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Breaking down sales and use tax compliance for SaaS companies

06.28.22

Read this if you have offices in more than one state or are a SaaS company.

For many software-as-a-service (SaaS) providers, sales tax compliance remains a challenge. Approximately 20 states currently subject SaaS to tax, and taxability varies from state to state, which impacts many SaaS companies that scale rapidly and unknowingly expand their nexus footprint into these states.

In South Dakota v. Wayfair, Inc., the Supreme Court held that states may assert nexus on an out-of-state business that exceeds a reasonable economic threshold, whether or not the business has physical presence in the state. The 2018 ruling is particularly impactful to SaaS companies because:

  • Cloud-based offerings are delivered electronically without the need for in-state presence.
  • Following the decision, all states have enacted some form of legislation that adopts an economic nexus threshold (typically, this threshold is $100,000 in sales or 200 transactions).
  • With Wayfair standards now in place for over three years, historical noncompliance is becoming more material, and states are expected to increase enforcement.

The issue of sales tax compliance has become more pressing now for two key reasons:

First, liabilities and exposures are cumulative, and material exposures may continue to mount for companies that are noncompliant. This is especially relevant for companies that have failed to adhere to the Wayfair nexus standards. In addition, the increasing presence of remote employees will expand the nexus footprints of many technology companies that offer flexible work arrangements.

Second, while tech M&A activity is expected to slow for the remainder of 2022, some SaaS firms may still be looking to sell or raise capital. Sales tax exposure will remain a priority consideration during the due diligence process for any strategic deals taking place. Due to the short lifecycle of most technology companies, tax due diligence is key in preparing for an exit or capital raise.

The impact of evolving tax policy

An increasing number of states are amending the statutory definition of taxable services to include SaaS or are categorizing SaaS as taxable “tangible personal property.” For example, Maryland recently enacted legislation that imposes sales tax on certain digital products, including SaaS.

Adding to the complexity, states often construe certain technology-based services as taxable SaaS. For example, state administrative guidance and case law may interpret online advertising and data analytics services as taxable SaaS if software is the predominant component of the offering. Also, as noted above, the state-by-state treatment varies widely. For instance, New York aggressively subjects cloud-based offerings to sales tax, whereas California does not subject SaaS or electronically downloaded offerings to sales tax.

Remote work

The recent adoption of remote-work models further complicates the determination of nexus and sales tax obligations, as companies hire employees in states where they have not previously had a physical presence. The vast majority (84%) of all technology businesses surveyed in BDO’s 2022 Technology CFO Outlook Survey expect to see some impact on their total tax liability as a result of onboarding out-of-state remote workers.

The presence of in-state employees is a nexus-creating activity irrespective of whether the company’s sales exceed economic nexus thresholds. Therefore, if a SaaS company has employees working in a different state than its headquarters, it is critical to track employee start dates by state and consider the potential sales tax obligations.

Understanding your risk exposure

In an exit scenario, CFOs don’t want surprises, and buyers don’t want to absorb liabilities. SaaS companies must carefully analyze their sales and use tax posture in the deal context to understand risks and proactively address any shortcomings. Failure to adopt appropriate tax compliance procedures at the onset of nexus-creating activities can lead to a material exposure.

Given the complex nature of SaaS sales tax, technology companies must address compliance in a step-by-step phased approach:

  • Nexus study
    An initial nexus study consists of an examination of a company’s state specific activities in determining whether it has a filing obligation in various states. This includes an analysis of both physical presence (e.g., property, payroll, in-state services, etc.) and state-by-state economic nexus standards.
  • Taxability analysis
    Once the company’s nexus profile is established, a comprehensive taxability analysis is required to determine whether the states identified in the nexus study subject SaaS and other ancillary services to sales tax. Depending on the nature of the company’s offerings, this may involve in-depth research on a state-by-state basis. For instance, if the company is providing a technology-based service that is potentially classified as a nontaxable service rather than SaaS, research in the material states is required to develop a supportable position. In addition, the taxability process will include an assessment of potential mitigating factors, such as tax-exempt customers, sale-for-resale exemptions and use tax remittance, on a customer-by-customer basis.
  • Potential exposure quantification/remediation
    If the company has nexus in states that subject its offerings to tax, the exposure should be quantified to determine the magnitude of exposure in those states. This will help to determine whether to proactively remediate the exposure through participation in state voluntary disclosure programs. Voluntary disclosure participation allows a company that is historically noncompliant to pay the applicable back taxes in exchange for a limited lookback period (typically three to four years) with the waiver of penalties. 
  • Sales tax compliance automation
    Once the company has addressed its potential exposure in the applicable states, it will have a subsequent filing obligation. Depending on the complexity, an automated sales-tax solution is often recommended to assist with the nexus, taxability and filing compliance going forward. An automated solution often increases efficiencies, saves time and helps mitigate tax compliance risk. 

Developing a plan to address sales tax prior to undergoing a diligence process is key to better understanding and controlling the compliance process. Failure to do so may lead to material escrow or purchase price allocation to remediate a sales tax issue that could have otherwise been prevented. 

Way forward

Understanding state and local taxes (SALT) can make a big difference for technology companies, especially SaaS businesses. Non-compliance with tax standards could lead to financial risks and even affect customer relationships.

There is ample M&A opportunity to consider in 2022, with valuations leveling off and cash reserves ready to be spent. Nearly two-thirds of tech firms (65%) plan to buy, sell, or partner this year, according to BDO data. Tech companies should prepare for deal making by being proactive about sales and tax compliance. Not doing so can block deals in the pipeline, as buyers and investors are keenly aware of tax compliance obligations.

Consulting a third party on SALT compliance, especially regarding economic nexus standards and taxability, may help SaaS firms receive the full value of their companies, mitigate exposure and liability, and empower company leaders to feel prepared when it comes time to sell.

If you have questions about your specific situation, please contact our Consulting and Compliance team. We're here to help.

Written by Angela Acosta, Thomas Leonardo, and Matthew Dyment. Copyright © 2022 BDO USA, LLP. All rights reserved. www.bdo.com

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  • David Erb
    Principal
    Manufacturing, Technology
    T 207.541.2255

BerryDunn experts and consultants

So far in our value acceleration article series, we have talked about increasing the value of your business and building liquidity into your life starting with taking inventory of where you are at and aligning values, reducing risk, and increasing intangible value.

In this article, we are going to focus on planning and execution. How these action items are introduced and executed may be just as important as the action items themselves. We still need to protect value before we can help it grow. Let’s say you had a plan, a good plan, to sell your business and start a new one. Maybe a bed-and-breakfast on the coast? You’ve earmarked the 70% in cash proceeds to bolster your retirement accounts. The remaining 30% was designed to generate cash for the down payment on the bed-and-breakfast. And it is stuck in escrow or, worse yet, tied to an earn-out. Now, the waiting begins. When do you get to move on to the next phase? After all that hard work in the value acceleration process, you still didn’t get where you wanted to go. What went wrong?

Many business owners stumble at the end because they lack a master plan that incorporates their business action items and personal action items. Planning and execution in the value acceleration process was the focus of our conversation with a group of business owners and advisors on Thursday, April 11th.

Business valuation master plan steps to take

A master plan should include both business actions and personal actions. We uncovered a number of points that resonated with business owners in the room. Almost every business owner has some sort of action item related to employees, whether it’s hiring new employees, advancing employees into new roles, or helping employees succeed in their current roles. A review of financial practices may also benefit many businesses. For example, by revisiting variable vs. fixed costs, companies may improve their bidding process and enhance profitability. 

Master plan business improvement action items:

  • Customer diversification and contract implementation
  • Inventory management
  • Use of relevant metrics and dashboards
  • Financial history and projections
  • Systems and process refinement

A comprehensive master plan should also include personal action items. Personal goals and objectives play a huge role in the actions taken by a business. As with the hypothetical bed-and-breakfast example, personal goals may influence your exit options and the selected deal structure. 

Master plan personal action items:

  •  Family involvement in the business
  •  Needs vs. wants
  •  Development of an advisory team
  •  Life after planning

A master plan incorporates all of the previously identified action items into an implementation timeline. Each master plan is different and reflects the underlying realities of the specific business. However, a practical framework to use as guidance is presented below.

The value acceleration process requires critical thinking and hard work. Just as important as identifying action items is creating a process to execute them effectively. Through proper planning and execution, we help our clients not only become wealthier but to use their wealth to better their lives. 

If you are interested in learning more about value acceleration, please contact the business valuation services team. We would be happy to meet with you, answer any questions you may have, and provide you with information on upcoming value acceleration presentations. 

Article
Planning and execution: Value acceleration series part four (of five)

The US Department of the Treasury and the Internal Revenue Service on November 29 announced the release of guidance providing taxpayers information on how to satisfy the prevailing wage and apprenticeship requirements to qualify for enhanced tax benefits under the Inflation Reduction Act’s clean energy provisions. 

The publication of Notice 2022-61 and further guidance in the Federal Register—published on November 30, 2022—begins the 60-day period for these key labor provisions to take effect. In other words, these requirements will apply to qualifying facilities, projects, property, or equipment for which construction begins on or after January 30, 2023. So, in order to receive increased incentives, taxpayers must meet the prevailing wage and apprenticeship requirements for facilities where construction begins on or after January 30, 2023.

Prevailing wage and apprenticeship requirements

The Inflation Reduction Act, which President Biden signed into law on August 16, 2022, introduced a new credit structure whereby many clean energy tax incentives are subject to a base rate and a “bonus multiplier” of 5X. To qualify for the bonus rate, projects must satisfy certain wage and apprenticeship requirements implemented to ensure both the payment of prevailing wages and that a certain percentage of total labor hours are performed by qualified apprentices. 

Projects under 1MW or that begin construction within sixty days of the date when the Treasury publishes guidance regarding the wage and apprenticeship requirements are automatically eligible for the bonus credit.

The newly released guidance addresses the Inflation Reduction Act's two labor requirements—providing prevailing wages and employing a certain amount of registered apprentices—that taxpayers must meet for clean energy developments to qualify for the bonus rate. Both the prevailing wage and apprenticeship requirements apply to the following tax incentives:

  • Advanced energy project credit
  • Alternative fuel refueling property credit
  • Credit for carbon oxide sequestration
  • Clean fuel production credit
  • Credit for production of clean hydrogen
  • Energy-efficient commercial buildings deduction
  • Renewable energy production tax credit
  • Renewable energy property investment tax credit

The prevailing wages requirements also apply to the following tax incentives:

  • New zero-efficient home credit
  • Zero-emissions nuclear power production credit

New guidance

The new guidance describes the process for identifying the applicable wage determination for a specific geographic area and job classification on the Department of Labor’s sam.gov website. If no prevailing wage determination is posted for a specific geographic area and/or job classification, the notice provides that taxpayers should contact the DOL’s Wage and Hour Division, which would then provide the taxpayer with the labor classifications and wage rates to use.

For purposes of the apprenticeship requirements, the guidance provides specific information regarding the apprenticeship labor hour, ratio, and participation requirements. The guidance also describes the good faith effort exception, whereby a taxpayer will be deemed to have satisfied the apprenticeship requirements with respect to a facility if the taxpayer has requested qualified apprentices from a registered apprenticeship program and the request has been denied or the program fails to respond the request within five business days.

The guidance also specifies the recordkeeping requirements taxpayers must comply with to substantiate that they paid workers a prevailing wage and satisfied the apprenticeship requirements.

Beginning of construction guidance

As mentioned above, taxpayers must meet the prevailing wage and apprenticeship requirements with respect to a facility to receive the increased credit or deduction amounts if construction of the facility begins on or after the date sixty days after the Treasury publishes guidance. Notice 2022-61 confirms the use of long-standing methods for establishing the date of beginning of construction:

  • The physical work test (starting physical work of a significant nature)
  • The 5% safe harbor (incurring 5% or more of the total cost of the facility)

For purposes of both tests, taxpayers must demonstrate either continuous construction or continuous efforts—the continuity requirement—for beginning of construction to be satisfied.

Article
Treasury issues prevailing wage and apprenticeship requirements guidance

Read this if your company is a benefit plan sponsor.

While plan sponsors have been able to amend their 401(k) plans to include a post-tax deferral contribution called Roth for more than a decade, only 86% of plan sponsors have made it available to participants, according to the Plan Sponsor Council of America. Meanwhile, despite the potential benefits of such plans, just a quarter of participants who have access to the Roth 401(k) option use it. Plan sponsors may want to consider adding a Roth 401(k) option to their lineup because of the potential tax benefits and other advantages for plan participants.

A well-designed Roth 401(k) may be an attractive option for many plan participants, and it is important for plan sponsors considering such a feature to design the plan with the needs of their workforce in mind. It is also critical to clearly communicate the differences from the pre-tax option, specific timing rules required, and the tax-free growth it offers. Additionally, plan sponsors should be mindful of potential administrative costs and other compliance requirements in connection with allowing the Roth option.

Roth 401(k)s: The basics

A Roth is a separate contribution source within a 401(k) or 403(b) plan that differs from traditional retirement accounts because it allows participants to contribute post-tax dollars. Since participants pay taxes on these contributions before they are invested in the account, plan participants may make qualified withdrawals of Roth monies on a tax-free basis, and their accounts grow tax-free as well.

Participants of any income level may participate in a Roth 401(k) and may contribute a maximum of $20,500 in 2022—the same limit as a pre-tax 401(k). Contributions and earnings in a Roth 401(k) may be withdrawn without paying taxes and penalties if participants are at least 59½ and it’s been at least five years since the first Roth contribution was made to the plan. Participants may make catch-up contributions after age 50, and they may split their contributions between Roth and pre-tax. Similar to pre-tax 401(k) accounts, Roth 401(k) assets are considered when determining minimum distributions required at age 72, or 70 ½ if they reached that age by Jan. 1, 2020.

Only employee elective deferrals may be contributed post-tax into Roth 401(k) accounts. Employer contributions made by the plan sponsor, such as matching and profit sharing, are always pre-tax contributions. If the plan allows, participants may convert pre-tax 401(k) assets into a Roth account, but it is critical to remember that doing so triggers taxable income and participants must be prepared to pay any required tax. In addition, plan sponsors must be careful to offer Roth 401(k)s equally to all participants rather than just a select group of employees.

Qualified distributions from a designated Roth account are excluded from gross income. A qualified distribution is one that occurs at least five years after the year of the employee’s first designated Roth contribution (counting the first year as part of the five) and is made on or after age 59½, on account of the employee’s disability, or on or after the employee’s death. Non-qualified distributions will be subject to tax on the earnings portion only, and the 10% penalty on early withdrawals may apply to the part of the distribution that is included in gross income. Participants may take out loans if permitted in the plan document. 

First steps for plan sponsors

A common misconception among plan sponsors is that a Roth offering requires a completely different investment vehicle. The feature is simply an added contribution option; therefore, no separate product is needed.

When considering the addition of a Roth 401(k) option, it is important for plan sponsors to check with service providers to determine whether payroll may be set up properly to add a separate deduction for the participant. Plan sponsors may also need to consider guidelines for conversions, withdrawals, loans, and other features associated with the Roth contribution source to ensure the plan document is prepared and followed accurately.

Education is an important component of any new plan feature or offering. Plan sponsors should check with service providers to see how they may help to explain the feature and optimize its rollout for the plan. One-on-one meetings with participants may be very helpful in educating them about a Roth account.

A word about conversions

If permitted by the plan document, participants may convert pre-tax 401(k) plan assets (deferrals and employer contributions) to the Roth source within their plan account. The plan document may allow for entire account conversions or just a stated portion. When assets are converted, participants must pay income taxes on the converted amount, and the additional 10% early withdrawal tax won’t apply to the rollover. Plan sponsors should educate participants on the benefits of converting to the Roth inside the company 401(k).

Collaborate with the right service providers to educate your participants

The right service providers may review your current plan design, set up accounts properly, actively engage and educate your participants, and offer financial planning based on individual circumstances to show how design features like a Roth account may benefit their situation. If you would like to start the conversation about adding a Roth option or enhancing your participant education program, contact our employee benefits team. We are here to help. 

Article
Plan sponsor alert: Roth 401(k) remains underutilized despite potential benefits

What are the top three areas of improvement right now for your business? In this third article of our series, we will focus on how to increase business value by aligning values, decreasing risk, and improving what we call the “four C’s”: human capital, structural capital, social capital, and consumer capital.

To back up for a minute, value acceleration is the process of helping clients increase the value of their business and build liquidity into their lives. Previously, we looked at the Discover stage, in which business owners take inventory of their personal, financial, and business goals and assemble information into a prioritized action plan. Here, we are going to focus on the Prepare stage of the value acceleration process.

Aligning values may sound like an abstract concept, but it has a real world impact on business performance and profitability. For example, if a business has multiple owners with different future plans, the company can be pulled in two competing directions. Another example of poor alignment would be if a shareholder’s business plans (such as expanding the asset base to drive revenue) compete with personal plans (such as pulling money out of the business to fund retirement). Friction creates problems. The first step in the Prepare stage is therefore to reduce friction by aligning values.

Reducing risk

Personal risk creates business risk, and business risk creates personal risk. For example, if a business owner suddenly needs cash to fund unexpected medical bills, planned business expansion may be delayed to provide liquidity to the owner. If a key employee unexpectedly quits, the business owner may have to carve time away from their personal life to juggle new responsibilities. 

Business owners should therefore seek to reduce risk in their personal lives, (e.g., life insurance, use of wills, time management planning) and in their business, (e.g., employee contracts, customer contracts, supplier and customer diversification).

Intangible value and the four C's

Now more than ever, the value of a business is driven by intangible value rather than tangible asset value. One study found that intangible asset value made up 87% of S&P 500 market value in 2015 (up from 17% in 1975). Therefore, we look at how to increase business value by increasing intangible asset value and, specifically, the four C’s of intangible asset value: human capital, structural capital, social capital, and consumer capital. 

Here are two ways you can increase intangible asset value. First of all, do a cost-benefit analysis before implementing any strategies to boost intangible asset value. Second, to avoid employee burnout, break planned improvements into 90-day increments with specific targets.

At BerryDunn, we often diagram company performance on the underlying drivers of the 4 C’s (below). We use this tool to identify and assess the areas for greatest potential improvements:

By aligning values, decreasing risk, and improving the four C’s, business owners can achieve a spike in cash flow and business value, and obtain liquidity to fund their plans outside of their business.

If you are interested in learning more about value acceleration, please contact the business valuation services team. We would be happy to meet with you, answer any questions you may have, and provide you with information on upcoming value acceleration presentations.

Article
The four C's: Value acceleration series part three (of five)

Read this if you are a Maine business or pay taxes in Maine.

Maine Revenue Services has created the new Maine Tax Portal, which makes paying, filing, and managing your state taxes faster, more efficient, convenient, and accessible. The portal replaces a number of outdated services and can be used for a number of tax filings, including:

  • Corporate income tax
  • Estate tax
  • Healthcare provider tax
  • Insurance premium tax
  • Withholding
  • Sales and use tax
  • Service provider tax
  • Pass-through entity withholding
  • BETR

The Maine Tax Portal is being rolled out in four phases, with two of the four phases already completed. Most tax filings for both businesses and individuals are now available. A complete listing can be found on maine.gov. Instructional videos and FAQs can also be found on this site.

In an effort to educate businesses and individuals on the use of the new portal, Maine Revenue Services has been hosting various training sessions. The upcoming schedule can be found on maine.gov

Article
New Maine Tax Portal: What you need to know

Read this if you are a financial institution with income tax credit investments.

Financial institutions and other businesses that participate in tax credit investments designed to incentivize projects that produce social, economic, or environmental benefits could benefit from proposed rules that simplify the accounting treatment of such investments and result in a clearer picture of how these investments impact their bottom lines.

FASB proposal

On August 22, 2022, the Financial Accounting Standards Board (FASB), issued a proposal that would broaden the application of the accounting method currently available to account for investments in low-income housing tax credit (LIHTC) programs to other equity investments used to generate income tax credits. The proposal, titled “Investments – Equity Method and Joint Ventures (Topic 323): Accounting for Investments in Tax Credit Structures Using the Proportional Amortization Method”, would expand the eligibility of the proportional amortization method of accounting beyond LIHTC programs to other tax credit structures that meet certain eligibility criteria.  

FASB introduced the option to apply the proportional amortization method to account for investments made primarily for the purpose of receiving income tax credits and other income tax benefits in ASU 2014-01. However, the guidance limited the proportional amortization method to investments in LIHTC structures.

The proportional amortization method is a simplified approach for accounting for LIHTC investments in which the initial cost of the investment is amortized in proportion to the income tax credits and other benefits received (allocable share of depreciation deductions). The cost basis amortization and income tax credits received are presented net on the investor’s income statement as a component of income tax expense (benefit). Under existing guidance, investments in non-LIHTC projects are accounted for using either the equity method or cost method, depending on certain factors. 

The proposal aims to address the concerns that the equity and cost methods do not offer a fair representation of the economic characteristics for investments for which returns are primarily related to federal income tax credits. Supporters of the proposal argue that the accounting method applied should not be determined by the legislative program under which the tax credits are authorized, but instead by the economic intent under which the investment was made. The hope is the FASB proposal will create a heightened sense of uniformity in accounting for investments in income tax credit structures. 

Additional provisions

Other provisions within the proposal would require a reporting entity to “make an accounting policy election to apply the proportional amortization method on a tax-credit-program-by-tax-credit-program basis” and disclose the nature of its tax equity investments and the impact on its financial position and results of operations. 

The significance of this proposal is amplified by the uptick in tax credit programs in recent years, including the New Markets Tax Credit (NMTC), Historic Rehabilitation Tax Credit (HTC), and Renewable Energy Tax Credit (RETC). While the FASB has yet to declare an effective date for the implementation of the proposal, comment letters from stakeholders were due October 6, 2022. 

For more information

To discuss the impact this new accounting pronouncement may have on your financial institution, please contact the BerryDunn Financial Services team. We’re here to help.

Article
FASB proposes changes to accounting for income tax credits

This is our second of five articles addressing the many aspects of business valuation. In the first article, we presented an overview of the three stages of the value acceleration process (Discover, Prepare, and Decide). In this article we are going to look more closely at the Discover stage of the process.

In the Discover stage, business owners take inventory of their personal, financial, and business goals, noting ways to increase alignment and reduce risk. The objective of the Discover stage is to gather data and assemble information into a prioritized action plan, using the following general framework.

Every client we have talked to so far has plans and priorities outside of their business. Accordingly, the first topic in the Discover stage is to explore your personal plans and how they may affect business goals and operations. What do you want to do next in your personal life? How will you get it done?

Another area to explore is your personal financial plan, and how this interacts with your personal goals and business plans. What do you currently have? How much do you need to fund your other goals?

The third leg of the value acceleration “three-legged stool” is business goals. How much can the business contribute to your other goals? How much do you need from your business? What are the strengths and weaknesses of your business? How do these compare to other businesses? How can business value be enhanced? A business valuation can help you to answer these questions.

A business valuation can clarify the standing of your business regarding the qualities buyers find attractive. Relevant business attractiveness factors include the following:

  • Market factors, such as barriers to entry, competitive advantages, market leadership, economic prosperity, and market growth
  • Forecast factors, such as potential profit and revenue growth, revenue stream predictability, and whether or not revenue comes from recurring sources
  • Business factors, such as years of operation, management strength, customer loyalty, branding, customer database, intellectual property/technology, staff contracts, location, business owner reliance, marketing systems, and business systems

Your company’s performance in these areas may lead to a gap between what your business is worth and what it could be worth. Armed with the information from this assessment, you can prepare a plan to address this “value gap” and look toward your plans for the future.

If you are interested in learning more about value acceleration, please contact the business valuation services team. We would be happy to meet with you, answer any questions you may have, and provide you with information on upcoming value acceleration presentations.

Next up in our value acceleration series is all about what we call the four C's of the value acceleration process. 

Article
The discover stage: Value acceleration series part two (of five)