Is Software as a Service Taxable?
The sales tax implications of Software as a Service (“SaaS”) have plagued the tech industry since the rise of remotely accessed software. To those in the industry, how software is transferred may not be the most defining or important characteristic of a program. However, it is probably going to be the very first question a sales tax lawyer will ask about your particular software. Generally, current sales tax law contemplates two modern forms of software: (1) downloadable and (2) remotely accessed. Downloadable software has its own sales tax issues, but remotely accessed software is generally considered Software as a Service, or SaaS.
The short answer to whether SaaS is taxable is, like many legal questions, it depends. The truth is, many states are struggling to fit SaaS into their current tax schemes. Sales tax laws were developed and enacted long before remotely accessed software came about. With many exceptions, state sales tax laws generally impose tax on the sale or lease of tangible personal property. Meanwhile, only certain services are taxable. In the 90s, software was purchased on a CD-ROM that was unquestionably tangible personal property. Now, however, as many computer programs are accessed remotely, there has been a loss of the tangible personal property element of these transactions. As a result, states needed to find creative ways to interpret their sales tax laws before losing revenue from software sales.
If remotely accessed software has eliminated the tangible personal property from a transaction, then in what category do these sales fall? Many states have decided that remotely accessed software fell out of the “tangible personal property” bucket right into the “services” bucket instead. Meanwhile, other states have let these software sales fall in the cracks between the two and, as a result, are currently not imposing their sales tax on remotely accessed software. Each year, new states jump on the SaaS bandwagon or tinker with their sales tax laws to try to recapture the lost software market.
A software seller concerned with whether their sales of software as a service are taxable should consider the following:
1. What type of software do you sell?
It may seem like an easy question. However, many software sellers offer customers multiple options when they make a software purchase. Often, both remotely accessed software and downloadable software are available separately or even together. For example, DropBox, a website that offers cloud storage, can be both remotely accessed online and downloaded onto a computer. While the service they provide is anything but “tangible” as the storage is in the cloud, some states will view the icon downloaded onto a desktop as tangible personal property. Therefore, it is important not just to consider the nature of the software, but also the delivery of it. Besides the software itself, what exactly does the customer receive? A downloadable app for their phone or an icon for their computer? What about a card in the mail with an access code on it?
States have different opinions regarding what qualifies as “tangible personal property.” Those states which have tried to modernize their sales tax laws have occasionally expanded the definition to mean something that is not tangible at all, such as an app on a phone or a program downloaded onto a computer. Meanwhile, other states have adopted SaaS legislation to directly tax remotely accessed software as a service. Other kinds of software sales may alternatively fall outside the taxing statute altogether in some states.
Understanding exactly what you sell is not just knowing a product, it is knowing clearly where your product falls within each state’s definitions of taxable software. You must know whether you are selling tangible personal property or a taxable service known as SaaS. You must know the tax implications of the delivery method of your product. You must be able to find where new technology fits into old tax laws. Don’t forget, each state has different state and local tax laws and if you are selling across the country you should be familiar with them all or risk an assessment during audit.
2. Where do you make taxable sales? (Situs)
Understanding whether your product is taxable tangible personal property or software as a service is only the first step in identifying a potential tax liability. Next, you must know where the sale occurs. With remotely accessed software, this can be difficult to determine. For example, remotely accessed software may be purchased by a person located in Georgia using a credit card with a Florida billing address. The software itself, however, will be remotely accessed exclusively by two employees in New York and Connecticut. Where does the transaction take place for sales tax purposes?
Identifying the location of a software transaction may be impossible for the simple fact that software sellers do not necessarily know where their software is ultimately going to be used. Even if they are aware, there may be the conflict that two or more parties use the software in different locations. Which state is then entitled to the sales tax from the transaction?
The location of a transaction, known as “situs” is not easy to determine and states take varying positions on where situs is. Worse yet, many states have altogether failed to address situs, and the only way to find out for sure of a state’s position may be during an audit unless certain precautions are taken beforehand. Potentially, two states can assess for the very same transaction, both believing they are entitled to the tax for different reasons. Imagine a scenario where you are assessed for double the tax possibly due on all your sales! While software companies make sales across the country, states lag years behind in adopting legislation, rules, and guidances to assist businesses in proper tax compliance. If a state decides in the future that they want to take a certain position on situs, they may potentially impose that position on you for years back in an audit. Don’t expect a state to care that you paid sales tax to another state. There’s a good chance you aren’t going to get credit for taxes paid to another state when it comes to a situs issue. They will likely just tell you to take that up with the other state and apply there for a refund for the taxes supposedly overpaid there (if that’s even possible).
3. Which states do you need to collect sales tax in?
You’ve identified every aspect, including delivery, of the software you’re selling and determined whether it was tangible personal property or Software as Service in each state in which you do business. You’ve identified the situs of each of your transactions. Unfortunately, that’s not the end of the road. Next you need to determine where you have nexus. Nexus is defined as a sufficient connection with a state that allows the state to impose its sales tax jurisdiction upon a business. There are many ways a business can have nexus with state, but the two main ones are physical presence and economic thresholds.
Physical presence nexus attaches when a business, its employees, or its inventory are physically located within a state. For remote software sellers, this may be as few as one or two states. Meanwhile, economic nexus varies from state to state. Almost all states with a sales tax have an economic nexus provision (although there are still a few that haven’t enacted one yet). These provisions vary state to state, but the most common one is $100,000 in sales or 200 transactions within a calendar year. If your sales pass either of those thresholds within a calendar year, you are required to register to collect and remit going forward.
Unlike physical presence, which is relatively straight forward, economic nexus laws are new as a result of the 2018 SCOTUS case South Dakota vs. Wayfair. As such, the kinks have not yet been worked out and many states remain unclear on how to deal with certain issues, such as exempt sales, international sellers, or a clear definition of a “transaction.”
In determining which states your software business must be registered with, you should first determine where you, your business, your employees, and your inventory are physically located. Next, you must identify the states in which you surpass their economic nexus threshold. A state-by-state chart showing nexus standards can be found HERE, but states will take different positions regarding whether exempt software sales count towards those thresholds. Therefore, a nexus analysis must be cross-referenced with a taxability analysis on your product.
Often, even after all this research, you may end up still unsure of whether or when you should register your business to collect sales tax in a state. This often occurs because states may offer only little or even no guidance in a particular area. In those cases, taxpayers may request a technical guidance letter from the state that will address the application of the state’s sales and use tax laws to the taxpayer’s sales.
Software sellers function in one of the most complex areas of sales tax law. Unfortunately, this not only makes ongoing compliance a nightmare, but it makes these businesses easy targets for audits. States looking to increase revenue can simply take an aggressive stance on a taxpayer making a large volume of software sales into their state. While previously, states were restricted in their audit power to go after only businesses with a physical presence in their state, now they can go after virtually any business making substantial sales within their border. Taxpayers who fail to give the proper tax treatment to their SaaS sales may find themselves with a devastating audit. Small errors made at the beginning of compliance can become severe problems when added up over a three or five-year look-back period in a sales tax assessment.
Additional Resources
The Sharing Economy and Sales Tax Nexus: A Peer-to-Peer Business Problem, By Jeanette Moffa, April 30, 2019
Are Software Subscriptions Taxable?, By Jeanette Moffa, May 1, 2019
Sales Tax Changes for Fulfillment by Amazon Sellers, By Jeanette Moffa, May 6, 2019
Jeanette Moffa is an attorney who concentrates on state and local taxes at Moffa, Sutton, & Donnini, P.A. She is an executive council member of the American Bar Association Tax Section State and Local Tax Committee and the Florida Bar Tax Section. Ms. Moffa is an author of both the CCH’s Expert Treatise Library: Sales and Use Tax as well the ABA’s Sales and Use Tax Deskbook. In addition, her regular columns on state and local tax issues can be found in State Tax Notes and Actionline, a publication from the Florida Bar’s Real Property, Probate, and Trust Law Section. She also serves as assistant editor to the Sales and Use Tax Deskbook and Actionline. Ms. Moffa is a regular speaker at the American Bar Association Tax Section conferences, the Institute of Professionals in Taxation, the Florida Bar Tax Section, the Florida Bar Real Property, Probate, and Trust Law Section, and the FICPA. In her free time, she teaches as an adjunct professor at Broward College.