Paying taxes is a key obligation every startup has to handle, but that is quite a bit easier said than done. Taxes in the U.S. are complex, especially when it comes to taxation across different states.
How can you make sure you’re compliant? The first step is understanding what types of tax you must pay and how each one works. Here’s a guide to sales tax and income tax for startups – read on to learn the difference.
Sales tax vs. income tax
The difference between sales tax and income tax begins in their names: One is a tax on the sale of products or services while the other is a tax on income. Not every startup must pay both; which one applies in each case depends on a variety of factors.
But even if a startup must make tax filings and potentially payments for both these types of taxes, it’s important to note that only income tax must come out of company coffers. Sales tax, by contrast, should be collected by the startup from its customers, with the startup having the duty to remit these payments to authorities.
The complexities of sales tax
In the U.S., sales taxes are regulated and collected by state governments. Each state has its own rules about which products or services are subject to sales tax — rules that can be complex and even seem nonsensical. In Texas, for example, data processing services (which include SaaS) are entitled to a 20% rate reduction, while downloaded software is treated as tangible property subject to the full rate of tax. This means the same software functionality is cheaper for customers in Texas if they purchase it as SaaS instead of downloading it.
Some products face varying tax laws across states. For example, in South Dakota, custom software that can be downloaded is taxable, while that same sale is exempt from taxes in North Dakota. Yet non-custom (aka “canned”) software that can be downloaded is taxable in both states. Meanwhile, in Colorado, both custom and canned downloadable software are exempt from tax, even though canned software sold in a physical format, such as on a CD, is taxable.
Startups must track the rules that apply to their products in any state in which they must collect sales taxes. These rules are confusing and often change, so many startups partner with a tax-management vendor that can help maintain compliance across states. You can learn more in the sales tax for beginners guide.