An Important Update On Software-as-a-Service (SaaS) And Sales Tax Questions And Answers

Tax Update On Software As A Service

The Software-as-a-Service (SaaS) industry has continuously grown since the first SaaS company was founded in 1999, and remains a complex and ever-changing field. It can be especially complicated when it comes to sales tax, and we constantly receive questions about it. The very nature of the product (is it a service or a software?) is a large part of the confusion, and as a result, states may define SaaS differently, which makes it hard for businesses, especially smaller ones, to keep up. SaaS is now taxed in over 20 states, but for different reasons. Other areas unique to SaaS companies in the realm of sales tax include the sourcing of revenue to the correct state, timing of the recognition of the sale and the application of the tax (versus recognition of revenue for financial/book purposes).

If you are new to the application of sales tax to SaaS, we recommend you check out our previous articles on the topic, including this one here, where we discuss in-depth what makes SaaS sales taxation so complex. In the current article, we discuss answers to specific SaaS sales tax questions and clarify how we can help companies move forward.

Q: How Has The SaaS Industry Grown This Year?

Before we dive into our SaaS and sales tax client questions, we want to share some SaaS industry updates to set the precedent for how large this industry has become. Since 2015, the SaaS industry has grown from $31.5 billion to an estimated $171.9 billion. That equates to 500% growth in only seven years. Overall, the annual growth rate is projected to surpass 17% in 2022. As you can see, this is a fast-growing field of technology, and it is important to stay ahead of your sales tax obligations.

Q: Do All States Tax The SaaS Revenue Stream? 

Currently, not all states tax the SaaS revenue stream, though many do. It gets a little complicated because SaaS is considered a service in some states and not in others. To make matters more difficult, some states tax these types of services, while some do not. For example, in Arizona, SaaS is considered a taxable service. In Washington, however, SaaS is considered to be a tangible software and is subject to sales tax because of that. In Texas, SaaS is regarded as a taxable data processing service and subject to 80% taxability (vs. 100%). Similar to all other aspects of sales tax, each state, and sometimes each city, has different tax legislation for different products and services. For instance, while the states of Colorado and Illinois do not tax the SaaS revenue stream at the state level, the cities of Denver and Chicago do! (Trust us, there’s some nuance there, so if you have nexus in those cities, give us a call!) Discover more about SaaS taxability by state in our previous articles here and here.

Q: What About A SaaS Company Engaged In An M&A Transaction (Or Thinking About It)?

We often see SaaS companies in the middle-market (MM) space become targets for acquisition. These companies are often not as well-represented by tax advisors (specifically in sales tax) as the purchasing company. Oftentimes, the company hasn’t considered all the ramifications of sales tax on SaaS until the purchaser brings it up in the due diligence process. Unfortunately, that can often be too late, as the seller is then left with significant exposure that can affect the purchase price, holdback, etc. and make a real financial impact on the seller shareholders. Ideally, a company planning an exit strategy via acquisition should engage in internal due diligence around this matter before getting deep into the deal. Here at Miles Consulting, we can help MM companies to either shore up their state tax exposure before a deal or during the due diligence process as an advocate for the seller. Coming in earlier is ideal, as it takes some of the urgency away and allows companies a bit of time to prepare analysis, take steps toward remediation (which may also include reaching out to customers regarding self-assessment) and overall employ an offense instead of defense. We often assist with determining how much companies potentially owe in retroactive sales tax (exposure analysis), how to come forward and fix it (remediation) and a plan to move forward.

Q: What Do We Do as  SaaS Company That Needs To Register In Various States And What Are The Ramifications Of Prior Year Exposure?

We are frequently introduced to clients wishing to become sales tax compliant. Ideally, they’d like to register and simply move forward with collection, remittance and compliance. Unfortunately, they often haven’t considered prior liabilities created by having nexus in a state (either physical presence or economic nexus). During the registration process, states will ask when nexus was created. If that date was in the past (and it frequently is), the state will expect the delinquent returns to be filed and overdue tax be paid.

We assist  with that process by determining clients’ nexus creation dates, estimated  amount of exposure, an overall game plan for remediation and then actually doing the “heavy lifting” of assisting with voluntary disclosure agreements (VDAs) or backfiling. There are some nuances of when you would want to do a VDA versus backfiling; this is something that we can help with as well! Once we help a client become sales tax compliant, we can also assist them with a plan to move forward with a strong sales tax compliance strategy.

Q: How Can I Implement Software To Assist With Sales Tax Compliance? 

Once a SaaS client becomes sales tax compliant for retroactive liabilities, they’ll need to consider how they would like to move forward in the actual collection of tax from customers, remittance of tax to the states and filing returns. They have many different options. One option is to do this internally, which can be cumbersome in a smaller organization as it takes a lot of time and effort. Clients can also choose to acquire a software solution, such as Avalara or TaxJar (Miles Consulting Group partners with these companies), to assist with collecting the correct amount. To determine how to remit tax, file returns and stay in sales tax compliance, businesses also have many options, depending on cost, convenience, technical experience, complexity, etc. They can choose a complete software solution, a complete human solution or a combination of the two. This last option is where we often come in to help — we work with software but also apply a human approach by including a level of review that cannot be achieved with software alone.

Do You Need Help With SaaS And Your State Sales Tax Compliance?

Have a question? Contact Monika Miles And Miles Tax Team.

Monika founded Miles Consulting Group which focuses on multi-state tax consulting, helping clients navigate state tax issues such as sales tax and income tax in interstate commerce, including e-commerce.

Prior to forming the firm, Monika worked for 12 years combined in Big 4 Public Accounting and private industry. Monika has provided such services as federal and state income/franchise tax compliance and consulting, sales/use tax consulting, audit support, and credits and incentives reviews. She has served clients in a variety of industries including manufacturing, technology, telecommunications, construction, utility, retail and financial institutions.

Monika graduated from the University of Texas at El Paso (UTEP) with a BBA in Accounting/Finance and has a Masters in Taxation from San Jose State University.

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