3 Vital Multi-State Tax Facts for SaaS Companies

Last week, we discussed various multi-state tax issues software companies often overlook. This week we look at another industry that often misses sales and use tax ramifications on their sales: Software-as-a-Service (SaaS). Many think that because it’s not a tangible product or even clearly defined as a service (at least according to traditional definitions), these companies don’t need to worry about state sales tax. Keep reading to find out why this could be a costly mistake.

3 Multi-State Tax Facts SaaS Companies Need to Know About

Fact 1: SaaS companies regularly establish nexus. Just as every business that engages in various activities across state lines, SaaS companies need to be aware of how they may be establishing a taxable presence, or nexus, across the country. For SaaS companies specifically, this is often done in a few ways:

• Sending employees or third-party contractors to customers in other states as a “traveling salesforce.”
• Renting server space in various states across the country.
• Housing servers in more than one state.

Fact 2: The way SaaS is taxed for sales and use tax can be confusing. Because SaaS doesn’t neatly fall into existing tax definitions, the taxability surrounding this product line becomes complicated.

Taxable items are generally defined as physical personal property or specifically enumerated services; neither of these definitions really fit SaaS. This leads to states interpreting the taxability of SaaS in different ways. In some states, for example, software downloaded electronically is exempt from taxes. And some of those states, including California, also don’t impose sales tax on SaaS. In others, software is taxable whether it’s purchased in a retail location or downloaded electronically. But is SaaS really software, or is it more of a service? And if it’s considered a service, which category does it fall into? Information services, data processing or something else completely? Texas, for instance, imposes sales tax (at a reduced rate) on SaaS as data processing services.

As you can see, there are a wide variety of ways SaaS companies could be subject to collection of a state’s sales taxes and not even be aware of it, which is why it’s important these businesses find out in which states they’ve established nexus and how those states interpret the law with respect to this interesting revenue stream.

Fact 3: If a SaaS company is responsible for sales tax, it may be also be subject to a state’s income tax. In the case of income tax, we also look first to nexus, and then the nature of the product sold. Depending upon how SaaS is classified (product or service) could impact how the income is apportioned to various states – impacting the amount of income tax paid in each state. Potential variances in treatment from state to state may further complicate matters for SaaS businesses. To add to the uncertainty, it is often difficult to determine where a SaaS product is being used, as a user could be mobile and access it from various states in a given timeframe.

Case Study: Miles Consulting’s Work with SaaS Companies

The good news is, even though all three of the above facts further complicate multi-state tax matters for SaaS companies, we can help provide clarity! Here’s an example where we helped a client with a similar problem.

One of our clients is a growing Silicon Valley based SaaS company. They provide their cloud-based solution to large companies across the country. As part of a desire to ultimately implement a software system to correctly capture and report sales tax, they determined that they needed some initial help before taking that step, and hired us to take a look at the overall potential state tax exposure. We reviewed where they have nexus (they had employees living and working in several states), and then matched that with states that impose sales tax on SaaS revenue streams. As part of our review, we also calculated retroactive exposure, since the prior management hadn’t ever considered these ramifications. We ultimately assisted the company in voluntarily disclosing those liabilities to a few larger states, and assisted them in alleviating penalties and in reducing their lookback period. We ultimately helped the client save almost $100,000, and then got them on the road to filing correctly currently. A huge success for our client!

It will be interesting to see how legislators better define these areas of confusion as the country’s businesses continue to offer services and products that don’t neatly fall into existing categories. In the meantime, stay tuned for more blog posts and articles about what technology companies need to know when it comes to multi-state legislation. Our next post in the series will take a closer look at the issues surrounding medical devices!

Author: Monika Miles founded Miles Consulting Group in 2002. The firm focuses on multi-state tax consulting—helping their clients navigate state tax issues such as sales tax and income tax in interstate commerce, including e-commerce.