SaaS sales tax and the consequences of non-compliance

Understand the serious consequences of sales tax non-compliance—the penalties, and potential legal ramifications your business may face when neglecting your sales tax obligations.

The average SaaS company is a fast-paced work environment. As you grow and begin to service more customers, keeping track of transactions, expenses, hiring, fulfillment, funding strategy, and so on gets harder. SaaS founders, CFOs, and other executives have to deal with a never-ending to-do list every day.

Obligations like remitting sales taxes to relevant authorities don’t have hard deadlines and most companies tend to ignore them until it is too late. Regardless of your reasons, there are consequences for sales tax non-compliance in the US and companies will be wise to avoid them. Keep reading to see why ignoring sales tax as a SaaS company is not worth the risk.

Key highlights

  • Sales tax is levied on goods and services by state, and local governments in the US.
  • The supreme court judgment on "South Dakota vs Wayfair 2018" established that significant economic presence in a state creates a nexus.
  • Back taxes, Issues with fundraising, M&A bottlenecks, failing tax audits, and exposure to litigation are all consequences of not complying with sales tax laws.
  • Factors like nexus thresholds, multiple sales tax laws, and conflicting reporting periods affect sales tax compliance.
  • Automation is the best sales tax compliance solution.

What Is sales tax?

Sales tax is a consumption tax levied on certain goods and services by state governments and local jurisdictions in the US. This tax is calculated as a percentage and the retailer collects it as part of the total payment at the point of sale. Since sales tax is not a national tax, the percentage charged varies from state to state.

In New York, for example, the sales tax percentage is 4% while the state government charges 6.25% in Texas. There are different regulations, revenue thresholds, and percentages for each jurisdiction which further complicates the sales tax system.

The evolution of sales tax for SaaS companies Evolution of Sales Tax for SaaS Companies

How does sales tax apply to SaaS companies?

”Quill Corp vs North Dakota 1992”

Before 2018, only companies with a “physical presence” in a state were mandated to collect and remit sales taxes. This meant that SaaS companies (which were only a handful at the time) could sell products digitally in a state without actually setting up their business there and were shielded from paying sales tax.

The Supreme Court set the precedent in "Quill Corp vs North Dakota 1992" and this judgment shielded Software companies throughout the internet boom. However, in the 2010s, state authorities saw how digital products and services had grown into a massive industry and realized they were losing billions of dollars in sales taxes every year.

"South Dakota vs Wayfair 2018"

The year is 2016 and South Dakota just passed a law that required companies without a physical presence in the state to collect and remit sales taxes if they meet/exceed certain requirements. This law was a direct challenge to online retailers and SaaS companies who previously didn't have to worry about sales tax liabilities.

South Dakota enacted the law to convince the supreme court that times had changed and the "Quill Corp vs North Dakota'' judgment was no longer practicable. Wayfair, an online home-goods retailer, sued the state for violating the commerce clause of the US Constitution. This legal battle lasted for roughly 2 years and eventually landed at the Supreme Court.

Supreme Court Judgment

In a historic 5-4 decision, the US apex court overturned the "Quill Corp vs North Dakota" judgment and ruled that states can now mandate out-of-state retailers to collect and remit sales if they have a substantial economic presence in the state.

The court held that:

  • The physical presence requirement was unsound and incorrect and an extraordinary imposition by the Judiciary on state authority.
  • technology has changed significantly since the first precedent was set in 1992.

Therefore all SaaS companies are required to comply with individual state sales tax laws provided:

  • They generate above $100,000 in revenue in that state or jurisdiction within the tax period or
  • They process more than 200 transactions within the tax period.

This threshold was set by the supreme court to provide a basis for state tax authorities to ensure sales tax compliance. However, note that the threshold that determines nexus varies from state to state.

Impact of the"South Dakota vs Wayfair 2018" judgment on SaaS companies

SaaS companies were most affected after this judgment. There were so many questions to answer. What has changed? How can we ensure compliance? What are the relevant sales tax laws in our stronghold states?

Each state has its sales tax laws, requirements, and procedures. The same goes for municipal governments. If SaaS companies fail to comply with their directives, "South Dakota vs Wayfair" will leave them open to litigation. As expected, SaaS companies are now fully adapted in 2023 and non-compliant companies suffer consequences.

What are the consequences of SaaS sales tax non-compliance?

Consequences of SaaS sales tax non-compliance Consequences of SaaS Sales Tax Non-Compliance

Sales tax compliance has gotten harder since 2018, and some SaaS providers still ignore proper compliance strategies. While it might be difficult, and costly to keep up with SaaS sales taxes, the alternative is far worse.

SaaS CFOs and founders must address sales tax early enough to mitigate future repercussions. For stuff like this, a stitch in time will save you. As a SasS company, these are some of the consequences of Sales Tax Non-compliance.

Back taxes, fines, and compounded liabilities

SaaS became taxable right after the 2018 judgment and most states have put laws in place to guide the collection process. If your company doesn’t collect and remit sales tax as and when due, it continues to accumulate. You can be asked to pay back taxes which means more liabilities and a weaker statement of financial position.

Back taxes and fines are one of the kindest consequences you can face for not complying with sales tax laws. It means the authorities believe your intent was not malicious and paying those compounded taxes will get you off the hook.

Merger and acquisition bottlenecks

Most SaaS companies don’t have long life cycles. They are usually bought out by established players like Google and Microsoft for huge sums of money (depending on their success). If you are looking to sell or merge, sales tax non-compliance can cripple that process. No company wants to come in and start settling liabilities from the get-go.

If your company is valuable enough, you might still be able to sell. However, you have to take a significant cut on your selling price to offset the back taxes and other legal fees that will arise from settling your sales tax problem. The best option is to remain compliant so your house is in order when your guests arrive.

Due diligence setback during fund raising

As a growing SaaS company, you are going to need a lot of money to scale. Most of this money will come from investment firms and banks. Nobody does paperwork like Wall Street. Once you grant them access to your books, they will spot your sales tax exposure and might decide not to invest with a non-compliant company.

Some investment firms who see your potential will ask for more than they should because they know you need them and will happily reveal your tax problem to other potential investors. SaaS founders should avoid scenarios like this by remaining compliant and making sure everything (especially financials) is by the law.

Failing sales tax audits

As long as you do business in the US, you will get audited for tax. It might be today, tomorrow, a year, or two years from now. One thing is certain – the authorities will come. Once you begin to scale and sell more, you will most likely exceed the threshold in multiple states and their tax monitoring systems will flag you sooner or later.

If you get audited and you fail the sales tax audit, you are automatically liable to some form of punishment. You will certainly have to pay back taxes. Tax authorities can also decide to fine you heavily for non-compliance. If they determine that you acted maliciously, you have a much bigger problem.

Exposure to litigation

Exposure to litigation is one thing you should avoid as a SaaS company. If you collect sales taxes and fail to remit them on time, you have acted maliciously and can be charged in court. Most times, tax authorities just want their money and they don’t want to spend on expensive court cases. However, if you push them to the wall, they will.

Litigation combines all the consequences of non-compliance and delivers them to your doorstep. If you are found guilty in court, no company will want to buy, merge or invest with you. You also deal with back taxes, fines, and legal fees. In addition, there’s a negative brand image waiting for you when it's all done.

Why is sales tax compliance difficult for SaaS companies?

Challenges of SaaS sales tax compliance in the US Challenges of SaaS sales tax compliance in the US

Sales tax compliance is compulsory for all SaaS companies selling to US customers. The hidden (or obvious) truth is that compliance is not always easy.

Sales tax laws are bulky, complex, and spread across multiple jurisdictions. As your SaaS company grows, you need to keep up with new tax liabilities. Here are some of the factors that affect smooth sales tax compliance:

US nexus law

In the US, nexus refers to the amount of physical presence or business activity that a company must have in a state before they are subjected to sales tax laws. Before the 2018 "South Dakota vs Wayfair" judgment, US Nexus law only recognized physical presence (offices, warehouses, retail stores, employees) as proof of nexus. Post-2018, that changed.

Nexus is now established when you have a significant economic presence in a state. This means once you cross certain economic thresholds, you are required to comply with state tax laws. In most states, the threshold is;

  • Above $100,000 in revenue, and/or
  • Above 200 transactions per year

The problem with this law is that you can hit the nexus threshold without knowing. For example, if you have 20 customers in a state and they buy from you monthly, you have hit the "200 transactions" threshold.

If you gain 1,000 customers in a state and they pay you 10 dollars monthly, you will hit the "$100,000" threshold for that year. This threshold varies from state to state and some are significantly higher than others.

Different state and municipal laws

States and local governments have autonomy when it comes to passing and enforcing sales tax laws. This means an average SaaS company with widespread customers needs to keep up with multiple tax codes all at once. The filing process, sales tax percentage, and nexus threshold can be different for each state or jurisdiction.

Sales Tax Rates for Different States as at 2021 Sales Tax Rates for Different States as at 2021

If you sell to customers in these seven states alone, you need to calculate different percentages per sale depending on the state. Keep in mind that local jurisdictions collect sales taxes too and you have to break this down further. The process is quite complicated and keeping up might require a tax department – or a simple automation solution.

Tax classification

Determining the appropriate tax classification for a new SaaS product or service can be challenging. Different jurisdictions may have different rules regarding the tax treatment of specific types of software or services. SaaS companies need to carefully analyze their offering and understand how it fits into the tax laws of each relevant jurisdiction to determine the correct tax classification.

Multiple registrations and tax returns across different states

Once you have successfully navigated tax calculation and collection, remittance becomes another problem. Since different authorities are responsible for collecting taxes in their respective territories, you need to file with each of them separately. As a growing SaaS company, you might need to register with hundreds of relevant bodies just to stay compliant.

Multiple tax remittance periods

States have different tax remittance periods. Most states collect sales taxes monthly, quarterly, bi-annually, and annually. While many states require taxes to be filed on or before the 20th of every month, it can range from the 15th to the last business day of the month.

SaaS companies prefer to file taxes annually which means most sales taxes are due in January (calculated for the preceding year). However, in states like Minnesota, New York, and Hawaii, sales taxes are due in February, March, and April respectively. As a SaaS company, you need to plan your sales tax remittance carefully to avoid missing deadlines.‚Äç

Transaction volume

Sales tax compliance is a struggle for growing SaaS companies. Even though an increase in transactions is a good thing, it also means an increase in your sales tax liabilities across different jurisdictions.

You have customers springing up everywhere and you need to keep up with transactions so you don’t cross a threshold without knowing. Monitoring transaction volumes manually might not be possible for a growing SaaS company. You need automation and software to help with this process.

Is there any SaaS company that was penalized for sales tax non-compliance?

Yes. Basecamp

Basecamp is a project management software company that has been operating for nearly 2 decades. Their customers include Shopify and 75,000 organizations from 166 countries. The changes in 2018 caught them unawares and their CTO David Heinemeier had this to say:

Our first introduction to sales tax was dealing with it as a liability. We discovered we should have been collecting sales taxes but we weren’t so we had a number of liabilities in different states that needed to be cleaned up

Basecamp had to pay millions of dollars to state tax authorities, and they have been sales tax compliant ever since. The money covered back taxes and penalties.

SaaS sales tax compliance solution: Automation as the best option

Sales tax is levied from different angles and it is almost impossible for you to keep up with them manually. You will need to charge, collect, process, and remit these taxes without error. In the past, you needed a robust tax department to help you with this process. Not today. As a SaaS company, automation is your best bet to navigate the complex world of US sales tax laws.

Automation allows you to handle all your sales tax processes with tested software and compile the right amount of taxes without error. When the time comes to pay Uncle Sam, you will do so without hassle. Why deal with regulations and tax codes from hundreds of tax authorities when you can just delegate it to software?

Paying lawyers and tax experts after failing sales tax audits is like taking medicine after death and as a SaaS CFO, you want to avoid that situation. Tax compliance is important for any business that wants to play long-term or sell eventually.

Moving forward

As a SaaS founder or CFO, you are putting your company at risk if you don’t take sales tax compliance seriously. It may seem like a little headache at first but will grow to become a major problem as you scale. Do the right thing today and automate your sales tax process.

Here, we answer some of the commonly asked question when considering automating your sales tax compliance.

How can we automate sales tax calculations and filings to ensure compliance and minimize errors?

The best way to automate sales tax calculations is with sales tax software. Most sales tax compliance software comes cheap and the average SaaS company can easily afford them. If you have a large budget and you want to reduce tax liability significantly, you can hire a professional tax firm to handle all your tax burdens (including sales tax).

Can software and SaaS companies be audited for sales tax compliance, and what are the consequences of Non-compliance?

Yes. SaaS companies can be audited and they often are. Tax authorities will audit your company if they have cause to believe you have passed the nexus threshold and are not collecting sales tax, or you are collecting sales tax and not remitting the right amount. The consequences can be anything from back taxes to fines and legal action.

Are there penalties or interest for failing to remit sales tax as a SaaS/Software company?

If you collect sales tax and fail to remit them, that is tax evasion and it is a serious felony in the US. Your company will most likely be prosecuted and you will end up with large fines, asset seizure, a negative brand image, or even a prison sentence.

However, if you don’t collect sales taxes due to ignorance or negligence, the penalty is much lighter. You will have to pay back taxes along with fines. Tax authorities will also keep a much closer eye on you.

Are there any exemptions or thresholds related to sales tax that apply to SaaS companies?

Yes. In Texas and New York, the economic nexus threshold for SaaS companies is $500,000. This means SaaS companies are only obligated to collect sales taxes once they start making up to $500,000 per year in that state.

What are the sales tax laws and regulations that apply to software or SaaS companies?

The supreme court judgment on "South Dakota vs Wayfair 2018" is the most important law that regulates sales tax and SaaS companies. States and jurisdictions have unique laws governing sales taxes in their territories.

Sales tax headaches? Time to pass the torch to the professionals.

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