SaaS providers need the right software to meet unique tax compliance needs

You’ve launched a new software start-up: Congratulations!

You’ve got a lot on your plate right now: Lining up your Series B funding, finding the right leadership team to execute your vision, talking with potential customers, recruiting the software engineers who will build your platforms, buying the software platforms that your own business will run on — and figuring out whether you should all be in one office, remote, or a hybrid.

Unfortunately, there’s one more thing to put on your plate — something too many software start-ups ignore until it’s too late — and that’s sales tax compliance.

Software companies face a unique set of sales tax compliance challenges that start-ups and smaller firms just aren’t prepared to handle, and that can lead to problems when state and local government auditors pay you a visit to look at your books.

There are three main problem areas for companies that provide software as a service, or SaaS. Let’s take a look.

In the old days, when an entrepreneur opened a brick-and-mortar business, sales tax compliance was relatively uncomplicated. You collected taxes on sales of taxable items — which typically were tangible physical goods — and you remitted those taxes to your local and state governments.

Pretty straightforward.

But when you’re offering software as a service, figuring out where you have sales tax obligations is anything but easy.

There are 45 states that collect statewide sales taxes, plus the District of Columbia and Puerto Rico. Since the U.S. Supreme Court’s 2018 decision in South Dakota v. Wayfair, Inc., all of them have enacted laws that say that companies like yours create “nexus” when you make sales to people or businesses within their state. That means those states can require you to register as a business within their state and start collecting and remitting sales taxes on transactions within their boundaries.

Each of the 45 sales-tax-collecting states has its own criteria for when businesses need to register and start collecting taxes, and each state has its own procedures and deadlines for companies to do this. You can get an idea about these criteria by checking out our state-by-state guide to economic nexus.

Then, there are tax rates to calculate. Each of the 45 states has its own sales tax rate, and most allow local jurisdictions to add their own taxes on top of the state rate. There are more than 13,000 such sales and use tax jurisdictions across the United States, some of them overlapping.

All this — and we haven’t even talked about what happens if you get customers outside the United States, which isn’t a far-fetched notion given that SaaS companies provide a product that can be easily accessed by anyone with an internet connection.

It’s not unreasonable to think that, if you’re a SaaS start-up, you’re going to have economic nexus — and thus sales tax obligations — in multiple states faster than you’re able to fully staff a tax compliance team to monitor the tax laws in all the states where your customers reside.

That’s going to be a real problem when you have your first audit, said David Lingerfelt, an attorney who is director of indirect tax and technology for Avalara. “A lot of start-ups don’t even have a tax department who can monitor to see whether they’re exceeding thresholds or whether they need to go register and start collecting taxes somewhere.”

Different states have different rules on how software is taxed, often depending on how the software is delivered to a customer.

For SaaS providers that means determining whether you’re leasing a service, providing a subscription, or selling tangible property — or something else altogether, like providing a communications service that might not be subject to sales tax but is subject to any number of federal, state, and local communications taxes.

Once you start bundling products and services together, that becomes even more complex. It’s very common for a software company to offer customers a suite of services: Perhaps your start-up offers your primary product through a cloud-based platform, but you also offer a back-up system that customers can load onto their local servers so they can keep processing transactions during a network failure.

Depending on your state, those two products might be taxed differently — even though the two products run the same core software. In some states, it might make a difference in how you record the sale on the invoice. Did you make one sale of a bundle of products, or did you sell separate products listed as separate line items?  

“Software is taxed differently in every jurisdiction, even though it’s the same software,” Lingerfelt said.

You can learn more about this by reading our state-by-state guide to taxing digital products.

The last big tax compliance issue SaaS providers face is sourcing — that is, determining which jurisdiction’s tax to apply to a transaction.

When you’re selling a digital product, you’ve got a lot of questions to sort through:

• Do I charge taxes based on the buyer’s billing address, or the address where the product is used?
• What if the product is used at multiple locations (which, given the growth in work-from-home and hybrid work arrangements, is more common than ever)? Which tax rate do I charge when my customer is an enterprise with offices in six states?
• And what if I’m selling to a company in the European Union, which requires sellers of digital goods to assess taxes based on the IP address?

For SaaS start-ups, the answer to these sourcing questions is to start with an ERP that can collect and store the kind of detailed information your tax team will need to answer these questions. Unfortunately, without a tax team in place to advocate for that functionality, SaaS start-ups all too often fail to consider the need for it, until it’s too late, Lingerfelt said.

“They’re not giving any thought that ‘I need something that collects information to source these sales,’” he said.

Avalara partners with leading ERP providers that can help SaaS companies automate their sales tax compliance function, using an integrated solution that works seamlessly with the other parts of your business’s platform.

To learn more, read our whitepaper on managing sales of software as a service.

Cover photo by Canva