4 Accounting Musts for SaaS Startups
Cloud-computing taxation is complex, so don't just sit and wait for your first audit and hope for the best.
Cloud-computing taxation is a complicated issue. Laws and regulations vary not only across national borders, but also across state lines. While there are handy primers available, wrapping your head around all the sales and use tax cases can be a real struggle.
Not helping matters is the fact that only a few states have concrete positions regarding whether to tax SaaS or exempt it. Enterprising fintech startups want to fill a void in the market with third-party integration that does real-time reporting across platforms, but not all early-stage SaaS companies stand to benefit from it.
The cost might be prohibitive, or your financials might be too complex for the software to handle.
If you’re in that position, don't just wait for your first audit and hope for the best. Find a solution before state auditors come knocking.
The muddy waters of SaaS tax
Regulations for SaaS don’t differ too much from those governing the traditional “perpetual license” model of software sales, but they do require extra clarification. Only a few states have taken clear positions on the matter, and these don’t always match up.
While Pennsylvania, Texas and Utah tax SaaS, it’s exempt in both Colorado and Virginia. And, with other states still looking for the best way to tax SaaS solutions, the need to keep on top of changing and evolving regulations is clear.
Proceeding with an offering with no concept of your specific liability could lead to some harsh treatment by state auditors. There are no excuses, then: Do your homework and have a professional check -- and a recheck! -- to ensure everything's correct.
There are a few other steps, moreover, that you should take before you call in the professionals. Practice the following four strategies to save your SaaS company’s bacon should state auditors end up on your doorstep:
1. Scale your tax planning with your company.
Few things cause bigger headaches for tax accountants than when a company doesn’t factor in compliance when it expands into new markets. In a survey of 29 states by the Governing Institute, 85 percent agreed that business-tax noncompliance is a problem, while nearly 30 percent rated it as a major concern.
The trouble is, you might be tax compliant in your original market, but if you’re expanding overseas or across state lines, you need to plan for your new liabilities in those places. I've worked with more than one client in the past who had a "set it and forget it" approach to taxes. Once those clients' businesses began to scale up, however, that tactic became a big problem.
Avoid this issue by ensuring you have a tax professional plugged into your company road map to guide your preparation. Having that knowledge available helps you avoid a potential compliance catastrophe.
2. Look beyond up-front revenue.
Recognizing revenue up-front is a risky strategy. If a customer requests an early exit from his or her contract and a refund, that could cause a problem if that cash is already earmarked for something else.
We regularly see companies that are on the cash-based accounting method when they come in the door, as that method is easy and intuitive at the earliest stages. But we urge caution: We always encourage our clients -- especially the ones seeking outside investment -- to move toward an accrual-based accounting method.
Factor revenue in over the length of the contract. And if a customer relationship is likely to extend beyond the life of the contract, build that into your revenue calculations to gain an accurate snapshot of the business.
3. Recognize extras.
Do you sell complementary services to supplement your core product? Are you charging fees outside of that core product? Things can get ugly in a hurry if you're not careful. I recently had to go through this exercise with a client; we had to spend additional time breaking down service and fee structures after the fact.
Allocate revenue among components based on the estimated selling price of each service or fee on a stand-alone basis. Many SaaS companies have already recognized the benefits of doing this.
Research from Armanino LLP shows a 13 percent decline in companies deferring non-subscription revenues between 2012 and 2014; that's a dip that is chiefly attributable to finding the stand-alone value those supplementary products possessed. This approach won’t just help break down the solo worth of your services; it will also help establish standards on the average life of your customers, too.
4. Keep on top of the changes.
Shifts come from every direction. New-revenue recognition rules went into effect earlier this year, and many states are still figuring out their approaches to SaaS tax.
Specifically, regulatory agencies are working hard to find appropriate rules, and with SaaS revenue growing at a CAGR of 19.5 percent between 2011 and 2016, it won’t be long before they’re on top of the situation.
Part of the work my team and I do each month is just stay abreast of additions, subtractions and amendments to tax codes. That task can sometimes be very complex, even for tax pros, but it's good to keep an open dialogue with your tax professional, to check in periodically on any potential alterations.
As SaaS becomes more ingrained in the world of commerce, the need to keep on top of changes will decline. But you should still check in regularly with your accountant or tax professional. You don’t want to be stung once a new rule is unveiled.
Overall, startups can’t afford to neglect their accounting partners in the current SaaS climate. As business and regulations both expand and develop, you need to understand your liability. Don’t leave it to state auditors to catch your mistakes.
Catch them yourself and save on the hassle and expense.
Anjum Tunuli is the chief tax officer at Early Growth Financial Services, a firm that addresses the lack of on-demand financial support available to startups. With more than 12 years of experience working with small-to-mid-sized companies and their ownership groups, Tunuli assists EGFS clients with tax and regulatory compliance and other valuation concerns. He resides in Orange County, California.