A couple of weeks ago we started a series about the nuances of state taxes as they apply to various technology industry niches. Today we continue by focusing on software companies and multi-state tax issues they face including nexus, sales and use tax, state tax legislation and more.
An Overview of Software Companies
Software companies make up a significant part of the technology sector. Software refers to, “The programs used to direct the operation of a computer, as well as documentation giving instructions on how to use them.” The software industry has certainly changed over the years – from the days of companies selling software on disks or other media, to today’s digital downloads of software, and even software as a service (SaaS), which is becoming very prevalent.
As Investopedia explains, software companies can provide a wide variety of products and services such as, “Software license sales, maintenance services, subscription fees, and other support services.”
Top players in the ‘software companies’ niche include the following – many of which are based in Silicon Valley:
- Microsoft
- Oracle
- International Business Machines (IBM)
- SAP
- Symantec
- EMC
- Hewlett-Packard
- VMWare
- CA Technologies
- Salesforce.com
Software Companies’ State Tax Issues
At Miles Consulting, we see several state tax issues relating to software companies, some of which we’ve explored before, like nexus.
- Nexus: Even though many software companies don’t offer physical products, they must still answer the question about whether the company creates a physical presence in a state, such that they are subject to the state’s taxing rules. As such, software companies face the same questions we ask other companies including:
- Do you send employees into multiple states for sales activities, training, installation or anything else?
- Do you have servers (or rent server space) or other property in other states?
- Sales Tax: The sales tax ramifications specific to software companies cover a few areas. First, “canned software” is generally subject to sales tax, while “custom software” is generally exempt from sales tax in most states. Canned software is defined as something you can truly just buy off the shelf at an office supply store, or even very expensive software that you’d buy from an independent vendor. Even if there is some customization involved, most software, unless it has been created especially for one company is taxable (most states have taken the position that software is a tangible thing). That said, separately billed charges for customization may be non-taxable – depending on the state and how the company is billed. In dealing with software companies, you must also ask the question – how is it delivered? Generally, if it’s delivered in a box, with a book or disk, or other tangible property included it’s taxable. If the software is downloaded electronically it may be exempt in certain states. But be careful – some states tax software irrespective of how it’s delivered.
- Income Tax: As with other technology sectors, software companies often don’t have to deal with state income tax issues in their first few years. Many of those years involve much investment in research and development costs and ultimately net operating losses! As such, it is important to take advantage of any federal and state R&D tax credits available, as well as to properly allocate the NOLs (net operating losses) to the correct states.
How Miles Consulting Assists Software Companies
When we work with software companies that come to us as new clients, we often see similar misconceptions from them about their state tax ramifications. Nexus is often an issue. Growing software companies often send salespeople out across the country to demonstrate products, make sales, etc. We often get the question – how much touch is enough to create nexus? And the answer, of course, is, “It depends.” It’s a gray area, but sometimes you can look to materiality to gain some comfort (or to assist in making the decision). For instance, if you sold a $1M software contract to a client in State Y, but you only went there one time, is that enough to create nexus? Alas, that question is asked all the time. And again, it could vary between the states.
We also spend a fair amount of time talking to our software clients about their method(s) of delivery, and the specifics of how they bill for their product. Line items for the software license, related maintenance (whether mandatory or optional) or any consulting services may all be taxed in different ways. Once those items are examined by state, we can assist the client with correcting any deficiencies and possibly applying some other best practices so that they can avoid issues going forward.
As with so many things related to multi-state taxation, it’s important to remember that what is good for one state may not be good for another. So companies expanding their footprint quickly will want to carefully analyze the issues above in multiple states. And we can help with that!
As you can see, there are a lot of complexities surrounding software companies and multi-state tax issues. Curious how other technology niche industries are affected? Stay tuned for the next post in our series!
Miles Consulting Group, Inc. is a professional service firm in San Jose, California specializing in multi-state tax solutions. Our firm addresses state and local tax issues for our clients, including general state tax consulting, nexus reviews, tax credit and tax incentive maximization, income tax and sales/use tax planning and other special projects, including the new California Partial Manufacturer’s Exemption for Sales Tax. To learn more, contact us today at www.MilesConsultingGroup.com.
