Does Your SaaS Business Owe Sales Tax? A Full Breakdown

A common thread between tax laws and regulations around Software-as-a-Service (SaaS) is their constant evolution, making it difficult to keep up with these crucial updates. For SaaS companies, managing these changing rules can be daunting, especially as more states and jurisdictions impose sales tax on digital goods and services. Failing to pay close attention to alterations in the law can lead to not just uncollected tax from customers but also costly penalties, making education on sales tax an important part of managing your business. 

Taxability, product classification, and nexus regulations vary by state, making compliance even more complex. In the mountain region alone, the laws are challenging to track, as Colorado applies sales tax to certain digital products while Nebraska, North Dakota, and South Dakota all have their own individual rules for digital goods.  

So, how do you keep your business compliant? The first step is understanding your product classification and nexus status in each state, then employing all the tools in your toolbox to stay updated on changing laws so you can avoid penalties and keep your operations running smoothly. 

Understanding SaaS and Sales Tax 

SaaS differs from traditional software because it does not require installation on a device and operates as a cloud-based service. Users access SaaS applications via the internet through subscription or pay-as-you-go pricing models. This process eliminates the need for local installation but also complicates how sales tax can be applied because it begs the question: Is SaaS a tangible good, an intangible good, or a service? 

This distinction is important because the method of delivery affects taxability. Tangible personal property (TPP) is perceptible to the senses, meaning it can be seen, weighed, measured, felt, or touched. While specifics vary, TPP goods are subject to sales tax in most states. Alternatively, intangible goods are non-physical services or digital products. The tax for these goods varies state by state, with some taxing the product while others do not.  

Given how these variations impact taxability, it is necessary for SaaS businesses to understand how their product is defined. Because SaaS is not a physical product that can be touched, it is considered an intangible good, but certain states classify it as a service (or exempt!) depending on the service or licensing agreement. Furthermore, there are additional definitions that alter SaaS products status, as several states classify it as a taxable digital service while others consider it exempt under certain circumstances. There are even a few states that consider it tangible personal property! 

How States Categorize SaaS for Tax Purposes  

The taxability of SaaS varies by state, often depending on how it is used or whether the software is provided under a license agreement or a service agreement. Each state categorizes SaaS differently, making it vital for tax professionals to understand the nuances in each state’s rules.  

Here are some examples of how taxability changes state-to-state: 

• Connecticut: SaaS taxability is conditional in Connecticut. If provided under a License Agreement, it is taxable. However, when offered under a Service Agreement, taxability depends on the nature of the transaction. If the service component is the primary purpose, it may be non-taxable, whereas if access to software is the main objective, it is likely taxable. 

• Illinois: Illinois does not tax SaaS if no tangible property is transferred. However, taxability may apply when the provider offers an application programming interface (API), applet, desktop agent, or remote agent that connects to its network and services. Additionally, customers in Chicago are subject to the Personal Property Transaction Lease Tax. 

• Iowa: How SaaS is used determines whether it is taxable in Iowa. Software sold for business use is exempt, while SaaS intended for personal use is taxable. For instance, if a SaaS product is sold exclusively to a commercial enterprise, it is not subject to tax. 

• Ohio: Ohio follows an inverse approach compared to Iowa—personal use SaaS is exempt, while business use SaaS is taxable. 

• South Carolina: South Carolina categorizes SaaS as a communication service for tax purposes. While the Department’s ruling in PLR #14-2 found that some SaaS products are non-taxable, other rulings have determined they are taxable, adding to the complexity. 

These variations highlight the complexity of SaaS taxability across states, requiring businesses to carefully analyze local tax laws to ensure compliance. A resource we rely on to help understand these nuances is Industry Sales Tax Solution (ISTS). For more information on their resource, check out this tool. 

Steps to Ensure Compliance 

Once the product is defined, you understand how each state views its taxability. How do you determine in which states you are subject to sales tax? To be subject to taxes in specific states, you must meet nexus requirements. Nexus is what connects a business to a tax authority. Once this connection is established, the business may be subject to the sales tax within that jurisdiction if the product is considered taxable in that state. 

However, nexus does not have one singular definition across all states with sales tax. With constant changes in how states define nexus, it is important to look at each state’s individual regulations when establishing sales tax nexus. The two primary types of nexus are physical nexus and economic nexus. Physical nexus is exactly what it sounds like, having offices, employees, or servers in a state. Although, it can also mean having inventory storage or participating in a trade show, which is why looking up the terms based on each state is so essential. 

Economic nexus is a more recent understanding of nexus, established by the 2018 South Dakota v. Wayfair decision. This ruling requires out-of-state sellers who do not have physical presence in the state, to register, collect, and remit sales tax if they meet requirements like a certain dollar or transaction threshold in that state.  

For more information on specific state’s economic nexus thresholds, click here. 

However, even if a business establishes nexus, it isn’t automatically required to register.  If everything the business sells is exempt, it might not need to be registered.  

Common Mistakes SaaS Businesses Make 

Staying compliant with sales tax is not a one-size-fits-all process and businesses cannot assume that exemptions will always apply. As more states expand their reliance on sales tax, broadening the tax base to include SaaS and other digital goods is trend.  Staying on top of these changes like the recent changes in Louisiana is critical.   

A notable example for understanding the importance of your categorization is a June 2024 New York ruling, where a SaaS company misclassified their product. The company believed that their vendor management system (VMS) was a non-taxable service when it was actually a taxable pre-written software. This error led to uncollected sales tax and compliance issues. (New York Tax Appeals Tribunal, DTA No. 829516, May 2, 2024) 

To mitigate these risks, SaaS businesses should: 

• Regularly review product classification to ensure compliance with current sales tax laws. 

• Determine the primary function of each transaction to identify whether software access is a taxable component. 

• Remain informed about evolving taxability changes to avoid unexpected sales tax obligations. 

Taking these proactive steps can help businesses avoid tax-related pitfalls and ensure ongoing compliance.  

Tools & Resources for Sales Tax Compliance 

There are several important tools to keep in your toolbox when it comes to keeping pace with sales tax laws, including: 

• Sales Tax Automation Tools: Platforms such as Avalara,  CereTax, and Vertex, Inc.,  offer options to mitigate the risk of noncompliance. From sales tax calculators and dedicated programs for simplifying sales tax to indirect tax software that automates compliance processes, options like these can make your business more efficient and streamlined.  

• State Tax Authority Websites: When it comes to sales tax, there is no greater authority than the states themselves. For a quick reference list of where to find state websites, click here. 

• Sales Tax Consultants: For a more personalized touch, contact a sales tax consultant. These professionals can assess your business and create a plan that addresses all your questions and concerns. For more information, check out the consulting side of Sales Tax Institute, YETTER Tax. 
• Industry Sales Tax Solutions (ISTS): This tool is the premier resource in determining the sales and use taxation of software, digital, and cloud services. You can get their state by state guide here.

Sales Tax & SaaS: Stay Informed, Stay Compliant 

Navigating sales tax compliance for your SaaS business may be challenging, but it is possible. Staying compliant requires keeping up with changes to your product classification, updates to nexus definitions, and evolving state rules on SaaS taxability. 

To ensure your business remains on the right side of tax regulations, take the time to check your sales tax obligations in each state where you operate. Leverage all the tools at your disposal, from research resources to state authority websites and having a dedicated sales tax consultant ensures your business remains on the right side of tax regulations.