Software’s Tax Tab Varies From State to State

The tax landscape for software and software as a service (SaaS) can quickly become convoluted and treacherous for businesses. Rules and regulations vary from state to state and, in some cases, even by local jurisdiction.  With so much ambiguity in tax laws, even minor differences in fact patterns can change a company’s tax treatment.

Precision is critical in approaching the purchase or sale of software or SaaS to avoid any surprises from unexpected state and local taxes.

In general, sales and use taxes apply to tangible personal property and certain enumerated services. Broadly speaking, states consider bespoke software custom designed for a given customer to be a professional service and therefore, in most cases, exempt from taxation.

Unfortunately, the uniformity of “canned” software—delivered in physical medium, downloaded, or accessed as SaaS—ends with the software itself. State law varies on the tax treatment, largely driven by different interpretations of the word “tangible.”

When developers and vendors largely delivered software on physical media—also when many legislatures wrote their sales tax laws—just tax professionals and attorneys in idle reflection mused about the distinction between which parts of a transaction actually made it taxable. However, with the proliferation of downloaded software and SaaS models, these differences become very important for businesses to know or potentially face an unexpected tax bill. Conversely, these nuances and exceptions can also work in a business’s favor, increasing the value of reading this article and understanding them.

This article focuses on tax issues related to prewritten or “canned” software that may or may not contain slight modifications for a customer and SaaS.

Canned Software

Generally, canned software is taxed in all delivery methods or only when delivered via tangible medium. States consider the software itself to be tangible personal property, taxed explicitly, or the inseparable tangible property obtained by its tangible delivery medium makes the software taxable by inference.

Software as a Service

State laws vary regarding explicit definitions of SaaS. Despite the increasing prevalence of SaaS over the last decade, many states do not have specific tax guidance on record.

In states that have addressed it—either through statute, regulation, legal precedence, or letter rulings—determining taxability is relatively straightforward. States without guidance introduce nuance and complexity where specific fact patterns may change the taxability.

Even with specific guidance, the taxability of SaaS often turns in part on a jurisdiction’s tax treatment of software, services, data and information processing services.

SaaS taxability often has much more nuance than traditional software purchases and specific fact patterns can change the taxability.

Examples

Let’s consider some taxability examples in a handful of states.

Canned software

Let’s compare the treatment of canned software in California and Texas. California imposes tax on the transfer of title of tangible personal property which includes software in a physical format; thus, electronically delivered software is non-taxable in California. Texas takes the opposite approach, defining canned software as tangible personal property; making it taxable in all delivery methods.

The common thread is that the state is taxing only tangible personal property. The differences are in what the state considers tangible.

SaaS

In California, as with ordinary canned software, there must be a transfer of tangible personal property for the transaction to be subject to tax. Sales and use tax does not apply to SaaS transactions in which a customer gains access to software on a remote network without receiving a copy of the software while the seller retains exclusive possession and control of it.

Texas treats SaaS as a “data processing service,” which is subject to tax with a 20% exemption. Because vendors never deliver software to a customer—tangible or otherwise—in the SaaS model, Texas does not argue that it is taxable software and instead taxes the service part of “software as a service.”

Colorado‘s tax law resembles California. There must be a transfer of tangible personal property for the software to be taxable.

It seems intuitive that a state taxing electronically delivered software will also tax SaaS, but this is not always the case. Consider Indiana, which explicitly imposes tax on electronically delivered software, but not software accessed over the Internet. The opposite can also be true.

South Carolina does not tax electronically delivered software, but does tax SaaS.

As you can see, the taxability of SaaS is clear as mud.  States like Nevada, which does not offer SaaS guidance and does not tax electronically delivered software likely will not tax SaaS. However, certain exceptions such as data or information processing service taxability may apply.

Nuance, Exceptions and Opportunities

The lazy answer to just about any sales and use tax question is, “maybe, it depends.” With thousands of tax jurisdictions, nothing has exceptions and nuances quite like sales and use taxes. However, nuance and fact pattern exceptions can work for taxpayers instead of simply representing a cost. Between multistate apportionment and applicable exemptions, it is possible to convert a burdensome tax obligation into tax saving opportunities.

Consider Illinois. Generally, canned software is taxable regardless of delivery method. However, the license of software is not taxable if it meets a five prong test laid out in tax regulation. If you are doing business in Illinois, it is important to be sure of what you are purchasing. Is it a copy of the software or is it a license to use the software? In the latter case, tax may not apply. 

Multistate use of software also can have an effect on taxability. Many states, including Texas, New York, and Colorado, allow the apportionment of software licenses based on where the users access the software. For example, if your Texas-based company has 1,000 users of a software, but only 750 are in Texas, then Texas tax applies to only 75% of those charges. While this added layer of complexity sounds irritating, it also represents opportunities for tax savings if you have been paying Texas sales tax on the full amount.

Generally speaking, if a state taxes canned software as tangible personal property, it may also exempt canned software as it would tangible personal property. For example, Texas defines canned software as tangible personal property. Therefore, exemptions may apply to software depending on how it is used or who it is sold to. Canned software used to operate manufacturing equipment is exempt when the equipment is exempt. Taking this concept further, canned software used by a software developer to produce more canned software may qualify as exempt manufacturing equipment itself.

Takeaways

With so much ambiguity in tax laws, even minor differences in fact patterns can change a company’s tax treatment.

The traditional model of selling software is relatively straightforward; although exceptions are always a possibility. A state will either tax all software, irrespective of delivery method, or only software delivered in a tangible format.

However, the taxability of SaaS has many more variables. If there is any doubt as to the taxability of a transaction, contact us. We are here to help.

Disclaimer: This information in this article is not to be construed as legal or tax advice. It is an informational piece aimed at enhancing awareness around indirect tax issues. Specific fact patterns and laws can always change tax applicability. Please consult with a tax professional before taking action and independently verify the accuracy of the tax law in the jurisdiction(s) applicable to you.

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