Wondering how your SaaS business got slapped with a multi-million dollar sales tax bill from one or multiple states?
Probably because you, like so many other SaaS companies out there, didn’t even know you had to collect and remit sales tax.
It’s really not surprising that many SaaS companies make this common mistake and find themselves unintentionally non-compliant. Sales tax laws across the United States are pretty inconsistent, especially for SaaS solutions. Some states consider SaaS a product, others consider it a service. That means determining if SaaS is taxable and at what rate is incredibly confusing.
The most common mistake we hear from SaaS businesses is that they didn’t know they had to collect and remit sales taxes at all.
How one prominent SaaS company learned sales tax the hard way
Basecamp, a leading SaaS-based project management solution, was a company that didn’t know they had to collect and remit sales taxes.
Basecamp didn’t collect sales tax because they didn’t know where and when SaaS products were taxable. They learned the importance of sales tax compliance the hard way—when they had to pay millions in back taxes.
It’s not hard to understand how Basecamp got this wrong. When the company first began web app development and selling software-as-a-service in 2004, their business model wasn’t even called SaaS. And, like every software startup, their small team had a million other things to worry about.
Early on, Basecamp had to deal with banks that were wary of their subscription plans. Then came customers who didn’t feel comfortable providing their credit card information online. With only a little more than 50 employees spread across the world, these challenges took precedence.
Meanwhile, new tax legislation for SaaS companies was brewing. While Basecamp sorted out the challenges of being a first-mover in their industry, digital goods and software services became liable to sales tax.
“Our first introduction to sales tax was dealing with it as a liability,” David Heinemeier Hansson, CTO and co-founder of Basecamp, told TaxJar. “We discovered we should have been collecting sales tax but we weren’t, so we had a number of liabilities in different states that needed to be cleaned up.”
Why sales tax mistakes happen
What Basecamp experienced is not uncommon. Sales tax laws vary at both the state and local levels. Busy SaaS companies often just don’t think to check the laws in every state and jurisdiction, especially if their solution isn’t taxable in the state where they founded their business. It’s very much a “you don’t know what you don’t know” type of business mistake.
At the state level, SaaS is sometimes taxable, sometimes exempt, and sometimes taxable with exceptions.
In Colorado, for example, SaaS is non-taxable because it is not delivered in a tangible medium. In Iowa, however, SaaS is taxable—as are all services arising from or related to installing, maintaining, servicing, repairing, operating, upgrading, or enhancing specified digital products.
Then in Connecticut, SaaS is taxable, but SaaS for personal use is taxed at the full state rate, while SaaS for business use is only taxed at the rate of 1%.
SaaS purchases can also be taxed at the local level. “By various estimates, there are between 7,500 and 14,000 different authorities that impose a sales tax in the United States,” according to the Sales Tax Institute. Local tax gets tacked on after state tax and must be reported and remitted as well.
Sales and local taxes are also subject to change every year, and change seems to be on its way soon. Accounting Today’s Roger Russell reports that local sales taxes are likely to trend up in a post-COVID world, as states and cities look for ways to dig out of debt.
One “possibility is states expanding the sales tax base by eliminating exemptions, especially for business-to-business transactions seen as costly ‘tax expenditures’,” according to Peter Michalowski, State and Local Tax Leader of PwC.
Perhaps more than ever, SaaS companies will have to pay close attention to developments in state and local tax laws over the next year to avoid noncompliance.
The price of noncompliance
Back fees and fines from sales tax noncompliance have the potential to crush a growing SaaS company, so when it comes to sales tax, ignorance is anything but bliss.
SaaS leaders have to stay on top of where they may have nexus and owe taxes as their businesses grow and sales tax laws across the country change.
So now the question is, who are you going to work with to get compliant and stay compliant? With so many different options available, we’ve created an evaluation guide, to help companies understand the most important features to look for in a sales tax software. Download our free guide here.