SaaS and Digital Services: Texas Sales Tax Nexus and Audit Exposure

Companies that provide software as a service (SaaS) and other digital services to customers in Texas must ensure that they comply with the state’s sales tax laws. While many services are exempt from sales tax under Texas law, SaaS and certain other digital services are not.

Since noncompliance with Texas’ sales tax laws can expose developers and other companies to substantial liability (including liability for interest and penalties), an informed approach to compliance is essential. For those that are not in compliance, it is also essential to make informed decisions about coming into compliance and preparing for the possibility of a Texas sales tax audit.

Texas’ Sales Tax Rules for SaaS and Other Digital Services

In Texas, there are 16 categories of “taxable services” that are subject to the state’s sales tax requirements. Companies that sell taxable services must comply with these requirements if they have either “physical nexus” or “economic nexus” with the state.

A company can have physical nexus based on various factors—from maintaining an office in Texas to having in-state sales representatives or a phone number that is answered in the state. It is not unusual for a company to have physical nexus without realizing it. Economic nexus is based exclusively on having annual in-state sales of $500,000 or more. Crucially, this threshold applies to both taxable and non-taxable revenue—a factor that can be critical for many service-based businesses.

One of the 16 categories of taxable services in Texas is “data processing services.” As the Texas Comptroller explains, data processing services can take many forms, including (but not limited to):

• Accounts payable or receivable preparation
• Application services
• Data conversion
• Data storage
• Software as a service (SaaS)
• Web hosting
• Website creation and maintenance

Again, this list is not exclusive. While the Texas Comptroller clarifies that “[m]erely using a computer as a tool to help perform a professional service is not a data processing service,” digital services can take a variety of other forms as well, and this makes it important for all digital service providers to assess their Texas sales tax compliance obligations based on their unique circumstances.

The first 20 percent of any charges for data processing services are exempt from Texas state sales tax. Otherwise, SaaS providers and other covered digital service providers must collect and remit Texas sales tax if they have either physical nexus or economic nexus (or both). Those that fail to comply with Texas’s sales tax laws can face consequences, including:

• Liability for all unpaid sales tax (regardless of whether the business separately collected sales tax from its customers)
• Interest on unpaid sales tax (interest begins to accrue 61 days after the due date for Texas sales tax)
• Penalties on unpaid sales tax (a 5-percent penalty applies to sales tax that is up to 30 days past due, while a 10-percent penalty applies to sales tax that is more than 30 days past due)

The Texas Comptroller can pursue various means of collection, and nonpayment of Texas sales tax may also result in criminal penalties in some cases. Knowing and intentional violations of Texas’s sales tax laws can potentially expose business owners, executives, and other individuals to fines and prison time.

Managing Texas Sales Tax Compliance for SaaS and Digital Service Providers

With all of this in mind, what can (and should) SaaS companies and other digital service providers do to effectively manage Texas sales tax compliance? The first step is to confirm that the company’s services qualify as “taxable services” under Texas law. While SaaS and other digital services will generally qualify, certain types of services may involve legitimate questions of taxability.

If a business sells SaaS or other taxable services in Texas, the next step is to conduct a nexus assessment. Does the business have physical nexus or economic nexus (or both)? If the business has a physical nexus but is located out of state, is it possible to eliminate the business’s in-state connections to avoid the need to maintain Texas sales tax compliance in the future?

If an Saas company or another provider of taxable digital services has (or has previously had) nexus with Texas, then it will be necessary to assess the business’s Texas sales tax compliance record. If the business is not in compliance, it will need to quickly take the necessary steps to begin managing compliance going forward (unless and until it terminates its nexus).

Coming Into Compliance Under Texas’ Sales Tax Laws

Businesses that are not in compliance with Texas’s sales tax laws will need to develop a plan for coming into compliance as well. Generally, this will involve working with local tax counsel experienced in resolving Texas state tax controversies. As discussed above, the consequences of failing to collect and remit Texas sales tax can be severe, and proactively coming into compliance can be critical for avoiding unnecessary liability.

Preparing for a Texas Sales Tax Audit

If you have questions about Texas sales tax nexus because your company has received an audit notice from the Texas Comptroller, it is too late to come into compliance proactively—and you will need to promptly begin preparing to defend against the audit. Regardless of a company’s compliance record, facing a Texas sales tax audit requires an informed and cautious approach.

Engaging experienced local tax counsel is essential here as well. An attorney experienced in dealing with the Texas Comptroller will be able to provide strategic advice and representation focused on resolving the audit as efficiently as possible and without unnecessary consequences. Of course, there are no guarantees, and taking prompt action is essential to preserving the company’s options for executing a strategic defense.

Speak with an Experienced Texas Sales Tax Attorney at Our Offices in Confidence

If you need to know more about SaaS companies’ and other digital service providers’ Texas sales tax obligations (or the risks of facing a Texas sales tax audit), we invite you to get in touch. To speak with an experienced Texas sales tax attorney at Brown PC in confidence, please call 888-870-0025 or request an appointment online today.