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Hi folks, Michelle Valentine here. I’m the co-founder and CEO of Anrok.

It’s happened. The year is 2021 and sales tax has entered the fintech mainstream, most recently with the Peloton fiasco. I’m here to break down what happened and why it’s something that every Internet subscription business needs to watch out for these days. Ping me on Twitter with your thoughts!

The lowdown

Last month, a federal class action lawsuit was filed against Peloton. The plaintiffs alleged that the company overcharged sales tax to thousands of customers in several states. The product in question was their digital subscription, the $39 monthly membership fee to access classes.

If a $30B market cap company like Peloton can’t get sales tax right, is there any hope for startups that are likewise selling across state boundaries?

Hold up, Internet sales can be taxable?

Most of us in the United States are accustomed to paying sales tax on purchases at cafes or shopping malls. Less common is seeing sales tax applied to our digital purchases. A few astute readers may have seen this notice from Spotify last month regarding sales tax:

The surprise is emblematic of a shift in America’s approach to taxation. Sales tax was first introduced in the 1930s after the Great Depression. The laws were developed for the traditional model of brick and mortar stores selling tangible personal property on site. However, the rapid advancement of computer technology has challenged state legislatures to keep up with the modern world.

When computer technology first emerged, it seemed to fit the sales tax mold. Floppy disks and CD-ROMs were a tangible medium that a consumer could purchase and own. But software soon evolved to being downloaded or hosted and accessed remotely. Since Internet subscriptions no longer fit into existing buckets, states have taken various approaches to addressing it. This results in software being defined and taxed differently across states. For those interested in learning more about the history, my team has written extensively about the evolution of SaaS taxability here.

Why is it so hard to get sales tax right for Internet goods and services?

There are three key pieces to the sales tax equation. First is where the customer is purchasing the subscription. Second is whether the seller has an obligation to collect and remit sales tax in the customer’s state. Third is whether the product being sold is taxable in the state. Let’s break these down one by one.

Unlike traditional brick and mortar businesses that have one location, Internet subscriptions can be easily purchased by anyone anywhere. A company like Peloton or Spotify will need to know where their customers are. And while the full address is most accurate, many Internet sellers - particularly those that sell software - will only have the zip code from a customer’s credit card.

The second piece of the equation depends on the company selling the good or service. There are two primary ways that Internet sellers can establish a taxing relationship with a state. This is often referred to as “nexus”. One way to establish nexus is to have a physical presence in a state. This can be as simple as having an office or a remote employee.

Another - and more recent - way is for a company to have established economic nexus in a state. Economic nexus was introduced in 2018 by the Supreme Court case South Dakota v. Wayfair and is based on sales activity in the state. Although each test can vary by jurisdiction, a typical example is when a seller has $100,000 in gross sales or 200 individual invoiced transactions in a state. This means that Internet sellers have to monitor sales across all states and measure their transactions against state specific thresholds.

The third piece of the equation is to understand whether the product being sold is taxable in the state. Internet sellers must navigate inconsistent and often vague definitions that vary by state to determine whether their products are taxable, and keep abreast of state tax legislation and interpretation. A seller can get the first and second pieces of the equation correct, but still mess up this third step and end up with an audit or unhappy customers and a lawsuit like in the case with Peloton.

So, what should Internet businesses do?

Sales tax for Internet businesses is particularly tricky. And unfortunately non-compliance or wrong-compliance can add up. The costs include the sales tax amount that would otherwise be collected from the customer, plus penalties and interest. This can represent ~4% of sales for SaaS sellers and can be as high as 11% depending on whether most customers are in taxable states. Not to mention, most SaaS companies also have a multi-vendor problem where they have multiple payment systems (including ACH), a separate billing system, a subscription management system, and sometimes even a quoting system like Salesforce CPQ that all need to coordinate with the tax engine.

As governments look for growth opportunities out of the pandemic, compliance is increasingly important. My prediction is that sales tax on software and the Internet economy will become table stakes. It will be akin to how startups do payroll tax withholding from day one. Or how every shoe purchase you make will have a sales tax determination.

The best way for Internet businesses to navigate the issue is to get ahead of the problem. The solution must be scalable and accurate for the business at hand. This is why we launched Anrok, to help SaaS companies monitor, calculate, and remit sales tax across borders.

In other words, the Peloton fiasco is avoidable...For those that are in the know, that is.

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Michelle is the CEO and co-founder of Anrok. She previously worked on product Airtable and invested in early stage enterprise software as a VC at Index Ventures. Michelle started her career at Goldman Sachs’ where she worked with State and Local governments to structure debt around their tax revenue.