Why US and foreign emerging companies should fear US sales tax

Some startup-focused blogs are fun to write, and founders like to read them.  Others are painful to write, founders really need to read them, and, very reasonably won’t want to.  This blog, unfortunately, falls into the latter class.

So let’s jump to the bottom line: 

• US and foreign startups are now likely to have an obligation to register for, and collect, sales tax from a much broader group of US customers than previously.
• Failure to comply may subject the companies and their officers/directors to liability for the unpaid tax, plus penalties and interest.
•  As a knock-on effect, this may delay capital raises and negatively affect exit transactions. 

Here’s why.

Background

We (Jeanne Goulet and Bob Mollen) first wrote about startup issues with US sales tax in 2016.  http://bit.ly/AvoidingSalesTaxTrap. Here is some recap of that discussion, plus an explanation why the problem for sellers has gotten much worse.

What is sales tax?

US sales and use taxes are transaction taxes imposed on customers at the state and local level. The applicable rules and amounts vary from state to state (and, indeed, locality to locality). If an item is subject to sales tax in the state, the ultimate customer is required either to (i) pay the sales tax to the seller, if the seller is registered to collect it, or (ii) pay an equal use tax directly to the state if the seller has not collected sales tax.

Larger business customers have generally complied with the requirement to pay use tax, not least because state tax authorities audit their compliance; individual customers making interstate purchases -- not so much.

Sales and use taxes typically are imposed on goods (tangible personal property); services mostly are not subject to sales tax.  

However, many states and localities (New York, for example) treat software as a service (SaaS) as standardized software -- they consequently impose sales and use tax on SaaS services. Needless to say, this is highly relevant to many b2b startups.

For our foreign readers: sales and use taxes differ from value added tax (VAT).  VAT is a tax on goods and services payable by each participant in a supply chain, but it is then recoverable in many circumstances except by the ultimate customer. Sales and use taxes, conversely, are imposed only at the ultimate point of sale, although intermediate parties in the chain may be forced to pay sales tax if they fail to establish their right to exemption.

When must a seller register for, and collect, sales tax in a particular state or locality?

A seller must collect sales tax from a customer in a relevant state and remit it to the state or local tax authority if: (a) what the seller is selling is subject to sales tax; (b) the customer is not exempt; and (c) the seller has sufficient nexus to the state as to permit the state or locality to require the seller to collect sales tax on its behalf.

Factors (a) and (b) above have not changed materially since we wrote our 2016 blog, although the list of states that treat SaaS as software has been expanding. 

What has changed, in a very important way, is the US approach to factor (c), and the expansion of what constitutes nexus.

The effect of this change is that US startups are likely to have nexus with a significantly greater number of states than before. 

Even more surprising, foreign startups that sell to US customers from abroad are likely to find that they may have nexus with a particular state or states, and are required to collect sales tax from customers in those states, even if they have no operations in the US.

So what is nexus today?

The physical nexus test and e-commerce. Prior to June 2018, a state could only require a seller to register to collect sales tax if the seller had a physical nexus with the state. That physical connection could be an office in the state, employees or independent contractors in the state, inventory in, or drop shipping from, the state, an agent or affiliate in the state, or potentially even temporary business activities in the state, like participation in a trade show in excess of a certain number of allowed days.

However, under this historical test of nexus, merely making a sale to someone in a state was not sufficient to provide nexus for sales tax purposes (NB: different tests have applied for corporate income tax or franchise tax -- this discussion relates only to sales tax).

So what changed? In a world where large amounts of commerce have moved to the internet, sales tax was not being collected on an increasing percentage of purchases involving interstate sales. For example, a consumer in Maryland who bought a laptop in California would not be charged sales tax by the California seller, and individual consumers were failing to pay use tax in an overwhelming percentage of such cases. As a result, states were losing significant sales tax revenue, and local retailers were competitively disadvantaged. While some large national online retailers made a decision to collect sales tax on a nationwide basis, many did not.

Economic nexus. In response to the large increase in e-commerce, the state of South Dakota passed a statute in 2016 requiring sellers with at least $100,000 of revenue or 200 transactions in the state to register to collect sales tax. This was contrary to a Supreme Court decision, dating back over 25 years, that had required physical nexus. A number of other states followed with similar legislation.

Several out-of-state retailers challenged the constitutionality of the South Dakota statute. 

However, by a 5 - 4 vote, the Supreme Court, in South Dakota v. Wayfair Inc., reversed its prior decision and upheld the South Dakota statute based on a theory of economic nexus.

As a result of the Wayfair decision, a further group of states have passed laws imposing a sales tax registration requirement on sellers based on an economic nexus test. As of December 2018, over 30 states reportedly have such provisions in place. The thresholds vary. For example, under New York law, the relevant threshold is at least $300,000 of revenue and 100 transactions. The Florida statute sets no minimum dollar amount or threshold number of transactions. It is not clear whether minimum thresholds are required for such a law to be upheld.

What is the effect?

The potential effects of this change are far-reaching. For example, previously foreign b2b SaaS startups selling into the US generally didn’t need to worry about US sales tax compliance until they were ready to set up in the US. US startups should have paid more attention (and would have had US tax advice in any case), but at early stage the practical risk may have seemed somewhat limited.

Now, though, both US and foreign startups may need to register for sales tax in multiple states at a much earlier stage. The failure to do so could subject them to an obligation to pay the tax due, penalties, and interest, potentially with no limit on the number of years that the state tax authority can look back. 

This issue is likely to come up in the context of buyer or investor due diligence, or when audited financial statements are prepared. 

Additionally, many states impose “responsible person” liability based on an individual’s “wilful failure” to comply with that state’s sales and use tax laws. Thus, notwithstanding the limited liability provided by operating through a corporation or company, officers and directors may have personal liability for unpaid sales tax, penalties and interest if they fail to collect, or remit, sales and use tax.

What to do?

1. This potentially is a compliance nightmare, but it can be managed.  Get early advice from tax advisors who are knowledgeable in this area on a nationwide basis, and keep that advice up to date.
2. Require your corporate customers to agree to pay use taxes and provide you with documentary evidence.  This won’t relieve the company of its own liability to collect and remit (so the company could still be subject to penalties and interest), but the taxing authority should not be entitled to receive double payment if your customer has, in fact, paid the appropriate “use” tax.
3. Use a service like TaxJar or Alvalara to help automate collection from customers, remittances to states and filings.

Conclusion

The Wayfair decision subjects US and foreign startups to a complex sales tax compliance burden.  There have been various proposals (preceding Wayfair) in the US Congress to facilitate eased collection of sales tax on a multi-state basis, but to date none have gained transaction. It remains to be seen whether Wayfair will provide renewed impetus for a rational approach to this problem.