As state's revenue departments start to more closely scrutinize the business models of managed service providers with taxes in mind, the MSPs are becoming increasingly worried that auditors don't understand their business.
In some cases, the result has been conflicting and confusing messaging regarding sales tax liabilities on managed services. CRN's Scott Campbell recently spoke with MSPs from three different states. Their experiences highlight some of the issues MSPs face and what their peers should do to avoid any trouble.
The observations also illustrate that interpretations of services can vary greatly from state to state, with each MSP having to dig a little deeper to fully understand what they need to do. Interestingly, each of the MSPs asked not to be identified for fear of reprisals from tax auditors within their respective states.
An MSP executive in Florida said the same questions he hears being asked MSPs today were also asked by tax auditors during an audit at his former company -- 12 years ago. That notion illustrates that government officials still do not understand exactly what IT managed services are, said the Florida MSP.
Too often, managed services is treated as a product because some MSPs also sell products to customers, said the executive.
"They're saying, 'You provided a cable so the whole transaction is taxable. You installed a printer so everything you do is taxable.' Aren't these questions answered by now? We can't be the only company like this," he said.
During a sales tax audit at this executive's former company more than a decade ago, the state initially sought a six-figure sum in taxes owed for services provided to customers, he said. Both sides negotiated it down to about $20,000, which the executive said allowed the company to remain in business.
"We ended up taxing everybody on everything after that," he said.
A recent audit at his current company was like a dj' vu moment, he added. Again, the state ruled that the MSP owed a six-figure sum in sales tax. "If that stayed we would have been out of business. We frantically tried to fight that. They come back with these inane decisions," he said.
This time, the state of Florida said that because the MSP installed software that was purchased as a product it made the services all taxable.
After an 18-month fight, the company hired an attorney who met with state tax officials who determined that the MSP owed no money at all.
"However there is still no difference between a year and a half before. We still don't know why it was not taxable or taxable," said the MSP.
Some MSPs split the invoice, with managed services on one bill and hardware and software on the other. But that's just asking for trouble, said the Florida MSP.
"They will find that and call you on that the first five minutes they walk in the door [for an audit]," he said.
The executive noted a precedent set in the advertising industry that is akin to what's going on with managed services. Billboard advertising by itself is not taxable, but one ad agency put a piece of plywood on the billboard, rendering the whole thing taxable, he said.
"They had some organizations in their industry get together. They hired a lawyer and passed specific rules about what's taxable for the advertising industry," he said.
He'd like to see the same collaboration occur within managed services to get a more consistent tax message from states, he said.
"Right now, MSPs want to forget [about an audit] and not make waves. But they could go through the same thing all over again. Rules need to be written by the state. I don't blame the auditors. That's the way it's set up. It's hard. We're not trying to get away with anything. It's not like we're charging customers sales tax and buying a new Cadillac with the money."
Even though this MSP now has a letter saying its services are not taxable, he's not convinced that the ruling won't be reversed at some point. "You would think it would be a precedent, but in three years we could go through the same old thing again."
An MSP executive for a company in Washington state said his company's interpretation is that any consulting services is not taxable. But as soon as the company lays its hand on any product, for installation or repairs, that's taxable. He added that that interpretation varies greatly from his previous employer.
Last year, the Washington MSP executive attended a public hearing where the state's stand on services was laid out. He said he has a better idea after attending the seminar but there are still some gray areas.
"If you use a digital product to do a service, say you're scanning documents, that's taxable. Somebody gives you bunch of documents and you give them back in a database. That's taxable as a digital automated service [in Washington state]. E-mail scanning is now taxable. Online backup, if you use Xilocore or somebody else, as of July 2009, that's a taxable service in Washington state," he said.
The MSP notes that Washington state has a director of interpretations to give rulings on laws. "There was a room full of confusion [at the public hearing]. The guy was trying to understand all the confusion to issue rulings," he said.
Unlike the Florida MSP's former company, the Washington MSP said he would never charge sales tax just to avoid owing taxes at a later date.
"We have an obligation not to charge sales tax if it's not taxable. That concept was discussed in detail [at the public hearing]," said the Washington MSP.
In some cases, the sales tax issue can cause issues with customers. For example, if one MSP charges the sales tax, the company could be at a 5-to-9 point disadvantage against an MSP that doesn't believe it has to charge the tax.
The Washington state MSP had one client who wanted a refund on sales tax it paid after a CPA doing an internal audit for the client felt it shouldn't have been charged.
"That created a strained relationship with the client. That's what made us dig into this more," said the MSP.
MSPs also face additional challenges if they have customers in multiple states. And if the data center they use is in a different state, that creates some concerns too, MSPs said.
"Somehow it's up to us to know if the [customer] has [to pay sales tax] or not. We might have a client with 50 users here [in Washington] and 50 users in Portland [Oregon]. We would have to charge the client on sales tax here but not in Portland," he said. "It's very much a risk. We also have a destination-based sales tax. Every city has different tax codes. Seattle is 9.5 percent. If you take a ferry ride to Bremerton, it's 9 percent. We have to accurately charge and report that to the Department of Revenue. We have to put in an address at the DOR Web site and determine which tax rate we're supposed to use. It's crazy. That means not only do invoices have to have the right tax rates, but proposals do as well."
Like the Florida MSP, the Washington executive said all his company wants to do is follow what is required by law.
"It's just so confusing and murky. I don't want to understate that we have an obligation not to tax if we're not supposed to. The inclination is to say you don't want to risk it so just tax. When in doubt, tax. That's not lawful either," he said.
The MSP's advice for other managed services providers is to take the time to understand tax laws to the best of your ability.
"Get letters from your Department of Revenue and stay consistent to what the letters dictate. Take the time to get involved in legislative affairs," he said.
While the Florida MSP advised not to split services and products into separate invoices in his state, the MSP in Washington suggested to do just that in his locale.
"We had to unbundle or they'd tax the whole thing. We had e-mail scanning that was in a managed services [package]. We had to unbundle and tax just that portion," he said. "In Washington, they told us, once it was determined that something was materially not taxable, but one piece was, we are required to unbundle it. That came straight from the [director of interpretations]."
Finally, an Ohio-based MSP likens the current MSP sales tax issue to the time when states did not charge sales tax on products ordered online.
"The issue is it's very hard to sell managed services without selling some product. The new dilemma is cloud services, hardware-as-a-service. That's what's precipitating this new issue. People are utilizing hardware on a utility basis. The states are looking at that as there's a piece of equipment being used here, some utility here. State statues and regulations sometimes don't deal with a use tax. They do deal with transfer of property. It makes it difficult state by state," said the Ohio MSP executive.
The Ohio-based company sells managed services and products to customers all over the world. If possible, the company tries to make sure the transfer of ownership is done in Ohio to simplify the tax-keeping process.
Like the Washington MSP, the Ohio-based company "assumes management" for equipment it sells to customers, in essence unbundling the product sale and services, according to the executive.
"We will sell something outright and charge them the sales tax. Then we proceed to manage it. Or we set up a lease agreement with them. That's going to have a separate item. I think keeping that clean from our perspective has fared very well. Where people get into trouble is when they try to bundle together a little too much," he said.
The Ohio MSP said he'd like to see more customers rent IT equipment, which could help avoid the whole issue.
"In that case, where you have four or five pieces of equipment coming off of contract, those things are fairly depreciated and owned by your company," he said. "You're providing a service that includes this equipment. My position is that's your equipment. There's no transfer of property here. You're providing a service on your equipment."
But the MSP acknowledges that different states have different use taxes, which would necessitate sales taxes having to be paid for rentals too.
"That's where CPAs come in. I suggest you get a letter from the DOR, have a CPA analyze it and give you a position letter. Then if you do get audited you say call my CPA. At least the large time-consuming piece may be headed off at the pass," he said.
The Ohio MSP notes that many CPAs are very involved with state legislatures, serving on committees and as consultants for various issues.
"They meet and talk about these types of things all the time. They are the authority on that. Some of them are involved right in the legislation," he said.
All three MSPs said the biggest issue is not even worrying about paying a hefty sum as a result of an audit, but the process of the audit itself. In many cases, even if a company ends up not owing the state money, it has cost the MSP a great deal of money and resources just to go through the audit.
"It takes the time and energy of top executives. It can be extremely distracting to the business. The repercussions are not just what if you need to pay the [government] a certain amount, but now have to go and alter existing contracts. That can be devastating," said the Ohio MSP.
MSPs should always have CPAs review their pricing plans and business model regularly, said the Ohio MSP. Second, MSPs need to consider what value they're bringing to the customer.
"My CPA even suggested that if I'm going to be selling equipment, I set up a leasing company. Not a division but a separate company. Deal with all the equipment on that side and all the consulting work through the service company. That would be the advice I'd give," he said.
Like the Washington MSP, the executive in Ohio said his company won't just add sales tax for the sake of charging the tax.
"Doing the right thing should always be done. But knowing the right thing is really the hard part sometimes," he said. "That's my biggest aggravation with this entire issue. They go in and audit these MSPs like they're trying to do the wrong thing. That attitude is really detrimental to everybody. There may be some MSPs out there that don't have a CPA or that didn't think about it. It's a complicated issue."