SaaS state sales tax laws are complex and vary state to state. To protect your business from unexpected liability, you’ll need to understand how these laws impact your economic nexus. Here’s our guide to understanding it all.
Identifying SaaS nexus is a lot like identifying nexus for other products and services. You look at sales tax laws in the states where you have sales. Then you determine if your business meets taxability or threshold requirements there.
Of course, in a post-Wayfair tax system, this is easier said than done. There are as many sales tax laws as there are states. And each state has its own approach to determining economic nexus and legal grounds for taxing SaaS companies.
Because of the unique nature of SaaS – part product, part service – there are a number of differences compared to other taxable businesses.This makes it one of the more confusing industries for determining nexus.
If you sell software-as-a-service, it’s worth considering how each contract you sign will expand your economic nexus and taxability.
The Unique Nature of SaaS
SaaS products are both a recurring service and a tangible technology. Because of this, there are a number of unique ways economic nexus impacts them.
It’s Rapidly Expandable
SaaS companies aren’t small businesses serving customers in a handful of states. They do business nationally and internationally. You probably do business in states across the country. This means you have to worry about tax laws in dozens of different states. And lately, economic nexus laws change like the wind.
You’ll need to stay on top of these complex regulations to stay compliant. This can be a ton of work, though, so many providers choose to work with sales tax specialists.
SaaS Sales Reach Nexus Thresholds Quickly
Each state has its own economic nexus threshold. This means that as soon as a business sells past that threshold in a state, it owes sales tax there. A typical threshold is around $250-500k. Businesses in industries such as drop-shipping have to sell thousands of products in a state to reach this.
The thing is, six figure SaaS deals are common. A SaaS company could pass the nexus threshold in a state with one or two sales. This means your business could rapidly develop nexus in multiple states. If you don’t stay on top of how these deals affect your nexus, you could face a mountain of sales tax liability.
It Often Involves Other Services
It’s pretty common for SaaS companies to offer services other than SaaS. After they close a deal, there are often other services involved, like consulting, training, cloud migrations, additional fees and instillations. All of these services are taxable, but in different ways than software. This can lead to you reaching the nexus threshold faster than anticipated.
Sales Tax on Services is Complicated
State tax laws assume products are taxable. Services, in contrast, are more complex.
Typically, states can only tax services if they specifically enumerate that category of service in their laws.
This means that the state has to decide to tax a particular service. But then those services that are deemed taxable could be exempt or non-taxable for other purposes in a given state.
For SaaS companies, this means your sales are only taxable in states that have provisions in place for taxing software services.
These laws are, of course, exceedingly complicated.
The Legal Basis is Unorthodox
To understand how states tax SaaS, you have to understand how we got here.
For decades,companies sold software as a physical product. First on large floppy discs, then on smaller floppy disks, then CDs and DVDs. Because of this, states were able to tax them like other physical products. Even when software switched to electronic downloads, the legal mechanism was the same.
When the states wrote a lot of their tax laws on software, they still based it on these traditional methods. Then came software-as-a-service, where software is hosted on a server and you access the software through a remote login.
Now states are just trying to catch up and fit SaaS into their traditional taxing matrix. Their challenge has been transitioning from taxing software as a product to as a service. Naturally, the way each state did this was unique.
Examples of SaaS State Sales Tax Laws
Some states have passed laws to makes SaaS taxable. In contrast, other states have tried to find creative ways to reinterpret existing laws to make software as a service taxable. Here are three different examples from three different states.
Texas has a law called data process sales tax that dates back to the ‘80s. This regulation dictated that anything with data input, data processing or data manipulation was taxable in Texas. Recently, the Texas Controller brought software-as-a-service under this umbrella.
What’s important for SaaS providers to note is that there are discounts available. Texas taxes 80% of the price of a SaaS sale, while giving you a 20% discount. This makes the taxability picture cloudier while helping businesses. It’s important for SaaS providers to take advantage of this so they don’t overpay.
In contrast, Arizona took a different (and somewhat strange) approach to taxing SaaS. Arizona decided that software-as-a-service isn’t a service. They said the software provider is renting out access to the computer that runs the software. Therefore, SaaS providers are taxed under asset rental laws. It’s important for businesses with nexus in Arizona and similar states to be mindful of this odd classification because it impacts taxability and registration.
If you’re a SaaS company, it’s also possible your sales tax could increase. Connecticut has traditionally taxed all digital goods and services at a reduced one percent rate. But they just passed a new law that will revert this category to the general sales tax rate. In short, if you do business in Connecticut or similar states, you should prepare for your sales tax to increase substantially.
Conclusion: What’s Next?
Overall, SaaS sales tax laws are a bit of a patchwork, which makes them difficult to navigate. As you acquire customers in new states, pay close attention to your growing nexus exposure and changing tax rates, and try to understand what your footprint might be. If you’re having trouble navigating the confusing web of tax codes, it’s worth consulting your CPA or state sales tax specialists.