Is There a Sales Tax on Software and SaaS?

Sales tax applies to a wide range of goods and services, but its application to software and Software as a Service (SaaS) presents a complex landscape. Unlike tangible products, software often exists in a digital form, leading to varied interpretations by state tax authorities. This digital nature means that defining what is taxable and how it should be taxed is a challenge for businesses and consumers alike.

Software Classification for Sales Tax

Sales tax applies to tangible personal property (TPP), which includes physical goods. Historically, software delivered on physical media, such as a CD-ROM, was considered TPP and subject to sales tax. The evolution of software delivery, particularly with digital downloads and cloud-based services, has blurred these lines. Many states interpret TPP broadly, sometimes including electronically delivered software in this classification.

The distinction between tangible and intangible property is important for sales tax. Intangible property and services have historically been exempt from sales tax unless specifically made taxable. Software, as lines of code, is often intangible. However, state tax laws have adapted, with some states defining electronically delivered software as TPP or a taxable service, even if no physical item changes hands. This re-evaluation aims to capture revenue from the digital economy.

State Approaches to Software Sales Tax

Sales tax is imposed at the state level, resulting in varied regulations across the United States. There is no single federal rule for software sales tax, leading to significant variations in how states classify and tax these products. What is taxable in one state might be exempt or taxed differently in another.

Some states broadly tax all software, regardless of delivery method or whether it is prewritten or custom. These states might classify all software as a taxable service or as TPP, even when accessed remotely. Other states adopt a more nuanced approach, often taxing only “canned” or prewritten software, designed for general use. Many states exempt custom software development, viewing it as a professional service rather than a product sale.

The taxability of Software as a Service (SaaS) also varies widely. Some states treat it as a taxable service, others as TPP, and many do not tax it. This inconsistency stems from states classifying SaaS as a nontaxable service, a taxable service, or even as tangible software. Some states consider SaaS a data processing service, which may or may not be taxable.

Taxability of Software Delivery Models

The method by which software is delivered or acquired significantly impacts its sales tax treatment. Understanding these distinctions is important for both sellers and purchasers. Varying interpretations across states complicate compliance for businesses operating in multiple jurisdictions.

Prewritten, or “canned,” software refers to off-the-shelf programs. When delivered on physical media, like a USB drive, it is generally considered TPP and is taxable. Even when delivered via digital download, many states classify it as taxable TPP, equating the electronic transfer to a physical sale.

Custom software, developed for a single client, is often treated differently for sales tax. Many states view its creation as a professional service rather than a product sale, leading to exemption. However, if tangible items, like manuals or backup disks, are transferred with custom software, those items may be taxable.

Software as a Service (SaaS) involves accessing software over the internet on a subscription basis, without physically downloading or owning it. Some states consider SaaS an intangible service and exempt it. Others may tax it if it includes a downloadable component or provides constructive possession of the software.

Digital goods, including software downloaded directly to a device, are often subject to sales tax, similar to TPP. Some states exempt electronically delivered digital products if no physical medium is involved. When software is sold as part of a bundled transaction, such as with hardware, taxability can become complex. Some states may tax the entire bundled price if the software component is a non-incidental part of the transaction.

Determining Sales Tax Obligations

Businesses selling software must determine their sales tax obligations by understanding where they have a taxable presence. This connection, known as “nexus,” triggers the requirement to collect and remit sales tax. Nexus can be established through physical locations, employees, or inventory in a state. Economic nexus rules mean a business can establish nexus by exceeding sales revenue or transaction thresholds within a state, even without a physical presence.

Once nexus is established, businesses must apply the correct sales tax rate based on sourcing rules. These rules determine the sale’s location for tax purposes, often based on the customer’s location or where the software is first used. Sourcing rules for digital products can be complex due to the lack of a physical delivery address.

Businesses should conduct due diligence to understand sales tax laws in all relevant states and local jurisdictions. This includes researching specific definitions of software, delivery methods, and taxability rules. Seeking professional tax advice can help navigate these regulations and ensure compliance, especially for multi-state operations. Maintaining accurate records of all software sales, including customer locations and delivery methods, is important for demonstrating compliance during audits.