US Sales Tax and Economic Nexus 
A comprehensive analysis covering everything software product makers need to know about compliance with US sales tax laws
- Economic nexus and how it determines US sales tax
- Penalties for non-compliance with US sales tax
- Steps software product makers must take to comply
- Exclusive state-by-state tax statistics for SaaS
and downloadable software
US Sales Tax: Compliance Challenges for Software Founders
US sales tax is a growing concern for software product makers and SMBs. Following a court ruling with far-reaching implications, any person selling software products in the US is now obligated to collect sales tax based on a customer’s location, regardless of where the business’s physical presence is.
This is just the tip of the tax iceberg, with regulations, processes, and varying thresholds throwing up obstacles that make it challenging for WordPress and SaaS developers to achieve compliance and protect their business interests.
It’s these complexities we’ll explore to help you understand and tackle this many-faced administrative beast.
Twofold Tax Conundrum
What Is Economic Nexus and How Does It Determine Your US Sales Tax?
Before the digital era and the game-changing court ruling, it was relatively easy for out-of-state sellers to find out if they had nexus — having physical business assets like stores, offices, employees, etc. meant you needed to collect taxes in those states.
If you had three warehouses in three different states, you’d have three nexuses.
Rise of eCommerce
The rise of eCommerce accelerated legislative reform because internet-based retailers were gaining an edge over local businesses by not having to collect or submit sales tax. As a result, states and their jurisdictions lost out on taxable income that amounted to billions of dollars annually.
Supreme Court Ruling
Sweeping change began with a 2018 Supreme Court ruling in the South Dakota v. Wayfair case. The revision meant that US states were now entitled to collect taxes from vendors who did not have a physical presence in a state but conducted business within it (I.E. an economic presence or nexus).
Economic Nexus Laws
Today, software product sellers will ‘trigger’ economic nexus when a specific transaction or revenue threshold is reached in a certain state:
- Most states have an economic nexus threshold of $100,000 or 200 transactions over the past 12 months of sales activity
What Are the Penalties for Non-Compliance With US Sales Tax?
States have the resources and power to swiftly prosecute tax dodgers. This is enforced by making it mandatory for software product businesses to submit tax in all states where they’re registered, regardless of whether they owe any sales tax in that period.
Software product makers who fail to submit and collect will be responsible for settling the outstanding sales tax amount with an average of 30% in added fines and interest. The below infographic calculates what this could look like for a business turning $50k per month for 5 years, with 70% of its customers in the United States.
- Approx. 25% of sales are taxable for the average business selling software in the US
- This amounts to $525k for which taxes were not paid
- An average 6% sales tax rate for downloadable software leaves the business in exposure of $31.5k
- The penalty is 10% of the tax due for the first month, plus 1% for each additional month or part of a month not exceeding 30%
- That’s $41k of taxes to be paid out of pocket
If the business were to scale to $100k per month, that’s $82k in exposure, which will grow in parallel with your business.
How Software Product Makers Can Comply With US Sales Tax
1
Determine Rules and Registration Processes for States in Which You Sell
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Is Your Software Product Taxable?
You need to understand if your software product is even taxable in the jurisdictions/states you sell. Once you know, you can determine the tax rates and economic nexus thresholds of the various states and jurisdictions that do tax them. -
How Can You Register?
Once a software business crosses the economic nexus threshold in a state, the developer/business owner is obligated to register at the state agency to collect taxes. To reiterate: the requirements for registration can vary from state to state, so the onus is on you as the product/business owner to source the details. -
When Do You Need to Register?
In Texas, for example, businesses from outside of the state must finalize registration by the first day of the fourth month after crossing the threshold. In Rhode Island, you have until January 1st of the year your business passed the threshold to register, collect, and remit US sales tax. Again, it’s up to software product makers to find this information. -
How Is Your Software Product Taxed?
What you’re selling also influences the compliance process — US sales tax laws are applied differently to digital products and SaaS products. For comprehensive, accurate numbers related to this, we’ve provided exclusive stats and research further down 😉
2
Research Your States and Jurisdictions to Calculate Tax Rates
There are fifty US states, each with its own sales tax laws and regulations. Each state has jurisdictions and every jurisdiction has specific tax rates, regulations, and registration processes. These are also known as local sales taxes. The combination of state-based and local sales tax sets the current average sales tax rate in the US between 0% and 9.55%.
Sales tax is horrendously complicated
The problem is that there are tens of thousands of separate sales tax jurisdictions, it’s not just 50 — one for each state. The rules to obey in all jurisdictions are overly complex. Source
Jeff Bezos
Amazon CEO
To give you an idea of the scope, Alabama has over 900 tax jurisdictions and Texas 1,900+. To give you an even better idea of the scope, check out the combined state and average rates for the entire country, as well as which states have economic nexus and which states tax digital goods 👇
Combined State and Average Local Sales Tax Rates, January 2022
City, county and municipal rates vary. These rates are weighted by population to compute an average local tax rate. The sales taxes in Hawaii, New Mexico and South Dakota have broad bases that include many business-to-business services. D.C.'s rank does not affect states' ranks, but the figure in parentheses indicates where it would rank if included.
Check out the state-by-state US sales tax rates:
Practical Steps for Software Product Makers to Reach US Sales Tax Compliance
There’s a lot to grasp here and we’d be remiss for not providing concrete, practical steps that you can take to safeguard yourself and your software business. The below steps are based on our experience of handling cross-state, cross-jurisdictional US sales tax for Freemius partners, who are selling downloadable software, subscriptions, and SaaS.
1
Identify the jurisdiction of every sale, which at minimum would require asking customers for their zip codes.
2
Map out a framework between zip codes and states.
3
For every state, determine the following:
- Does the state collect sales tax?
- What are the economic nexus thresholds?
- Is the product you’re selling taxable and what is the tax rate? This differs between B2B and B2C sales
4
Where your software products are taxable, monitor the transaction count and sales volume for states that have an economic nexus. If you’ve reached the threshold in the previous 12 months, current calendar year, or previous calendar year (as mentioned, it differs by state), you’ll need to register in the state for sales tax.
5
Once registered, collect sales taxes in those states. For active subscription renewals, analyze your subscriptions database and update all relevant subscriptions so that when a renewal is processed in a jurisdiction you’re registered in, the sales tax amount will be added to the renewal. Don’t forget to inform affected customers about the additional sales tax in advance.
6
Simultaneously, monitor state tax changes and other updates. For instance, a state can adjust its economic nexus threshold, start putting sales tax on software, or implement other criteria that would be better handled by an accountant or a sales tax person than yourself. Each time an amendment takes place, update your system and evaluate the impact on your subscriptions.
That’s a lot to digest, but thankfully there are viable routes to take instead of dealing with everything yourself.
How to Avoid the Hassle of US Sales Taxes
A Merchant of Record Solution Can Solve the Headache Before It Begins
Already dealing with administrative stress? Or are you trying to nip it in the bud before it begins? Here’s how a Merchant of Record (MoR) can help:
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It handles all billing-related administration, like subscriptions and invoicing.
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An MoR is liable for every payment made by buyers purchasing software products or SaaS.
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It keeps track of and compiles all due sales tax payments, assures PCI compliance, and handles fraud, refunds, and chargebacks.
Although a company can be its own MoR, handling payments, compliance, and associated liabilities is resource-heavy and time-consuming. This is especially true for smaller software companies, where product development and growth are the main priorities, and establishing the infrastructure and processes needed to become an MoR just wouldn’t make business sense.
In the vast majority of cases, it makes sense for software SMBs and product-making solopreneurs to use an MoR service provider to bear the tax burden and related administration for them.
How Freemius Helps Software Product Makers Like You With US Sales Tax
Without Freemius, I wouldn't even sell WordPress plugins.
There is almost no way around having a merchant of record to collect and manage taxes worldwide as a company from within the EU. You would most likely need a full-time contractor to handle that, and paying the revenue share to Freemius is nowhere near the typical salaries here.
Patrick Posner
Simply Static
Are you concerned that you’ve crossed an economic nexus threshold (or several), and in turn neglected to collect or pay your taxes?
A managed platform like Freemius can handle all of your global and US sales tax affairs so that you can focus your time and energy on developing awesome software products. As a Merchant of Record, we are liable for sales tax compliance (and many other regulations like EU VAT, GDPR, LGDP, etc.). If we get things wrong, this liability is our problem and you simply don’t need to worry about it.
Freemius works with US tax experts to determine the correct product categorization and required tax rate in each state and jurisdiction that has an economic nexus threshold. We also take care of updating subscriptions, monitoring sales tax rate changes, and all other compliance factors.
US Sales Tax and Economic Nexus
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