US sales tax and economic nexus for software products
- Economic nexus and how it determines US sales tax
- Penalties and fines for not complying with US sales tax
- How software product makers can comply
- Exclusive state-by-state tax statistics for downloadable software and SaaS
Sales tax compliance challenges faced by software makers
US sales tax has become an escalating worry for software product makers and their businesses. Due to a significant court ruling, anyone selling software products in the US must collect sales tax based on where the customer is located, regardless of the business’s physical location.
This is just the beginning of the tax maze. Regulations, processes, and varying tax thresholds create hurdles that make compliance challenging for software sellers.
We delve into these complexities to help you tackle this many-faced administrative beast and protect your software business’s interests.
Understanding economic nexus & its impact on US sales tax for software products
Before the digital age, the ease of e-commerce, and a key court ruling, it was simpler for out-of-state sellers to determine nexus. Having brick-and-mortar assets like stores and offices in a state meant you were required to collect taxes there. This extended to flesh-and-blood assets too.
The following were the “accelerators” that ushered in the new era of economic nexus:
E-commerce Emerges
The growth of e-commerce spurred legislative changes as online retailers gained an advantage over local businesses by not collecting or submitting sales tax. This led to significant revenue losses for states, amounting to billions each year.
Supreme Court ruling
A major shift occurred with the 2018 Supreme Court decision in South Dakota v. Wayfair. The ruling allowed states to collect taxes from vendors without a physical presence but with an economic presence — or nexus — in a state.
New economic nexus laws
Today, software product sellers can “trigger” economic nexus by reaching a certain transaction or revenue threshold in a state. Most states set this threshold at $100,000 in sales or 200 transactions over the last 12 months. However, these thresholds can vary by state and jurisdiction, as we’ll explore in more detail later.
What are the penalties for software sellers who don’t comply with US sales tax?
States have the tools and authority to swiftly pursue and prosecute tax evaders. This is enforced by requiring software businesses to file tax returns in all states where they’re registered, even if they don’t owe any sales tax for that period.
Software product makers who don’t submit and collect sales tax will have to pay the owed amount, plus an average of 30% in fines and interest. Look to your right to see what this could mean for a software business making $50k per month over 5 years, with 70% of its customers in the U.S.
About 25% of sales are taxable for a typical software business in the U.S., totaling $525k in untaxed revenue
With an average 6% sales tax rate for downloadable software, the business faces a tax liability of $31.5k
The penalty is 10% of the tax due for the first month, plus 1% for each subsequent month, up to a maximum of 30%
This brings the total out-of-pocket cost to $41k
How software product makers can comply with US sales tax
Is your software product taxable?
First, find out if your software product is taxable in the states/jurisdictions where you sell. Once you have that info, you can look up the tax rates and economic nexus thresholds for those specific areas.
How do you register?
Once your software business hits the economic nexus threshold in a state or jurisdiction, you must register with the state’s tax agency to start collecting taxes. Remember, registration requirements differ across states, so it’s on you, as the business owner, to find out the specifics.
How is your software product taxed?
This is where things get tricky for software businesses. US sales tax laws vary for digital and software products. For accurate and detailed stats, we’ve gathered exclusive data further down this page.
When must you register?
In Texas, out-of-state businesses must complete registration by the first day of the fourth month after passing the threshold. In Rhode Island, you need to register, collect, and remit US sales tax by January 1st of the year after you crossed the threshold. It’s the responsibility of software product makers to stay informed about these deadlines.
Each of the fifty US states has unique sales tax laws and guidelines. Different jurisdictions exist within each state, each with specific tax rates and regulations, commonly known as local sales taxes. When state and local taxes are combined, the average sales tax rate in the US ranges from 0% to 9.55%.
To drive home the scope, Alabama alone has over 900 tax jurisdictions, and Texas exceeds 1,900. This shows how complex (and potentially overwhelming) US sales tax can be for software sellers.
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.
Amazon CEO
Overview of combined state and local sales tax rates, January 2022
As promised earlier, here are the state-by-state US sales tax rates we’ve gathered exclusively for software sellers and their businesses:
Steps for software sellers to achieve US sales tax compliance
To help you navigate the complexities of US sales tax, we’ve outlined practical steps to protect your software business, your products, and you as a seller. These tips are based on our experience managing cross-state and cross-jurisdictional sales tax for Freemius makers who sell software products.
- Does the state collect sales tax for software products?
- What are the economic nexus thresholds?
- Is your software product taxable, and what is the applicable tax rate? Note that this may differ for B2B and B2C software sales.
A merchant of record solution can handle the admin before it becomes a problem
Already feeling overwhelmed with sales tax-related tasks? Or dreading the hassle before it’s even begun?
Here’s how a merchant of record (MoR) can ease the admin (and the anxiety):
It takes care of all billing-related tasks, such as managing subscriptions and generating invoices
It manages all sales tax payments, ensures PCI compliance, and deals with fraud, refunds, and chargebacks
An MoR is responsible and liable for every payment made by customers buying software products
How Freemius supports software makers like you with US sales tax compliance
A managed platform like Freemius takes care of all your global and US sales tax responsibilities, letting you focus on developing awesome software products. As your merchant of record, Freemius assumes liability for sales tax compliance and other regulations like EU VAT, UK VAT, GDPR, LGDP, etc. If issues arise or we get things wrong, the responsibility falls on Freemius, so you don’t have to worry about it.
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.
Simply Static
Freemius works with US tax experts to correctly categorize products and determine the appropriate tax rate for each state and jurisdiction with an economic nexus threshold. We also manage subscription updates, monitor changes in sales tax rates, and handle all other compliance factors.
