Sales Tax for SaaS Companies
Sales Tax for SaaS Companies
Everything you need to know about sales tax with Anrok CEO Michelle Valentine
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Who Hates Sales Tax?
The last thing founders and executives want to think about is sales tax (I hate it too).
But…it also happens to be a very important topic that companies need to get a handle on before it becomes a major problem. Even though your customer pays the tax, it’s on you to collect properly. If you don’t then it can create A LOT of problems for companies:
Sales tax liabilities that you must pay out of pocket
Fines and penalties
Dealing with states and cities on cleanup
Delay M&A and/or become a significant adjustment to purchase price
Create issues going public and require disclosures
There are a few common pitfalls:
Not collecting at all: Many early stage startups aren’t even aware it’s something to consider initially, only to find themeselves still not collecting years later.
Not proactively monitoring: Company’s often assume they’ll be informed when they need to collect tax and don’t track nexus properly, resulting in tax liabilities accruing long before they begin collecting
Not charging correctly: Company’s often aren’t sure of the right rate to use for the services they offer – or of specific rules in different cities and municipalities – leading to a discrepancy in what they collect and what they are actually required to pay.
If you realize you aren’t collecting or aren’t calculating properly you have two choices. Neither of which you’re going to like:
Back bill the customer and ask them to pay the sales tax. Warning: this will make a lot of customers mad. Ask me how I know :)
Eat the cost and pay the sales tax yourself. Can be a very expensive hit if you haven’t been collecting sales tax properly for a long time.
While I know enough about sales tax to be dangerous, I wanted an expert’s advice so I asked Michelle Valentine to help explain sales tax for SaaS companies. Michelle is the CEO at Anrok and was previously an investment banker at Goldman Sachs. She also worked as a venture capitalist at Index Ventures, investing in early-stage startups – so you know she’s seen these challenges from many perspectives
Keep reading to learn more about how sales tax impacts tech companies…
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Founders and finance folks of cloud companies can learn more about various topics from experts, get questions answered, etc. Sales tax could be one of the topics.
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Understanding Sales Tax for Cloud Companies
In the fast-paced world of startups and tech, sales tax has suddenly become a hot topic. Why? It all comes down to a groundbreaking Supreme Court decision in 2018: South Dakota v. Wayfair. This ruling fundamentally changed the game for SaaS and tech companies, introducing new complexities and potential pitfalls in the realm of sales tax compliance.
Before Wayfair, the rules were relatively simple: if you had a physical presence in a state, you needed to collect sales tax there. Post-Wayfair, the concept of "economic nexus" was introduced, meaning companies could have sales tax obligations in states where they had no physical presence at all. This shift has put sales tax squarely on the radar of CFOs and finance teams across the software and digital economy.
Why does this matter? Because getting sales tax wrong can lead to significant financial costs and legal risks. If you're not collecting sales tax from your customer on a taxable sale, the business is accruing liabilities and will at some point pay out of pocket - this could be during one of the many state audits, in an acquisition escrow situation, or as part of the disclosures when going public.
Tax is no longer a back-burner issue – it's a critical component of your financial obligations and risk management.
The Basics: Sales Tax Mechanics
Let's start with the fundamentals. At the heart of sales tax compliance is the concept of "nexus" – the level of connection between a business and a taxing jurisdiction that triggers a sales tax collection obligation. Post-Wayfair, there are two primary ways in which a company can establish nexus:
Physical presence. Typically, this will be an employee, whether working from your office or working remotely for a defined period of time. It can also include significant property sitting in a state, for example, a large amount of server equipment at a data center in state or inventory in an in-state warehouse.
Economic nexus. This means that you have hit a certain level of sales and/or transactions to customers in the state, triggering a filing obligation. Each state has defined this level differently, with an example being once you have made $100,000 of sales into the state or have 200 transactions in the state, in New York it’s $200,000 of sales, in Connecticut it’s $100,000 and 100 transactions, in Minnesota it’s $100,000 or 200 transactions. Even more things can come into play, like what sales are included in the assessment and the timeframe of sales. All in all, it’s confusing.
Economic nexus requirements vary significantly by state based on: revenue threshold measured by dollar amount, transaction threshold measured by number of invoices, whether all sales or just taxable sales are used in the assessment, amongst other methods.
Given the rise of remote work, even small startups generating little revenue can have sales tax obligations from day one because of a single remote employee in a state.
Taxable or not Taxable?
The first step in beginning the sales tax journey is to get a good understanding of your product catalog. What are you selling? And is it taxable in the places in which your customers are purchasing the product?
The taxability of software and related services varies significantly from state to state. Some states continue to only tax tangible personal property, while others have expanded their definitions to include digital goods and certain services. Moreover, some states are starting to tax certain enumerated services like: software as a service, data processing services, or information services, each of which can be defined differently by state.
Today, there are over 20 states in the United States that tax software. Many countries also tax software and digital goods from the very first sale. As states continue to play catch up to the modern world in their taxing statutes, what is non-taxable today may be taxable tomorrow, so keeping abreast of the tax rules and monitoring for changes is essential.
Determine Location to Charge Sales Tax
The typical transaction in the U.S. follows the destination-based sourcing method, where the sales tax amount is calculated based on where the customer "receives" the item sold. This means that, in many cases, sales tax should technically be charged based on where the customer receives/benefits from the product/services. In a seat-based cloud tool that would mean where the individual users are located that use the software.
Enterprise software contracts
In practice, the vast majority of companies are not separating an enterprise contract to all the locations of where all the users are located. In a remote environment those users could be all over the world and continually changing.
What typically occurs is that the contract states that sales tax will be based on the shipping address on the contract (see below). And since the company doesn’t have any better information (they don’t have individual user locations) then doing it this way is generally OK.
The shipping address listed above will be used to determine the appropriate taxing jurisdiction of the products and services purchased. Fees due under this contract are net of any applicable taxes that are required by law.
Self-serve model
Unless you are a software business doing pure enterprise and invoiced sales, you are unlikely to have accurate addresses for all customers.
Many software companies, especially those with self-serve models, often lack complete customer address information. Your customers could virtually be anywhere. This can make it difficult to accurately determine tax jurisdictions and rates.
While it is best to have the full customer address along with the 9-digit zip code, some states recognize that this is not always feasible. Thankfully, there is a hierarchy developed by the Streamlined Sales Tax (SST) member states, that most states will adhere to.
If the credit card 5-digit zip code is all you have, you need a tax engine with a sophisticated enough address validation system to account for such situations. This is crucial to ensure that tax is calculated instead of dropped or rejected. If you have any self-serve revenue or sometimes lack the full customer address, make sure your tax engine can work with the address data you have and account for all your transactions.
What is your global strategy?
While the focus of this post is on U.S. sales tax, startups are finding themselves selling internationally from an early stage. With global growth, you’ll need to familiarize yourself with value-added tax (VAT), or its close counterpart Goods and Services Tax (GST).
More than 170 countries around the world have a value-added tax (VAT) regime with more than 80 applying VAT to digital goods and services transactions, including those categorized as SaaS. Like sales tax in the US, it is an "indirect" or "consumption" tax, meaning that the tax is not paid by the business making the sale, but by the consumer making the purchase.
To determine whether VAT applies on a sale of your product or service, there are three main factors to understand:
Your customer's location
The taxability of your product in that country
Your customer's VAT registration status.
The urgency of whether you need to address collecting VAT as a remote seller can be influenced by what portion of your products are considered B2B vs B2C. You can read more about B2B VAT ID validation and global tax compliance in this guide.
The Results: Future-Proofing Revenue
In 2024 - a post-Wayfair world - sales tax management is no longer just a compliance issue – it's a critical component of financial strategy. By understanding the basic mechanics of sales tax, why it is important, and anticipating key considerations, you can turn sales tax management from a potential liability into an operational advantage.
Remember, the goal isn't just to comply – it's to create a scalable, efficient system that supports your company's growth while minimizing risk. By taking a proactive approach to sales tax management, you're not just protecting your company – you're positioning it for long-term success.
Footnotes:
Check out Brex (today’s sponsor). They help a lot of companies with some of these finance problems.
Need a fractional CFO and/or bookkeeper that specializes in software and tech? Reply to this email (or email me at onlycfo@onlycfo.io) and I will help you.
Check out OnlyExperts for to find offshore accounting resources. They have some amazing talent.
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