It’s an exciting time for a technology entrepreneur when their company starts making a profit and grows large enough to catch the eye of a potential buyer. Not only does it show that hard work and dedication are paying off, but being considered for acquisition or investment is a sign of success and can open new opportunities for the company.
As standard financial and tax due diligence procedures get underway and the intended close date is on the horizon, unfortunately, one common issue that, if not addressed properly, can threaten the success of a sale is sales tax.
Sales tax reporting is a crucial component of the exit phase. The due diligence process often uncovers sales tax liabilities that often result in reducing the seller’s profits or jeopardizing the sale altogether. These tax 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
By understanding these critical concepts, you can avoid delaying or even losing out on a deal for your technology company.
What Is Nexus, and How Do I Determine if My Company Is Subject to It?
Nexus is a connection to a state that allows the state to impose sales tax collection obligations on your business’ transactions. There are two kinds of nexus to consider in your company’s analysis: physical and economic.
Physical Nexus
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. Remote employees can also create nexus in the state where they work. However, physical presence can also manifest in a variety of different ways, depending on the state.
For example, an employer creates nexus in most states by sending employees or independent contractors to customer locations outside of the company’s home state to conduct software implementation. Even if employees or independent contractors are only at a customer location for a few days, it can be sufficient enough to create nexus.
The Supreme Court of the United States (SCOTUS) case in Tyler Pipe v. Wash. Dept. of Rev., 483 U.S. 232 (1987) 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 representatives into a state typically creates sales tax nexus.
Economic Nexus
To further complicate the concept of nexus, the 2018 Supreme Court Wayfair ruling determined that physical presence is no longer the only way to create sales tax nexus.
A company will 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 easily reach $100,000 in sales with only a few transactions. The good news is that creating a nexus does not necessarily require sales tax collections. Many states do not impose tax on electronically downloaded software, Software-as-a-Service (SaaS) and associated services. However, discussing with your Sales Tax Advisor which states impose which requirements to ensure your company is filing properly and avoiding potential penalties is always recommended.
Can Sales Tax Be Charged on Services?
It is crucial that a clear understanding of the product or service sold is accurately classified for taxability purposes. Equally important to considering the actual product or service being sold is the language in client contracts and invoices. The last thing you want to happen is to sell a nontaxable product or service with contract language that implies a taxable product or service is being provided. In addition to this oversight, other risks can create bumps in the road. Consider the following scenarios:
- 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 the 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 first be downloaded. This sale is now taxable wherever SaaS or electronically downloaded software is subject to sales tax. Many more states tax electronically downloaded software than those that tax SaaS, although more and more states are beginning to tax SaaS.
- A company sells software and corresponding services and considers itself 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 that 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. Just one misclassification could result in significant exposure.
Do I Need To Collect an Exemption Certificate?
While not as complex as the other topics, the lack of exemption certificates is a common pitfall for many 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. The lack of required exemption certificates may expose the target company to liability and can stall the due diligence process.
Don’t Lose the Deal
The due diligence process is a major undertaking. Don’t put the time and expense you’ve invested in building your business in jeopardy by disregarding or minimizing the complexity of sales tax. Being proactive will give comfort to your buyer or investor that your business is running well and that there aren’t any sales tax skeletons in the closet. When done correctly, collecting sales tax is an administrative burden, not a tax the business bears. If, however, your business falls into one of the traps discussed above, that administrative effort can become a financial nightmare, ultimately impacting the transaction.
Sales Tax Consulting Services
Contact Cherry Bekaert’s Sales & Use Tax team to learn more about how to set up your technology company for financial success, particularly before a potential sale.
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