Demystifying U.S. sales tax rules for SaaS businesses
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Software as a service, or SaaS, is a booming industry, with some SaaS companies generating millions or even billions of dollars per year. With this much rolling in, it becomes imperative to pay your taxes to avoid hefty penalties down the line. Tax laws are complex no matter what business you’re in, but they can become even more complex when it comes to digital products, especially SaaS products like data processing services.
These services teeter in a legal gray area because they’re not physical products, and many states only charge sales tax on physical goods. On the other hand, prewritten software is a product, and many local tax regulations require sales tax to be paid on products aside from medicine and food.
If you’re a SaaS business owner, it’s important that you understand the tax rules for this unique type of business. Below, you’ll find a comprehensive guide to tax rules for United States SaaS businesses.
What is SaaS sales tax?
Sales tax is a type of consumption tax. Essentially, most products designed for personal use, business use, or even communal use come with a sales tax that businesses charge customers when they check out. Those businesses are required to pay these sales tax dollars to their State’s Department of Revenue.
On the other hand, SaaS sales taxes are a bit different because these services are intangible. You can’t go to the store and pick up any SaaS product since they’re digital goods. Instead, companies sell these prewritten programs as services.
That’s where the gray area comes in.
Many states don’t require service providers to collect and pay sales tax, but SaaS providers break the barrier between products and services. Some states have caught on to this tax loophole and begun requiring SaaS services to collect and pay sales taxes, or use taxes, as if they were selling products rather than services.
Who does sales tax on SaaS apply to, and where does it apply?
State sales tax laws vary wildly from one state to the next. It’s important to understand the different SaaS sales tax requirements for the state your business is located in as well as the states it does business in. Check out key state tax laws below.
Arkansas: Not taxable
California: Not taxable
Colorado: Not taxable
Connecticut: Taxable (sales taxes vary depending on personal or business use)
Delaware: Not taxable (no sales tax state)
Florida: Not taxable
Georgia: Not taxable
Idaho: Not taxable
Illinois: Not taxable
Indiana: Not taxable
Iowa: Taxable (sales taxes vary depending on personal or business use)
Kansa: Not taxable
Kentucky: Not taxable
Maine: Not taxable
Maryland: Taxable (sales taxes vary depending on personal or business use)
Michigan: Not taxable
Minnesota: Not taxable
Mississippi: Not taxable
Missouri: Not taxable
Montana: Not taxable (no sales tax state)
Nebraska: Not taxable
Nevada: Not taxable
New Hampshire: Not taxable (no sales tax state)
New Jersey: Not taxable
New Mexico: Taxable
New York: Taxable
North Carolina: Not taxable
North Dakota: Not taxable
Ohio: Not taxable (no sales tax state)
Oklahoma: Not taxable
Oregon: Not taxable (no sales tax state)
Rhode Island: Taxable
South Carolina: Taxable
South Dakota: Taxable
Vermont: Not taxable
Virginia: Not taxable
West Virginia: Taxable
Wisconsin: Not taxable
Wyoming: Not taxable
International sales tax on SaaS
SaaS businesses in the United States that only sell their services domestically are somewhat in luck. That’s because the unique U.S. tax code makes it possible for many states not to charge taxes on prewritten computer software.
But if you sell your services around the world, it’s important that you take an international approach to tax management.
That’s because most countries around the world see SaaS as a taxable service. Even if your business is in Oregon, a state that doesn’t impose sales tax at all, if you do business with consumers in Europe, the U.K., Japan, China, Canada, and most other countries around the world, you’ll be required to pay taxes on your revenue.
International sales taxes are often significantly higher than domestic sales taxes. Some countries charge 20% or more for sales tax on SaaS services.
It’s important that you pay attention to U.S. tax codes as well as your tax liabilities around the world and do everything you can to stay compliant.
5 important SaaS sales tax rules you need to know
The more you know about SaaS sales taxes, the better equipped you are to keep your business in compliance with the rules and avoid troublesome penalties. There are several rules in the tax code, and your accountant should be able to help you navigate those rules. The most important rules you need to know are explained below.
1. Rules around the economic nexus threshold
The term “nexus” is a legal term that’s used to describe events that give states legal jurisdiction over you and your business. For example, a physical nexus is a physical activity in a state, like opening a storefront, that gives the state the ability to tax your company’s earnings.
Economic nexus thresholds place an economic limit to the economic activities companies can take part in within a state before facing tax obligations to that state.
Before 2018, the economic nexus threshold only applied to corporate income taxes. However, in 2018, Wayfair challenged regulators and won a Supreme Court decision that applied the economic nexus threshold to state sales taxes across the United States.
Today, you must complete one of the following events for an outside state to have jurisdiction over your business in terms of sales tax:
- Dollar-value economic nexus threshold. Your business must earn at least $100,000 in revenue in the state to fall under state sales tax jurisdiction.
- Transaction economic nexus threshold. Your business must complete a minimum of 200 transactions in the state to fall under state sales tax jurisdiction.
Keep in mind that these economic nexus thresholds are either or. If you earn more than $100,000 in revenue in a state in any given year with under 200 transactions, you’re still required to follow that state’s tax regulation. Moreover, if you perform more than 200 transactions in any given year with a total value of less than $100,000, you’ll need to pay your taxes to that state anyway.
2. Penalties for noncompliance
The government is the world’s largest and most powerful collections agency. At some point, you will end up paying your taxes or facing stiff penalties. When it comes to sales tax compliance, those penalties happen quickly.
Sales tax payments are typically due quarterly, and you’ll pay dearly if those payments are late.
Although penalties vary from state to state, most states start with a 10% penalty that’s imposed once the tax payment is 30 days late. At 60 days late, most states impose a 20% penalty. That penalty continues to grow at a rate of 10% per month to a maximum penalty of 50%.
So, if you don’t pay your sales taxes on time, you could end up paying 150% of your total tax bill.
3. Registration is typically required
If your business is in a state that charges sales tax for SaaS transactions, or you reach an economic nexus in another state that allows them to impose sales taxes, you’re typically required to register your company with the state’s Department of Revenue.
Registration is usually easy and inexpensive, but it’s an absolute must in order to do business in these states.
Each state has its own rules and regulations, but in most states, if you do business that creates sales tax events and don’t register with the Department of Revenue, you’re committing a crime. For example, in Florida, failure to register with the Department of Revenue is a first degree misdemeanor punishable by up to one year in jail and fines up to $1,000. Moreover, you’ll still be required to pay taxes plus a penalty of 6% per annum on all back taxes due.
4. Tax compliant receipts and documentation
If your company ever gets audited, it’s important to have the documentation you need to hand to the tax authorities handy. One key set of documents is tax compliant receipts. Every time you make a sale, it’s important to produce a receipt for that sale that shows the following:
- Sale amount
- Taxes collected
- State or country of the buyer’s residence
You also need to keep track of the amount of money you’re paying in sales tax every time you make a payment, whether or not your business created any nexus events, and if so, records of tax payments in those jurisdictions.
Keep in mind that tax audits typically go back three years. So, you’ll want to keep all documents on file for at least that period of time.
The bottom line here is that good record keeping is crucial in any business. SaaS businesses are no different.
5. International taxes
You don’t have to worry about international taxes if your SaaS business only operates in the United States. On the other hand, if you do business with customers in any other country, it’s important to pay close attention to international tax implications.
Keep in mind that in most other countries, SaaS services are just as taxable as any other product or service. Some of the most popular countries include:
- Europe. Taxes on SaaS services in Europe vary from one European country to the next, but they all charge a sales or use tax. Tax rates may be as high as 20% or more.
- Japan. You’ll pay a sales tax rate of around 10% on SaaS sales in Japan.
- United Kingdom. The United Kingdom charges a 20% sales tax on all e-commerce sales, including SaaS services.
- Canada. Sales tax rates on digital goods in Canada vary by province. Nonetheless, you’ll typically need to pay between 5% and 13% of sales.
- China. China’s sales taxes on SaaS services vary by region but usually range between 10% and 15%.
Keep in mind that these taxes are levied on top of any tariffs the company charges for doing business with United States providers. So, it’s important to consider all financial liabilities a country poses to your company before you decide to do business in that country.
Which SaaS services are and are not taxable
From an international standpoint, most countries don’t have rules for which SaaS services are and are not taxable. Essentially, if you offer software as a service, you’ll need to pay your taxes on sales.
The same goes for most U.S. states.
Most states that charge SaaS service sales taxes require those taxes to be paid regardless of the service. However, there are some states that charge different tax rates for personal use SaaS and for business use SaaS.
Nonetheless, if you offer SaaS out of a state that charges sales tax, chances are you’ll have to pay the tax. The same goes if you’re offering SaaS services at a large scale to consumers in states that charge sales tax on these services, even if your home state doesn’t.
Tips for managing and simplifying SaaS sales tax
At first glance, managing SaaS sales taxes may seem like a headache in the making, and if you do it all manually, it is. On the other hand, there are a few things you can do to take the headache out of SaaS sales tax accounting. Here are some tips to get you going:
- Take advantage of quality accounting software. Thanks to technological innovation, there’s a software solution for just about anything these days. Accounting is no different. A quality piece of accounting software can help you manage taxes on a state-by-state and country-by-country basis so you’re not left doing all the calculations by hand.
- Keep your paperwork in order. The biggest problem most businesses face in an audit situation is simply not being ready for that audit. Good record keeping processes can solve that problem. Always keep records of sales, tax payments, expenses, and all other information the tax authorities will be looking for if you get audited.
- Stay on top of tax regulations. The United States tax code changes every year, as is the case in most states and other countries around the world. Stay abreast of the changes in the tax code to ensure you incorporate any changes as they happen.
- Hire a professional. If your business has grown to the point where it seems impossible to handle your accounting duties on your own, you’ve got a good problem on your hands. It’s time to bring a professional in so you can focus on more important things, like growing your business even more.