Are you in the business of selling software and similar products to consumers? Have you considered the different state rules on charging sales tax related to software sales? Your business may be liable for paying the sales tax even if you have not properly collected sales tax from your customers.
A common misconception for many companies is: software is considered intangible property and the company is not required to collect and remit sales tax on its software sales. However, most states have concluded that for sales and use tax purposes, software is often considered tangible personal property, and therefore, subject to sales tax. With the evolution of technology, there are many ways consumers can access software:
- Purchase software in tangible CDs
- Download software electronically
- Access software online
As a result, when it comes to sales tax related to software, there is never a simple answer. Companies selling software should remember and understand a few concepts.
Triggering Sales Tax Withholding Requirements
Sales tax nexus
The first step is to test if you have sufficient contact or nexus in a particular state. You have withholding and filing requirements on software sales when your activity triggers nexus in a specific state. Nexus is a term used to designate that a company has a legal presence in a state – in other words, the organization is doing business in the state. Generally, the following represents traditional activities that will create nexus in a state:
- Employing workers
- Owning or renting physical property
- Deriving income from within the state
Additional nexus creating activities often overlooked by businesses include:
- Having sales representatives soliciting sales in the state
- Providing services in the state
- Leasing a warehouse or storing inventories in the state
- Having a related party doing business in a state that uses similar trademarks, sells similar products, or performs other related activities
- Shipping products into the state using company vehicles
- Click-Through Nexus
As a result of these complexities, it is important that companies regularly analyze the business’ operations to determine if nexus has been established in a specific state. This includes researching state law changes and carefully monitoring your employees’ activities outside of your home state.
Taxable vs. tax-exempt property
After nexus has been determined in a particular state, the next step is to test if computer software you are selling is taxable or tax-exempt in that state. A few states, such as Hawaii, New Mexico, and South Dakota, have rules taxing all software sales. Even though no state exempts all software sales, Florida and Maryland have come close. While the specific rules vary depending on the state, many states tax some kinds of software and exempt others depending on whether they are canned, customized software, and the delivery method used.
Pre-written (Canned) Software
Pre-written software (also referred to as “canned” software) is computer software which is not designed by the creator of the software to the specifications of a specific purchaser. Generally, canned software is subject to sales tax in most states regardless of the delivery method, be it through a tangible medium, via load and leave, or electronic transfer.
There are always exceptions to the general rule. For example, Arkansas and South Carolina have ruled that prewritten computer software is subject to tax when it is delivered in a tangible medium, but it is exempt from tax if it is delivered electronically.
Mandatory or optional maintenance contracts for prewritten computer software are generally subject to sales tax.
Custom software is developed and designed to the specifications of a specific purchaser. Generally, this type of software is not subject to sales tax in most states, regardless of the delivery method.
Mandatory and optional maintenance contracts for custom software are generally not subject to sales tax.
More firms are transitioning to Software as a Service (SaaS) arrangements – i.e., cloud computing. These services allow businesses to access certain software remotely. The nexus issue relates to whether the company providing the software should collect and remit sales tax as a product sale or as non-assessed services. In our experience, the following questions will help in determining whether your business is required to charge and remit sales tax on SaaS arrangements:
- Does the business already have nexus in the state from other activities?
- Does the state consider cloud computing a service or the sale of a product?
- If cloud computing is considered a service, does the state tax services?
- Who controls the end product – the purchaser or the software company?
Bottom line is that numerous state taxing authorities have widened their nexus standards so that many more software companies now have sales tax obligations. Sales tax implications to a particular business are highly fact dependent. For more information on sales tax compliance, speak with your tax advisor or visit the individual state’s website.