3 sales tax gotchas for software companies

Your software company needs to get sales tax right. Otherwise a lot of things can go wrong: audit penalties, interrupted IPO or funding round, slowed growth.

It’s easy to make a misstep without even realizing it, starting with one of the most basic aspects of sales tax compliance: identifying where you need to collect and file, i.e., where you have nexus.

That should be simple, right?

The Supreme Court ruled in 1992 (Quill Corp. v. North Dakota, 504 U.S. 298) that having a physical presence in a state is what makes your company responsible for complying with its sales tax laws. Physical presence can mean a variety of things, such as having an office, store, warehouse, or employee located in a state. But not all meanings are so obvious. In fact, in order to tax more types of sellers (namely, out-of-state sellers) and more types of transactions (ecommerce, digital downloads, streamed content, SaaS), states are taking some liberties with how they define physical presence.

As a result, these three business activities may, surprisingly, extend your sales tax responsibilities to more states than ever before.

1. Selling licenses: In the past, if the extent of your relationship with a state was selling software and licenses to use that software to its residents, you didn’t collect sales tax on those transactions. You didn’t have a physical presence in the state — no office, no contract workers, not even a trade show booth for a few days out of the year.
   
   The gotcha: Now some states, such as New Mexico and Texas, are treating software licenses as a physical presence. You hold ownership of the license, granting temporary use rights to your customers for the duration of the license agreement. Thus you have property in the state by way of the license, and that’s a physical presence. It could be time to collect. 
2. Storing data: Your business can’t run without servers; they host SaaS, websites, ecommerce, and more. You may maintain your own servers, lease space through a third party, or use a mix of the two. Either way, it’s the location of those servers that counts when it comes to your sales tax obligations.
   
   The gotcha: If you store data on servers located in various states, some states, such as Arizona, consider that data to be a physical extension of your business located within the state — somewhat akin to a remote employee. It doesn’t matter if you own the servers yourself or if a third party does. Storing data on a server in another state could be a sales tax trigger. 
3. Placing cookies: Browser cookies, that is. You place them on users’ browsers when they come to your website and then track and retarget them with advertisements on other sites. Cookies aren’t something you sell, yet they can have a sales tax connection.
   
   The gotcha: Some states, such as Massachusetts, contend that the short snippet of code, or cookie, you place on computers within the state constitutes physical presence, i.e., something you own is being stored in the state. And storing property translates to physical presence. No matter how you bake it, cookies could create nexus for you in states where you don’t otherwise have a sales tax obligation.

It can all make you miss the good ol’ days when physical presence meant something more concrete — a store, a warehouse, a salesperson, a trade show presence, an office. But the more states need revenue, the more creative their definitions of physical presence may become, so long as Quill still stands anyway.

Just remember: In some states, it’s not the business activity alone that creates nexus. A revenue or market caveat can appear in nexus legislation. When that’s the case, you’re on the hook for state sales tax if your sales into the state meet or exceed a certain threshold. You may also become accountable if it’s deemed your business is making clear attempts to establish and maintain a market in the state.

It’s a lot to keep up with, especially given that you’d rather devote resources to developing and marketing your software or SaaS products. If you need help making sense of your nexus responsibilities, speaking with a state and local tax (SALT) expert can help.

Another tactic is to operationalize a sales tax strategy that can help you stay on top of ever-changing sales tax rules for digital goods and services. Download Part 2 of The Software Executive’s Guide to Sales Tax to learn about operationalizing your sales tax strategy today.