6 tax-related do’s and don’ts for SaaS startups in 2023

6 tax-related do’s and don’ts for SaaS startups in 2023

1. Don’t assume that sales taxes are inapplicable

Many software manufacturers incorrectly assume that sales tax does not apply to transactions. The rules can differ significantly depending on whether you are selling traditional software, SaaS, or a hybrid product, and, more importantly, how the taxing jurisdiction at issue defines your product or service.

Accordingly, the safest bet is to assume that unless there is some exception, “Uncle Sam,” or more likely his smaller state relatives, will always want to tax the transaction.

Most states treat prewritten (“canned” or “off-the-shelf”) software as tangible personal property and subject to applicable sales and use taxes. This is generally true regardless of whether (1) the software is obtained via tangible media or downloaded or (2) the transaction is labeled a sale or lease.

In contrast, some states, for example, California and North Carolina, only tax prewritten software that is received in tangible form or can be downloadable into a tangible form (e.g., customers can back up the program to their own equipment).

Having your contract periodically reviewed by a technology and a tax attorney is important to help minimize the liability that could result from not being compliant with the tax laws.

The state taxability of custom software generally is dependent on whether the state taxes personal services. For example, Arizona, California, and Texas all generally exclude custom software from the tax base, but the District of Columbia, New Mexico, and Tennessee do tax custom software. This tax treatment is generally the same in situations where prewritten software is customized for a client. Some states will even tax the entire transaction, not just the value of the customizations.

To make matters even more complicated, there are often different tax treatment for SaaS. While a state like Missouri currently exempts both custom software and SaaS from taxation, other states, like Kentucky, tax the SaaS but exempt custom software. Yet other states like Texas treat SaaS as data process services that are taxable at a special rate.

As you can see, understanding the taxation related to software products and SaaS services is incredibly complex.

2. Don’t ignore or rely on “boilerplate” contract provisions

All too often, business executives gloss over commercial contract provisions that they deem to be boilerplate or otherwise “standard” provisions. In reality, these provisions can have extensive consequences for both software manufacturers and customers alike.

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