Software As a Service: Making Sense of SaaS Sales Tax Laws

Many of you have asked: What is Software as a Service (SaaS)? And why am I seeing a sales tax charge related to it on invoices?

We know it’s a bit confusing, so we checked in with a certified public accountant (CPA) to answer some questions and help you understand what SaaS sales tax is and why it applies to you.

Based on tax laws, companies have traditionally charged sales tax for physical goods that you could hold in your hands, such as DVDs or cassette tapes, said Dustin Hubbard CPA, with CliftonLarsonAllen, LLC, a public accounting firm in Greenwood Village, Colo.

Because many digital consumables are no longer tangible physical items, sales tax collection on those items came to a screeching halt, until now. And it undeniably hit state governments’ bottom line.

What is the SaaS sales tax?

When companies are remote sellers that provide SaaS, which generates revenue, like many other goods, tax laws require companies to charge customers sales tax for those “non-tangible” cloud-based digital services, Hubbard said.

Therefore, if a company exceeds a certain amount of economic activity in a state without having a physical presence, explained Hubbard, that company becomes subject to sales tax collection and remittance requirements.

Take a software upgrade, for example. Don’t bother loading a floppy disc into your computer drive. Those days are long gone.

Today’s consumer prefers downloadable software and other non-physical or non-tangible digital services, according to Hubbard. However, he said those non-tangibles require companies to collect sales tax for the SaaS services they provide.

Newer tax laws are a response to changes in how we consume services, according to Hubbard, coupled with government regulations that dictate sales tax collection.

“States have expanded the definition of physical goods,” he said. “Now we’re not buying the tangible goods. We’re buying a Netflix subscription, which is not a tangible good.”

Whether you’re streaming episodes of Nurse Jackie for an upcoming binge session or paying for digital email advertising campaigns or online job postings, depending on the state where the seller resides, that company providing SaaS services must charge SaaS sales tax for those non-tangible services, Hubbard said.

No company can escape tax laws, whether it’s charging sales tax for non-tangible email marketing campaigns or retail stores that sell digital video game downloads.

Sales tax varies by state

In terms of state sales tax laws related to SaaS, it’s an undoubtedly tricky subject, according to Hubbard, who noted each state has its own set of tax laws, as well as each county and city.

“In my experience, taxes are not labeled as a SaaS tax,” he said. “Typically, I’m dealing with sales taxes across cities, states and counties, and whether a jurisdiction is going to impose sales on tax on SaaS.”

Plus, there are plenty of tax rate combinations to make sense of in the United States. A tax rate combination is the sum of taxes charged from state, county, city and special districts.

“It’s set up at a special jurisdiction level, and the rough number is about 12,000 to 15,000 different [tax] rate combinations.”

Take the state of Colorado, which is one of the most complex sales tax regulation states. That is partly because the state sets its own tax rules in some jurisdictions.

“County rates vary depending on which county you are in, (and the) same is true with cities,” Hubbard said. “Here in Colorado, 70 cities get to set their own tax rate, whereas other states need approval to set their city-level sales tax rate.”

Nonprofit SaaS sales tax tips

Kathleen Thies, JD, has worked in public accounting for more than 15 years and now oversees state and local taxes for nonprofit clients as a director with CliftonLarsonAllen LLP, in Arlington, Va.

For some nonprofits, there’s a misconception about which taxes they are required to pay.

If a 401(c)(3) nonprofit does not have a sales tax exemption certificate on file with their state, Thies said, it’s safe to assume they will be subject to SaaS sales tax like any for-profit entity.

“Most states will provide a tax exemption if you are a federally designated nonprofit, 501(c)(3),” Thies said. “It signals sellers not to charge sales tax.”

Nonprofits without the certificate can contact their state office of revenue to apply for it, she said.

“Apply for an exemption for sales tax certificate,” she said. “That way if a vendor charges you sales tax, the nonprofit could provide the certificate and say they are not supposed to be charged sales tax.”

Then, request an amended invoice minus the sales tax. “Some nonprofits may not realize they can provide that documentation,” she said.

Thies added that when nonprofits are exempt from paying income tax, this is not the same as sales tax, which is why it’s important to have the correct state sales tax exemption paperwork on file.

Tax law caveats

Are you a trade association? Then this tip is for you.

“You need to understand what group of nonprofits this exemption is extended to. Not every 501(c) is exempt,” Thies said.

Different types of nonprofits are subject to different state tax laws. For example, Thies said a 501(c)(6), such as a trade association, doesn’t have the same sales tax exemption rules as 501(c)(3).

“Look at your home state’s rules as to which organizations are exempt,” she said.

Contact your state department of revenue or department of taxation to discern how tax laws apply to your organization. The Tax Foundation website is another helpful resource.