What you sell, how you sell it, and to whom it is sold all determine your sales tax liability — and it is anything but simple.
States are becoming increasingly more aggressive with the assertion of nexus and the taxation of service companies, especially software, SaaS (software as a service), and other technology service companies.
Learn how state tax laws are accelerating one year after Wayfair.
In order for your company to develop a strategic tax plan, comply with state tax laws, and avoid noncompliance penalties, it’s important that you have a grasp on state sales tax nexus, sales sourcing, and the taxability of software. What you sell, how you sell it, and to whom it is sold all determine your sales tax liability. And with the recent South Dakota v. Wayfair Supreme Court decision, things have gotten all the more complicated.
Here is a general overview of some things your company should be aware of, but because state taxation is so onerous and complex, working with a knowledgeable sales tax advisor is generally the best way to optimize your tax strategy and compliance procedures.
Sales tax nexus creates surprising connections with states
In order for a state to be able to tax your company, a taxable presence, or “nexus,” must be established. For sales tax purposes, this has historically meant that your company must have some sort of physical presence in the state. This physical presence can be established through a number of different means.
1. Employees/property in the state
The most obvious and easiest way to establish physical presence is with company property. If you have office space, servers, inventory, and other physical assets located in a state, then you have unquestionable nexus and will be obligated to comply with that state’s tax laws. You also have nexus in states where you have employees on your payroll. Look at your Forms 940 and 941 returns to see the states in which unemployment withholdings are taken; you have nexus in those states.
2. Traveling sales representatives
The physical presence of traveling sales representatives or other employees is much harder to establish, as your company is likely not withholding payroll taxes in each state the representative or employee visits. One way of determine if you have nexus in various states is to check where you list things such as “sales territories,” “where to find us,” “on-site customer training,” or “trade show attendance” on your website or in other materials. Taxing authorities or your own tax advisor may inquire about your sales representatives’ business travel and what their destinations are to see if you have nexus in various states.
3. Third-party contractors
Typically, the use of contractors for sales, repair, warranty work, installation, collections, credit checks, repossession, etc., in a particular state will be enough to create nexus for your company.
4. Affiliated entities
If your company has multiple entities in its group, one entity’s nexus in a state may in fact create nexus for all the other entities in the group as well. The best way to explain this is by example:
- Customers can order products from the retailer’s online site then pick up, exchange, file customer complaints, or return products to the brick-and-mortar store in the customer’s state.
- Customers can buy a gift card in the store and use it in on the online site for products that cannot be found in the physical store.
If similar relationships happen for various entities within your company, you may have an affiliate nexus issue. The test is whether your customers can tell a difference between your entities or if the customer sees them as one entity.
5. Click-through nexus
Click-through nexus came about through the growth of Amazon.com. Amazon has in-state affiliates who link others through to Amazon.com. These affiliates are individuals such as bloggers or writers or other retailers. If someone links through to Amazon.com from an affiliate’s site, then Amazon pays that affiliate a commission. Based on this relationship, states pursued Amazon for taxes and won by arguing that Amazon has contract sales representatives in their states.
If your company has similar arrangements, then nexus with the states your affiliates are in is created.
The Wayfair decision adds additional sales tax burden
However, a new trend has started for sales tax nexus. On June 21, 2018, the U.S. Supreme Court issued its highly anticipated decision in South Dakota v. Wayfair. In this five-to-four ruling, the Court overturned the requirement from its 1992 ruling in Quill Corp. v. North Dakota, which held that sellers must have a physical presence in a state before they can be required to collect sales tax there.
- Effective May 1, 2016, South Dakota enacted a law which asserted sales tax nexus over any seller with either at least $100,000 of annual in-state sales, or at least 200 transactions to in-state purchasers annually — even if the seller had no physical presence there (a so-called remote seller).
- As a result of the Wayfair ruling, states are no longer required to prove that a seller has a physical presence there before they may require the seller to collect their sales tax.
- The sales tax economic nexus standard used by South Dakota satisfies the requirements of the Commerce Clause because, when viewed in the context of other elements of South Dakota’s sales tax regime, it is not overly burdensome to remote sellers, including small businesses. A number of states have already passed economic nexus thresholds for sales tax purposes. These thresholds vary by state.
The new economic nexus laws in many states are still under constitutional review in state courts. However, your company could be subject to additional sales tax registration and reporting requirements. It is worth thinking about and preparing for this compliance burden.
Sourcing the sale for state sales tax obligations can be tricky
Sales tax law requires that sales be sourced in order to determine which state(s) have the right to tax the transaction. Historically, the ultimate destination of a tangible good was indicative of the state which taxed the transaction. In the context of software or SaaS, the lack of physical delivery makes the location of this delivery unclear. To solve this, states have taken a couple of approaches to sourcing.
- Hosted server location — The seller will deliver the software to be downloaded onto a specific customer server in a specific location. This method is easier for the seller to follow, as this information might be determined in the sales contract or can easily be obtained from the customer.
- User location — There are two approaches to determining user location.
- New York has stated that the users are the customer’s employees who use the software and their location of use. To the extent a customer’s employees are using the software within and without New York, receipts should be sourced to New York in proportion to the receipts attributable to the customer’s employee-users in New York to everywhere. Tennessee started using this approach in July 2015 after a legislative change.
- Utah, however, sources receipts to the address of the purchaser, which might not be the actual location of use. This information is likely more easily obtainable for the seller than the employee-user locations.
These various sourcing rules, and the difficulty in identifying the location of the server and user, which might be in multiple states, highlight how important it is for your software or SaaS company to keep timely and accurate records in case of a state audit.
Taxability of the transaction varies widely among states
Taxability refers to whether the specific items being sold are taxable under the state law. Sales tax originally was a tax on the sale of tangible personal property at retail. Suffice it to say that the tax applies to the final sale of a good to the ultimate consumer/user of that good. In addition to tangible goods being taxable, over the years many states have started to tax specifically enumerated services.
A few things should be clarified with regard to the taxability of software.
- Many times the method of delivery matters and can make the software taxable. For example, if software is delivered on a tangible medium (CD, disk, zip drive, etc.), it is more likely to be taxed then if it is downloaded. Some states do not make a taxable distinction based on delivery method and just tax all software.
- Many states do not tax custom software (built specifically for one customer) but do tax prepackaged software (built for repeated use to many different customers with minimal to no modification required). Prepackaged software is also referred to as canned, shrink-wrapped, and off-the-shelf. The main point is that if the software is made for repeated sale to multiple customers, it falls in this category. Custom software is often not taxable, as the true essence of the transaction is the service (i.e., the completion of programming that the customer is not capable of doing on his or her own). Prepackaged software is more likely to be taxable as the retail sale of a product.
- States have also addressed the customization of prewritten software. A prewritten computer software program is a custom software program only to the extent of its modifications. As such, many states will tax the cost of the prewritten portion of the software but exempt the customized value of the software.
- Some states consider software to be “data processing services” and specifically tax these services. Sales and use tax typically doesn’t apply to services unless specifically enumerated. In these states, data processing is an enumerated service.
As with many state tax questions, the taxability of a transaction involving software, SaaS, and technology depends on the state in question and the language in the contracts.
How we can help
The range of different products and services offered by software, SaaS, and similar companies — and the lack of definitive guidance in many states — make for continued difficulty and uncertainty in determining sales tax obligations. Additionally, new laws or interpretations by states periodically change the way software and SaaS should be treated for sales tax purposes.
If the taxability of your company’s software and SaaS have not been reviewed or have not been updated in several years, CLA’s state and local tax advisors and software industry professionals can assist in completing that review.