The Smarter Startup

Would My Startup Survive Due Diligence? Part 1: Sales Tax


Ask an investment banker or M&A attorney to name common deal landmines right now, and Sales Tax will undoubtedly be high on the list.

Welcome to the first in a series of articles examining areas of due diligence that can delay or derail transactions, and leave startup founders red-faced right when they want to shine the most. From our position as CFOs in venture-backed startups, we see the same issues arise time after time; whether you’re a startup founder or an investor, knowing these landmines exist and addressing them in advance of transactional due diligence will save you tons of time, stress and aggravation down the road.

Ask an investment banker or M&A attorney to name common landmines in deals right now, and Sales Tax will undoubtedly be at or near the top of the list. Some startups are blindsided when learning, usually early in diligence, that their products and/or services are actually subject to sales tax, that their business has nexus in states they didn’t realize, and those independent contractors they’ve been relying on to grow so efficiently actually need to be classified as employees (we’ll cover Employee Classifications in a later post). Rectifying these situations can put startups on the hook for substantial back taxes, penalties and interest, so it behooves founders to take a hard look at these issues and get them squared away sooner rather than later.

Some startups are blindsided when learning, usually early in diligence, that their products and/or services are actually subject to sales tax, that their business has nexus in states they didn’t realize, and those independent contractors they’ve been relying on to grow so efficiently actually need to be classified as employees.

Generally speaking, a good hint that a finance function might be too much for early-stage companies to tackle on their own is when other startups develop software to preform that function for them (think Shopify, Carta, etc.). Sales Tax is one of those functions – companies like Avalara and TaxJar exist because sales tax is full of complicated and arcane filing rules and requirements that can differ substantially from state to state, and by product or service. Even the definitions of what is taxable and what isn’t can be dramatically different depending on the state, and even seasoned sales tax professionals can arrive at very different conclusions when discussing a company’s sales tax obligations.

Covid-19 Blurred the Sales Tax Lines Even More

First, the explosion in the virtual delivery of previously in-person products and services potentially changes their sales tax status. Secondly, the dispersion of employees to states different from the one in which their company operates may have created a nexus⁠—a connection to a taxing jurisdiction⁠—in that state where none existed beforehand, thus making any sales in that state subject to sales tax. Both can trip up the unsuspecting startup, even those that were tracking sales and payroll tax obligations closely.

Ultimately, sales tax comes down to what you do, and where you do it. Some states, like California, don’t typically tax SaaS revenue, whereas others, like New York, most certainly do. Some have exclusions for services, others define tech-enabled services as taxable. Many startups are already up-to-speed on sales tax; if you’re unsure, we suggest allocating revenues by product and by state for the past few years and looping in your CPA or accounting firm. They’ll analyze what you’re selling and where, and whether sales tax needs to be collected and submitted. As noted, applications like Avalara and TaxJar can be hugely helpful with properly collecting, filing and remitting sales tax in multiple jurisdictions.

Collecting & Remitting Sales Tax is the Seller’s Obligation

While the buyer usually pays any sales tax due, it is the obligation of the seller, NOT the buyer, to collect and remit it to the states necessary. Some companies include a clause in their contracts that expressly makes sales and other taxes an obligation of the buyer, but this does NOT relieve the seller of the need to collect and remit (although such language may allow you to approach the client for any unpaid taxes). Also – NEVER collect sales tax without remitting it to the relevant states on time. Sales tax is considered a trust tax, along with payroll taxes, which means you are collecting it on behalf of the state, and you have a fiduciary duty to ensure it is properly collected and remitted.

If you run the numbers and it looks like you should have collected sales tax but didn’t, don’t despair. Most states have voluntary disclosure programs that will work with you to get things straightened out. You (or your clients) will still have to pay and remit the uncollected taxes, but penalties and interest are often waived for companies who come forward after realizing the error. As with any tax issue, always consult with your legal counsel and accountants before proceeding.

Sales tax issues can, and do, come up during transaction diligence, and they can seriously derail otherwise promising discussions. Do yourself a favor – get with your professional tax advisors, ask the right questions, and make sure you’re compliant with sales tax before it becomes a difficult conversation with your potential investors or acquirers.