Should you collect sales tax on software licenses?

A Utah-based online company that sold software licenses to customers in Texas was audited by the Texas State Comptroller. The Comptroller determined that the company should have collected sales tax on the licenses for the nine years they did business in the state. Even though the company argued that it had no physical presence in Texas, it was held liable for the taxes.

According to the Texas ruling, because the agreement between the seller and its customers stated that the seller would maintain ownership of the software even as customers downloaded it, that set up nexus for the seller. Texas statutes define software as tangible property, and when the software entered the state via purchasers' computers, it created a physical presence -- and therefore nexus -- for the seller.

Texas isn’t the only state to require sellers to collect sales tax on software licenses. New Mexico also considers the licensing of software to an in-state user to be taxable because it considers a license to use the software as tangible personal property. And since the sellers “own” the personal property on computers in New Mexico, the state assigns them nexus.

The State of New York has also decided to make software licensing subject to sales tax, but makes the tax location-specific. For example, if you sell a software license to a purchaser in New York, you will have to determine where the purchaser will direct or use the software and charge the sales tax rate for that jurisdiction. If your customer has employees in New York and in other states, the New York Department of Taxation and Finance asks you to “collect tax based on the portion of the receipt attributable to the users located in New York.”

The issue of taxability on software licenses is rapidly changing, and not all states agree on the solution. To ensure that you stay in compliance and don’t end up owing years of uncollected sales taxes like the Utah-based business that sold software licenses in Texas, you should be proactive in your research. Contact the department of revenue in each state in which you do business, or save some time by automating the process with sales tax reporting software.