Software as a Service, or SaaS, allows one company to offer software through cloud computing. While this sounds complex, people use these services every day. Adobe Creative Cloud, Microsoft One Drive and QuickBooks Online fall into this category.
State taxation on SaaS is still confusing despite many states using interpretive guidance of existing laws to impose tax on SaaS transactions.
But only a few states have SaaS-specific taxation.
Tennessee, for example, imposed a tax in 2015 on remotely hosted software. If your entity isn’t taxing customers in Tennessee, it needs to be.
SaaS requires your team to stay ahead of tax compliance starting with our first point.
1. Research Tax Compliance Before Expansion
SaaS can be deployed globally, but many entities start in one country and then expand further. Your startup may be following tax compliance codes throughout the United States, but if you expand into the European Union, a whole new set of regulations and codes needs to be considered.
There are new liabilities when expanding across country and even state borders.
You’ll need a tax professional to help you through your plans of expansion. The goal is to stay ahead of any tax compliance concerns before they become a problem. There’s also the painstaking changes that happen to tax codes around the world.
You might collect 5% sales tax now, but if the sales tax changes overnight, you need to collect the new percentage as soon as possible.
If you don’t have an accountant to help identify these changes immediately, you may not be collecting the right sales tax.
Fines and penalties will outweigh the cost of hiring a professional to help you get your startup’s compliance on track.
2. Determine the Solo Value of Services
Core products are almost always expanded as a company realizes that they can charge extra for add-on services. For example, a simple cloud backup service may charge $20 for their monthly service and an additional $10 upfront fee and $5 per month for file restoration of deleted files.
If you don’t properly account for these extras, your accounting will become very confusing very quickly.
You need to account for all the money earned, but you also want to account for the solo value of the service.
The monthly fee may be accounted for as monthly revenue, while the upfront fee for starting the restoration is not.
And this is just an example, of course. Stand-alone values of additional products is very important to help you better understand your operations, customer lifecycle and how much a solo service is worth. You’ll also want to allocate your revenue among components.
It’s a very complex process, but knowing where money is coming from and when is very important for SaaS companies that are heavily reliant on monthly recurring revenue.
3. Consider Accounting Methods
SaaS companies often choose cash-based accounting. This accounting method recognizes revenue when the physical cash is received. The accounting method recognizes expenses in the same manner. The problem with this major accounting method is that it doesn’t account for potential termination of contracts.
A SaaS company may charge a lower fee for a 12-month upfront payment, but they may also allow the customer to terminate their contract.
For example, if $100 was received, the company would account for the entire $100 in revenue and may earmark it towards another expense. But what happens if the contract is broken and the customer is owed $50 that’s already been utilized?
This can cause a major disruption in a business’s plans – and a lot of angry customers.
Accrual-based accounting is slightly more complex, but it’s a smarter avenue for a SaaS company in most circumstances. The idea behind this method of accounting is simple:
- Revenue and expenses are accounted for when the expense occurs
When this method of accounting is followed, it allows the company to have a better understanding of its profitability and helps the company avoid earmarks that may leave them low on cash flow. The customer above’s payment would be divided up among the 12-month period, ensuring that when the refund was requested, the money wasn’t allocated somewhere else.
An accountant can help an SaaS company overcome these issues that may seem minor at first, but have a tendency to spiral out of control as the entity grows.