Tax Strategy for Tech Companies
There’s never a dull moment in the world of tax! With 10,000 local U.S. taxing jurisdictions, fifty states, the IRS, and 195 countries in the world, there are plenty of open palms for your tax dollars. I’m not sure why people get a glazed look in their eyes when I point this out at cocktail parties.
Okay, maybe it isn’t that exciting, but a business plan for a technology start-up, or even an established tech company, should include a comprehensive tax strategy. Alas, most of my work comes from companies that end up spending far more than necessary because they waited too long to think comprehensively about tax requirements.
To be effective, tax strategy must be considered early and often. Early because, while a running loss may not generate income tax exposure, technology companies are typically subject to sales/use taxes (and, in some states, gross receipts taxes) from the first commercial sale onward. Especially for technology companies, this is often because tax rules are a moving target.
As states struggle to reshape their tax regimes to meet revenue losses caused by the ever-changing technology market, rules that were true last year may not be true next year. In 25 years of multistate tax consulting, I have yet to see the year where a major tax change has not occurred that may materially affect many of my clients.
Moreover, since the recent federal corporate income tax rate reduction, state income taxes for the profitable company now represent a far greater percentage of the total income tax burden. Tax planning is critical to optimize your effective income tax rate, and state taxes may no longer be given short shrift in the development of your tax strategy.
For inbound companies (foreign companies selling into the U.S.), there are frequently expressions of surprise when I note that a U.S. tax treaty does not bind individual U.S. states in the application of their tax rules. The same is true when I bring up the complexity of sales tax rules and the existence of sales tax compliance requirements based merely on sales volume and/or the number of transactions in many states.
Lack of planning or failure to reconsider tax strategy as your business evolves increases tax liability, ensures the loss of available tax credits and incentives, and creates compliance nightmares. This in turn limits stakeholder profits and generates additional tax costs when it comes time to exit the business.
Tax Planning for the Best of Times and the Worst of Times
When you have a great product to launch, there is a lot that goes on behind the scenes to bring concept to reality. While a product’s benefits, marketing launch, and sales projections make decidedly better cocktail party conversation, you may find that the tax department’s role contributes nearly as much to your company’s success.
Does your company pricing strategy take into account future tax audit assessments? I doubt it; more likely pricing minimizes margins in favor of sales volume. If you are shooting for a 20% margin, are you willing to give up 50% of that margin to pay tax that need not ever have been your burden? This is what can happen with sales tax noncompliance. Sales tax should be the customer’s burden. But, when an audit occurs 3 years after a sale, it is usually impossible to go back to customers to collect the tax that should have been reflected on the original invoice. Moreover, associated penalties and interest frequently exceed 50% of the tax and are likely impossible to recover.
It is time well spent to think through how authorities will view your product and business practices from a tax perspective. This is true not just on initial deployment, but at every stage of your business’s development. While everyone may be feverish over the surefire success of your new product in the market, it is imperative to consider potential tax risks well before that success ever comes to fruition.
Know Your Nexus
Nexus is the tax concept that determines when your company may be subject to gross receipts, income/franchise tax and sales/use taxes in each state. Nexus rules are continually changing and evolving and vary for tax type as well as between jurisdictions with independent taxing rules.
Last year saw an economic recession, a dramatic jump in e-commerce, and widespread remote work, including people whose work crossed state lines. These factors, along with extraordinary COVID-related expenditures in state jurisdictions, are sure to result in continual aggressive action by states to expand the definition of nexus in order to increase the collection of sales tax as a way of rebuilding depleted state budgets.
If there is a software element to your business, it is critical to understand how each state classifies taxability of your platform to ensure you’re meeting sales tax compliance requirements. If your business utilizes a software-as-a-service (SaaS) model, understanding taxability and economic nexus in each material state is crucial. Nearly half of U.S. states consider SaaS to be taxable. Even if you consider your company a provider of services, any use of technology to facilitate delivery of those services may taint an otherwise nontaxable transaction and render it taxable. Additionally, many states tax certain services, while certain states tax many services (regardless of whether there is an associated use of technology)! Yep, clear as mud.
Start with your Endgame in Mind
While the best practice is to consider tax impact early on in the business cycle to avoid unnecessary exposure later, this simply doesn’t always happen. At some point, a transaction may loom for your business.
I implore you: don’t wait for transaction due diligence to evaluate any tax compliance deficiencies. If you do, the result may end up with an acquirer making decisions for you as to how to address exposure. Trust me, they will not be making their choices in your best interests when they calculate a tax holdback from sale proceeds or manage the exposure mitigation process post-closing.
By getting ahead on a comprehensive tax strategy now, you will increase the profitability of your business and potentially save yourself and your organization millions in tax dollars. If you are ready to discuss a tax strategy that will help support your goals, or if you hope to minimize tax exposure due to noncompliance, my team stands ready to help.
Since 1997, Carl Roscoe has worked on a wide spectrum of state and federal corporate tax issues and projects. He has significant experience in income/franchise/gross receipts, sales/use, property and payroll tax matters. Currently, he focuses primarily on merger and acquisition due diligence, mitigation/remediation of historical tax exposure, and on emerging company tax concerns. Carl joined GAGNONtax in 2001, where he also serves as general counsel.