Contributor: Chris Grimes, CPA
Congratulations! Your technology business is profitable and growing. There is expressed interest in an acquisition of the company. The standard financial and tax due diligence procedures are in full swing and everything appears to be going well. Then the topic of sales tax comes up days before the intended closing date and things take a turn for the worse.
Today, sales tax issues are one of the main reasons that acquisitions of technology businesses are stalled. Due diligence often uncovers sales tax liabilities that end up reducing the seller’s profits or jeopardizing the sale all together. These exposure issues result from a variety of issues including:
- Misunderstanding the concept of sales tax nexus
- Misclassifying revenue
- Not collecting the documentation to support exempt sales
In order to avoid putting your business in a situation where a deal is killed due to an unfortunate oversight, it is critical that these concepts are understood.
Misunderstanding Nexus
Nexus is a connection to a state that allows the state to impose sales tax on your business’ transactions.
Physical Nexus
Physical presence was first addressed in the Supreme Court of the United States (“SCOTUS”) case, National Bellas Hess v. Department of Revenue, 386 U.S. 753 (1967). Most businesses understand that operating a brick-and-mortar business in a state is a physical presence that establishes nexus which requires the company to register and collect sales tax for taxable sales. However, physical presence also can be created a variety of different ways, depending on the state.
For example, nexus can be created in some states when an employer sends employees or independent contractors to customer locations outside of the home state to conduct software implementation. Even if employees or independent contractors are only at a customer location for a few days, this will be sufficient to create nexus per SCOTUS case Tyler Pipe v. Wash. Dept. of Rev., 483 U.S. 232 (1987). This case stated “the crucial factor governing nexus is whether the activities performed in the state on behalf of the company are significantly associated with its ability to establish and maintain a market in the state for its sales.” Since these implementation services are required to complete a sale of the software provided by the company, an obligation to register and report sales tax on taxable sales could be created. Similarly, sending salespeople or even third party sales reps into a state typically creates sales tax nexus.
Economic Nexus
To complicate the concept of nexus, as of June 21, 2018, the Supreme Court determined in South Dakota v. Wayfair, Inc., 138 S. Ct. 2080 (2018) that physical presence is no longer the only way to create sales tax nexus. A company can create nexus in a state by merely exceeding certain economic thresholds set by a state. The most common threshold is $100,000 in sales or 200 transactions. Most software companies can reach $100,000 in sales with only a few transactions. The good news is that the creation of nexus does not necessarily mean sales tax collections are required. Many states do not impose tax on electronically downloaded software, SaaS, and associated services.
Misclassifying Revenue
It is crucial that a clear understanding of the product being sold is appropriately mapped for taxability purposes. Not only should you consider the actual product or service being sold, but also give consideration to the language in the client contracts and invoices. The last thing you want to happen is to be selling a nontaxable product or service and the contract language implies a taxable product or service is being provided. In addition to this oversight, a few other risk areas are as follows:
- A company is marketed as a service provider. The company uses software to perform a multitude of services, however remote access to software with some degree of functionality is also provided to the customer. While services are considered nontaxable in many states, bundling services with the sale of software may result in a taxable transaction.
- A company is marketed as selling cloud based software, which is partially correct, however in order to access this software, an application with various forms of functionality must be downloaded. This sale is now taxable wherever SaaS or electronically downloaded software are subject to sales tax. Many more states tax electronically downloaded software than tax SaaS.
- A company sells software and corresponding services. The company considers themselves a provider of professional services. These “professional services” include installation, training, deployment, testing and support services. Most states will consider these sales to be implementation services, rather than professional services. Given these implementation services are required to complete the sale of electronically downloaded software or SaaS, they may be subject to sales tax.
As you can see, many pitfalls can arise when classifying revenue for taxability purposes. One misclassification could result in significant exposure.
Exemption Certificates
While not as complex as the other topics, lack of exemption certificates is a common pitfall seen with almost all businesses. In short, when selling taxable property/services for resale to non-profits, state governments or educational institutions, either sales tax or a resale/exemption certificate should be collected, with some exceptions. Lack of required exemption certificates may open up the target company to liability and can stall the due diligence process.
Avoid Killing the Deal
Going through due diligence is a major undertaking. In order to avoid ending up in a situation where significant time and expense have been invested just to have a deal fall apart, be proactive when it comes to sales tax. If handled right, sales tax is an administrative burden and not a tax upon the business (it is your customer’s tax). However if your business falls into one of these traps discussed above, that administrative effort can become a financial nightmare affecting the sale of the company.
If this scenario sounds familiar and you would like to discuss due diligence or other sales tax matters, contact Cherry Bekaert’s Sales Tax Team.
