Demystifying US Sales Tax for SaaS companies

SaaS sales tax in the United States is complex, to say the least. In his well-known work, ‘The Wealth of Nations,’ Adam Smith writes: Subjecting people to frequent inspections, and disagreeable examinations by tax collectors may cause them a great deal of unwarranted worry and vexation… Moreover, while vexation is not strictly speaking an expense, it is unquestionably similar to an expense at which every person would gladly redeem himself.

This ‘expenditure’ for many American SaaS enterprises entails comprehending state-by-state SaaS sales tax rules and procedures.

How does Sales Tax in the United States Work?

As there is no centralized federal sales tax system in the United States, each state has its own set of regulations and procedures for sales tax eligibility and filing. When it comes to software, the US divides it into three categories: tangible software, downloaded software, and cloud-based software. 

Cloud based software such as SaaS, is hosted on a server and used by clients via the internet. The taxability of your SaaS, on is determined by the state in which you sell it. That leads us to the next point:

Is your SaaS taxable?

SaaS is divided into two groups in states where it is taxed: Tangible personal property and Computer/ Data processing service.  

For example, canned or prewritten computer software is included in the definition of ‘tangible personal property’ in the state of New York. SaaS is taxable as a sale of ‘tangible personal property’ in New York since it is the selling of canned or prewritten computer software. However in a state like Texas, SaaS transactions are considered taxable data processing services. Understanding the state sales tax rules for your SaaS business is difficult due to the many different definitions and categorizations.

States where SaaS is taxableAlabama, Arizona, Hawaii, Iowa, Maine, Mississippi, New Mexico, New York, Pennsylvania, Rhode Island, South Carolina, South Dakota, Tennessee, Texas, Utah, Washington, Washington D.C., West Virginia
States where SaaS is not taxableArkansas, California, Colorado, Florida, Georgia, Idaho, Illinois, Indiana, Kansas, Kentucky, Michigan, Minnesota, Missouri, Nebraska, New Jersey, North Carolina, Oklahoma, Vermont, Virginia, Wisconsin, Wyoming
Personal/ business useSaaS for personal use is taxable in Louisiana, Maryland, Massachusetts.
SaaS for business use is taxable in Nevada, North Dakota, Ohio.
*In Connecticut, SaaS for personal use is taxed at full state rate, and for business use is taxed at 1% only

What are Tax Thresholds and How Do They Work?

The next step is to assess your tax burden now that you know whether or not your SaaS firm is taxable. This is determined by the amount of the sale, the mode of purchase, and the location of your firm.

The ‘South Dakota vs. Wayfair’ ruling in the United States ushered in a new age of sales taxes. State governments now have the authority to determine that remote/online sellers are subject to sales tax. This only applies to vendors who get a significant portion of their overall sales or transactions from that state. States must now define what constitutes a “nexus.” This nexus determines your tax liability, also known as a ‘tax registration threshold’ in some nations.

As a result, SaaS businesses may be taxed in new countries where they do not have a physical presence but fulfill the sales or transaction requirement.

What is the term “economic nexus”?

Your tax burden is determined by an economic nexus based on sales revenue from a specific state. A nexus is essentially a commercial relationship to the state. A nexus is defined by each state as a physical presence or an economic tie. The standard threshold is $100,000 in annual sales. Some states have extra thresholds based on sales revenue.

What is the procedure for registering for sales tax?

Now that you know how much tax you owe, there’s only one more step (sigh!) before you can begin collecting sales tax. You must obtain a valid US sales tax permit in each state where you have a connection. It is considered tax fraud if you do not do so. Most states allow you to apply for your permit online. You can even do it by snail mail if you’re old school.

You can also register with the Streamlined Sales Tax (SST) Registration System. SST was established to make collecting sales taxes easier. The Streamlined Sales and Use Tax Agreement is currently ratified by 24 states. You will receive the relevant ID and permit once you have registered.

Sales Tax Calculation and Collection

You’re now ready to start collecting sales tax from your clients. Take the following steps:

  1. Find out where your buyer is located.
  2. Based on state law, calculate the tax rate for the locality.
  3. Make sure you’re aware of all applicable tax rates. Different tax rates may apply to sales in a county, city, or other locality.

These steps appear to be straightforward. To avoid becoming entangled in any complications, it’s always a good idea to visit each state’s tax office website.

Keeping Track of Sales Tax

It only makes sense to keep correct records and documentation for taxes if you’re going to all that trouble to compute and collect them. This includes the following:

  • Invoices and receipts that are tax-compliant
    These include all necessary information to the tax authorities, such as the buyer’s identification, the things purchased, the unique invoice reference number, the date, and the sales tax breakup, in the event of an audit. Tax receipts are also required as documentation if you are filing for any tax deductions.
  • Credit notes and refunds
    If you’re giving a full or partial refund, you’ll need to issue a credit note to prove it. This will assist you in avoiding taxes that you no longer owe. It is recommended that secure digital recordings be kept for several years. This will make it easier for you to produce any records needed during audits.

Returns on Sales Taxes

On the website of each state’s Department of Revenue, you can complete sales tax returns independently. Make a mental note of the following:

  • The frequency with which returns are filed.
  • The deadlines for filing returns
  • Analysis of the tax reporting process (county, city, locality-wise)

Even if you didn’t collect any taxes in a jurisdiction where you have a tax permit, you must still file returns. You must file a ‘zero taxes’ return in such circumstances.

Accounting for Sales Tax and Software as a Service (SaaS)

Tax cannot be recorded as revenue because firms collect sales tax on behalf of tax authorities. A journal entry is used to record sales tax. You can debit sales tax payable’ and credit ‘cash’ when the sales tax is remitted.

Conclusion

Sales tax compliance has become easier because of technological advancements. However, before you get started, make sure you understand the sales tax regulations in each state where you conduct business. Because every business is unique, finding the correct compliance plan to meet your needs is crucial to saving time and resources. The United States is a tricky country. Even more so for a SaaS company!

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