Do You Have to Charge Sales Tax on Digital Products?

Sales tax is a consumption tax imposed by state and local governments on the sale of goods and services. Traditionally, this tax applied to tangible personal property, items you can physically touch and own. The digital age has introduced complexities, as many products are now delivered electronically without a physical form. This shift creates challenges for businesses and tax authorities in applying sales tax laws to these intangible offerings. The varying approaches across jurisdictions make understanding sales tax obligations for digital products a significant hurdle for online businesses.

Defining Digital Products for Sales Tax

Defining a “digital product” for sales tax purposes is not straightforward, as states often have their own interpretations. Generally, digital products are intangible items delivered electronically, consumed or used on a device rather than in the physical world.

Examples include e-books, music downloads, streaming services, online courses, and downloadable software. Digital art, photography, and virtual items within video games, such as skins or in-game currency, are also considered digital products. These items are typically accessed through a download, streaming, or online subscription.

Some states may treat these products as equivalent to tangible personal property for sales tax purposes, even though they are intangible. The definition can become further complicated if a digital product is bundled with a physical component, such as a backup CD or a printed manual. In such cases, the entire sale might become taxable, even if the digital product alone would typically be exempt.

The distinction between a digital product and Software as a Service (SaaS) is also important. Digital products are often one-time downloads the user keeps, while SaaS involves subscription-based access to software hosted in the cloud. Sales tax laws can differ significantly between these two categories.

Understanding Sales Tax Nexus and Digital Products

Sales tax nexus is a legal term determining where a business has a sufficient connection to a state to collect and remit sales tax. Traditionally, this connection was established through a physical presence, known as physical nexus. Examples include an office, a warehouse, employees, or attending conferences within a state. If a business has these physical ties, it is generally required to collect sales tax on sales made to customers in that state.

The landscape of sales tax nexus changed with the 2018 Supreme Court decision in South Dakota v. Wayfair, Inc. This ruling overturned the physical presence standard, allowing states to require remote sellers to collect sales tax based on their economic activity within the state. This new concept is known as economic nexus.

Economic nexus is typically triggered when a business’s sales into a state reach a specific dollar amount or a certain number of transactions within a defined period. Many states have set common thresholds, such as $100,000 in gross revenue or 200 separate transactions. For instance, if a business sells digital products from its home state but reaches $120,000 in sales to customers in a different state, it would likely establish economic nexus there.

These economic nexus thresholds generally include all sales, not just taxable ones. This means revenue from sales of non-taxable digital products still counts towards determining if a business has met the threshold. Once a business crosses a state’s economic nexus threshold, it is obligated to register for a sales tax permit and begin collecting and remitting sales tax to that state. The exact timing for registration can vary, often requiring registration by the first day of the month following when the threshold was crossed.

State Approaches to Taxing Digital Products

The taxation of digital products is determined at the state level, as there is no uniform federal sales tax. States have adopted various approaches, creating a complex and inconsistent tax landscape. Some states classify digital products as tangible personal property, making them subject to sales tax, while others exempt them entirely or have specific rules.

Many states have comprehensive sales tax laws that apply to a broad range of digital products, treating them like physical goods. For example, states like Alabama, Arkansas, Connecticut, Hawaii, Idaho, Kentucky, Louisiana, Maine, Minnesota, Mississippi, Nebraska, New Jersey, New Mexico, New York, North Carolina, Ohio, Pennsylvania, Rhode Island, South Dakota, Texas, Utah, Vermont, Washington, West Virginia, Wisconsin, and Wyoming generally impose sales tax on digital products such as e-books, music, movies, and streaming services. In these states, if a product is taxable in its tangible form, it is often taxable in its intangible, digital form.

Other states take a more nuanced approach, taxing only certain types of digital products or under specific circumstances. For instance, California generally exempts electronic data products transmitted over the internet, including software, e-books, and digital images, unless delivered with physical components. Illinois considers the sale of digital products as a transfer of intangible goods, which are generally not taxable. Florida generally does not levy sales tax on digital products but imposes a Communication Services Tax on video and music streaming services.

Some states distinguish between “canned” (prewritten) and “custom” software. Many states tax prewritten software delivered electronically, while custom software is often viewed as a service and may be exempt. The 24 states that are members of the Streamlined Sales and Use Tax Agreement (SSUTA) use standardized definitions for “specified digital products,” including digital audio works, digital audiovisual works, and digital books. However, even among these states, the actual taxability of these products can vary. Businesses must research and monitor the specific rules for each state where they have established nexus to ensure compliance.

Key Steps for Sales Tax Compliance

Once a business determines it has sales tax obligations for digital products in a particular state, the next step is to ensure compliance with that state’s sales tax laws. The initial action involves registering for a sales tax permit, also known as a seller’s permit, in each relevant state. It is illegal to collect sales tax without a proper permit, and businesses should complete this registration before commencing sales tax collection. Each state’s taxing authority manages its own registration process, which can often be completed online.

After registration, businesses must accurately calculate and collect the correct sales tax rate on their digital product sales. This process is influenced by sales tax sourcing rules, which determine whether a sale is considered “origin-based” or “destination-based.” Most states use destination-based sourcing, meaning the sales tax rate is determined by the buyer’s location or “ship to” address, requiring sellers to calculate state, county, city, and other local sales tax rates for that specific location. Sales tax automation software can help streamline this complex calculation process by automatically determining applicable rules, tax rates, and the amount due for each transaction.

The collected sales tax must then be filed and remitted to the appropriate state authorities. States impose varying filing frequencies, commonly monthly, quarterly, or annually, often based on the volume of sales a company conducts and the amount of sales tax collected. Businesses are typically required to submit sales tax returns and remit payments electronically. It is advisable to file returns a few days before the official due date to account for any potential processing delays or state-specific requirements, as late filings can incur penalties, such as a $50 fine plus interest on the outstanding amount in some states.

Maintaining accurate and comprehensive records of all sales, collected taxes, and filed returns is another critical compliance step. Proper record keeping is essential for verification during potential audits and for preparing future tax filings. Businesses should retain documentation supporting sales transactions, tax calculations, exemptions claimed, and remittance records for a period typically ranging from three to seven years, as specified by state regulations. This diligent record keeping helps demonstrate compliance and can mitigate risks associated with audits or inquiries from tax authorities.