By now you have probably heard of the 2018 U.S. Supreme Court ruling in South Dakota v. Wayfair (“Wayfair”), which granted all 50 states the ability to reach out to out-of-state sellers and require the collection of sales taxes. This ruling applies to out-of-state sellers of subscription software as well. So even if your home state (say California) does not collect sales tax on SaaS software, the state where your subscriber lives just might (like New York). It is this intersection—or nexus—of out-of-state seller requirements combined with SaaS taxability that early stage SaaS companies have to watch.
What Triggers State Registration & Filing Requirements?
Most states have minimum annual dollar thresholds, transaction count thresholds, or both that trigger registration and filing requirements. Likewise, having remote workers in some states may also trigger nexus. An unwelcome side-effect of the Covid-19 remote working lifestyle has triggered physical nexus for many early stage startups. Nexus requirements vary widely and are constantly evolving. I recommend bookmarking this handy visual reference from Avalara.
Most states have minimum annual dollar thresholds, or transaction count thresholds, or both that trigger registration and filing requirements. Likewise, having remote workers in some states may also trigger nexus.
So when should startups begin to prepare for these administrative headaches?
For most states, the economic nexus threshold is $100,000, or 100 transactions, or maybe both. New York is currently $500,000 and 100 transactions. If you are an enterprise SaaS company with large contracts of $10,000 and you invoice customers once a year, you may not hit the 100 transaction minimum for a while. But if you invoice monthly or quarterly, you will hit that mark much sooner.
Preparation Checklist for Sales Tax on SaaS
- Step 1. Very early on, you need to start accumulating invoicing data on a state-by-state basis and monitor progress relative to the thresholds for each state.
- Step 2. Prepare the sales organization and pricing teams that this is coming well in advance. Over-communicate on this. Nobody likes surprises.
- I routinely hear push-back from sales teams that customers don’t want to pay sales tax. Of course not; no one does. But in my experience, customers who live in states that tax SaaS are already used to paying tax on SaaS. They are a lot less surprised about it than you are.
- Step 3. Make sure your invoice processes can calculate the sales tax and your back office has the processes for collection, remittance, and tax compliance.
- Step 4. Register with the appropriate states before you cross the threshold. Pick up the phone and call the state taxing authorities. They can guide you through the process, and more importantly, advise you on exactly when to start collecting. I have been pleasantly surprised when the occasional state taxing authority has advised that I could wait a bit longer.
- Step 5. Automate the process. There are a number of SaaS-oriented sales tax automation providers that will integrate with your billing and accounting systems. They prepare the returns and remit the taxes seamlessly.
- Be forewarned that implementation is never seamless. It will take at least 3-6 months to integrate fully.
It’s always best to engage your tax professional to help guide you through the process. This is not a situation where a startup should ask for forgiveness later. The penalties for non-compliance are high, and some states are very aggressive in audits.
The key is to be prepared in advance. State tax requirements sneak up on early stage SaaS companies much faster than most are expecting.