Published: May 14, 2024

 Rental Expenditure Nuances of Taxation, a Series
 Part 3: Software Sales Tax in Texas: A Complex Landscape

Software Sales Tax

In this 5 part series, Clarus Partners discusses the sales tax implications and nuances around renting property.

Recap of Part 1: Why Renting Can Trigger Sales Tax Obligations

In Part 1 of this series, we explored a common misconception about sales tax compliance for businesses operating across state lines. If you missed it, you can read Part 1 here. We met a business owner who mistakenly believed his low revenue in remote states meant no sales tax filing obligations. However, upon closer examination, it turned out the business rented expensive equipment nationwide, creating a physical nexus (ownership of property) in many states. This triggered sales tax filing requirements well below the usual $100,000 economic nexus threshold. This scenario highlights the crucial distinction between selling and renting tangible personal property when navigating sales tax compliance across state borders.

Recap of Part 2: When Rental Becomes Service – Understanding Equipment with Operator

Part 2 tackled how an operator’s presence affects equipment rental sales tax. While standard rentals like tuxedos (taxable) involve your control, things get trickier when someone operates the equipment for you. This “Operator Effect” can potentially make it a non-taxable service, as you’re paying for the operator’s expertise, not just the equipment itself. But beware – how the agreement is worded matters. Separating equipment and operator charges might still tax the equipment portion. We explored this with real-world examples, highlighting the difference between renting a crane (taxable) and hiring a crane company for material movement (potentially non-taxable service). Similarly, a water extraction company using equipment to clean your flooded home (non-taxable service) differs from renting the same equipment yourself (taxable). Remember, the transaction’s essence, not just the rented items, is key for tax determination.


Sales Tax on Rentals: While sales tax thresholds often come to mind, there are important distinctions for businesses renting equipment across state lines. Specifically, if the sale of a widget is taxable, the rental of that same widget will typically be taxable as well. However, there are some material differences between these two transactions that the astute seller and purchaser would be well advised to consider.

Part III – Is it a Sale? Or is it a License?

Software Sales Tax in Texas: A Complex Landscape

There are many inconsistencies and questions to answer when assessing states’ treatment of software for sales tax purposes. These include factors like:

  • Software type: Canned vs. custom
  • Tangible personal property: Does it apply?
  • Delivery method: Physical media or download?
  • Software vs. SaaS (cloud-based): Makes a difference

Sales tax professionals grapple with these issues to determine taxability.

A New Twist: Software Sales vs. Licenses

However, a recent state administrative ruling has brought to the forefront another issue.

  • Is it a sale of software?
  • Or is it a sale of a software license?

Background: A Seller’s Tangled Web

A seller based outside of Texas had made sales of software programs to customers in Texas since at least 2015. The seller had an employee in Texas, giving it physical nexus, from 2018 – 2019, but the employee moved out of Texas in midyear of 2019. When the seller determined it had physical nexus and should have collected tax during the period the employee was based in Texas, it filed a Voluntary Disclosure Agreement and agreed to pay the tax on any sales made into Texas beginning with the date the employee moved into Texas and ending with the date the employee moved out of Texas.

The Analysis: Licenses vs. Sales and the “Physical Nexus” Trap

When the Texas Comptroller reviewed the seller’s transactions, it determined that the business was selling “licensed software applications.” These are distinguished from basic sales. Generally, when a transaction involves the sale of personal property, the incidental rights of ownership are transferred to the buyer.

The buyer can do what they want with the property purchased. However, when a transaction involves the license of software, the purchaser is limited in its use of the software. There are copyright law issues that prevent the unauthorized distribution or reproduction of the software. The buyer is also typically limited in the number of users allowed. If you purchase 15 licenses, you are not allowed 16 users.

What it boils down to is that software licenses are more akin to rentals in that the “seller” maintains effective ownership of the software. And this can be controlling under state law. This distinction meant that the seller intended to pay the sales tax on sales for only the year it had an employee in Texas. But it wound up having to pay the sales tax on all revenues generated in Texas for the disclosure period in the Voluntary Disclosure Agreement – a full four years.

The seller thought its physical nexus would be limited to the period its employee lived in Texas. But actually, the seller’s physical nexus threshold was crossed the minute it licensed/rented its software in Texas. Again, the logic behind this is that when a seller sells a license to a software application, the transaction more closely resembles a rental than an outright sale, causing the seller to own property engaged in business in the state, thus creating physical nexus.

The Takeaway: A Costly Misunderstanding

The difference between a software sale and a software license quadrupled this seller’s tax liability. This case highlights the importance of understanding the nuances of software sales tax in Texas, especially regarding licenses and their implications for physical nexus.

Do You Have Questions?

If you have any questions about this or any other sales tax issues, please reach out to Clarus Partners.

R.E.N.T. Series – Sales Tax on Rentals

Steve Hanebutt, CPA, MST, Fort Worth-Dallas office