it has received complete information about a customer’s location, most states will accept good faith documentation at the point of purchase.
Tools, tips and resources
Engage an expert as early as you can. Do not assume that your product or service is non-taxable or that you’ve identified all your areas of potential tax liability. Don’t think you won’t have to worry about it yet, because waiting can have big consequences down the line.
Establishing your nexus and interpreting how state and local laws apply to your offering is complex and hard to understand. As this space continues to evolve, it isn’t something that can be figured out once and repeated each year.
Important tax considerations your expert should help you with include:
- Identifying sales and revenue by state, employee locations, agents and office/other property locations.
- Performing a high-level exposure evaluation and nexus study.
- Completing registrations for all states in which you will be taxed.
- Ongoing consulting and planning for changes to your solution, delivery or regulations.
It’s easy to be hit with a penalty or miss out on an important opportunity because your business fell out of compliance without you knowing it. Again, tax liabilities can affect fundraising, due diligence and mergers. These days, startups often generate revenue in multiple states right from the moment they launch, which is great, but success brings scrutiny from regulators and potential audits.
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