What do recent changes to state taxes mean for US SaaS startups?

Trends indicate that a majority of businesses plan to fully adopt software as a service (SaaS) by 2025, and if the past is any indicator, that means state legislatures are working hard to capture revenue from this new sales stream.

As with many U.S. laws and regulations, tax laws regarding SaaS vary quite a bit and continue to evolve. Currently, some states consider SaaS to be software while others categorize it as a service. In addition, some states tax all services regardless of type, and more than 20 have a way to target SaaS. At least four states (New York, Pennsylvania, Texas and Washington) are aggressively pursuing SaaS. There’s also the issue of bundling — on its own, SaaS might not be taxed, but it will be when paired with hardware.

In the early days of a startup, there’s a tendency to think that the only tax worry would be an audit in the future, the likelihood of which is low. However, tax issues become a problem when you’re fundraising or facing due diligence for mergers and acquisitions. The party conducting due diligence will be focused on sales and use tax, as any liability could transfer to the buyer. We saw this with a new client recently — they hadn’t performed a risk assessment and the buyer identified almost $1 million dollars in tax liability. This reduced the purchase price significantly.

Startups think they’ll have lots of time to get to this point, but they actually need to focus on it right away. Any negligence, if identified, could exclude a company from any statute of limitations.

While no business is exempt from taxes, it’s critical for startups to understand when they’re liable for tax, and if offering a SaaS solution, how each set of local laws applies.

Determining your taxability

To identify which states you’ll owe sales taxes to, first establish your nexus by determining your physical or economical presence.

You can determine your physical nexus by examining which states you have employees, office, property or agents in. Are you “maintaining, occupying or using permanently or temporarily, directly or indirectly, an office, place of distribution, sales or sample room or place, warehouse, server, storage place or other place of business?” Or is there an “employee, representative, agent or salesperson working in the state under the authority of the company on a temporary or permanent basis?”

An economic nexus is established for sellers “not having physical presence in the state.” In this case, the state will collect sales tax from customers and remit if the seller meets a set level of sales or number of transactions in that state.

With broad definitions like these, it’s easy to see how complex taxes can become.