SaaS and Sales Tax – A Sales Tax Guide for Digital Businesses

In the evolving world of Software as a Service (SaaS), tax compliance presents a challenge for businesses operating across state lines. The sales tax implication of SaaS, as well as related software and services, varies significantly among jurisdictions. The questions most frequently posed by SaaS providers center on the taxability of their services and the distinctions among canned software, modified software, and customized software from a state tax perspective.

Beyond these foundational inquiries, taxpayers often seek guidance on the tax treatment of standalone services—such as integration or implementation fees—when sold alongside SaaS and the criteria states employ to differentiate taxable and nontaxable offerings.

Taxability Rules in the SaaS Space

SaaS, characterized by its delivery of software functionality over the internet on a subscription basis, challenges traditional tax classifications, and blends elements of tangible property and intangible services. This section provides an in-depth examination of SaaS taxability rules in New York, Pennsylvania, California, Texas, and Ohio, drawing on current state regulations and official guidance.

New York

In New York, SaaS is subject to sales tax under a broad interpretation of tangible personal property, as outlined by theNew York State Department of Taxation and Finance. The department’s Tax Bulletin ST-128 (TB-ST-128) specifies that prewritten computer software—including software accessed online via a subscription model—is taxable, irrespective of its delivery method (physical media, download, or cloud access). This classification extends to SaaS, with the tax obligation sourced to the location where the purchaser primarily uses the software, not the provider’s location.

The state sales tax rate is 4%, supplemented by local rates that vary by jurisdiction, often resulting in combined rates exceeding 8% in areas like New York City. Businesses must register with the Department of Taxation and Finance to collect and remit this tax, and exemptions are limited, applying only to specific scenarios such as software used exclusively in research and development, as noted in Tax Bulletin ST-121 (TB-ST-121). SaaS providers must also consider the implications of bundled transactions, where additional services may render the entire sale taxable unless separately stated and substantiated as non-taxable.

Pennsylvania

Pennsylvania imposes sales tax on SaaS, classifying it as tangible personal property under amendments introduced by Act 84 of 2016, as detailed by thePennsylvania Department of Revenue. According to the department’s Sales and Use Tax Information on Canned Computer Software and Digital Goods, SaaS subscriptions are taxable. The state rate is 6%, with additional local taxes in Allegheny County (1%) and Philadelphia (2%), and the tax is assessed based on the customer’s location of use, perRevenue’s Taxability Guidelines.

SaaS providers must obtain a Sales Tax License and file returns, with sourcing rules requiring precise determination of user locations. The Department’s Letter Ruling SUT-17-001 further clarifies that maintenance and support services tied to SaaS are also taxable unless separately stated and performed after October 30, 2017, adding complexity to compliance efforts.

California

California generally exempts SaaS from sales tax, as it is not deemed tangible personal property under theCalifornia Department of Tax and Fee Administration (CDTFA) guidelines. Per Regulation 1502, Computers, Programs, and Data Processing, electronically delivered software—including SaaS—escapes taxation provided no tangible medium (e.g., CD or USB) is transferred to the purchaser. This policy results in a base state sales tax rate of 7.25% applying only to physical software sales, with local rates potentially increasing the total to over 10% in some jurisdictions.

The CDTFA’sPublication 109, Internet Sales, reinforces that SaaS providers typically do not need to collect sales tax on subscriptions. However, if sales exceed $500,000 annually, they must monitor nexus thresholds, as registration may be required. This exemption positions California as a favorable environment for SaaS businesses.

Texas

Texas taxes SaaS as a data processing service, a classification established by theTexas Comptroller of Public Accounts. UnderTax Code Section 151.0035 andRule 3.330, 80% of the SaaS sale price is subject to sales tax, with the remaining 20% exempt to encourage technological development. The state rate is 6.25%, augmented by local rates averaging a total of 8.19%, and the tax applies based on the location where the service is used, as outlined inComptroller Publication 96-259, Taxable Services. SaaS providers must register for a Texas Sales and Use Tax Permit and file returns.

Ohio

Ohio’s approach to SaaS taxability is contingent on the user’s purpose, taxing subscriptions for business use but not for personal use, as governed by theOhio Department of Taxation. UnderOhio Revised Code Section 5739.01(Y), SaaS is classified as an electronic information service or data processing service, taxable when provided to businesses at a state rate of 5.75%, with local rates pushing the total to as high as 8%.
 

The Department’sSales and Use Tax: Digital Products FAQs clarify that this distinction requires providers to verify customer intent, often through contractual terms or customer certifications. Businesses must register via the Ohio Business Gateway and remit taxes based on the situs of use, with exemptions available for software used solely in exempt activities (e.g., manufacturing), per Information Release ST 2003-01.

Differences Between Canned Software, Modified Software, and Customized Software

The taxation of software in the SaaS industry hinges significantly on its classification, that being, is the SaaS canned, modified, or customized, as states apply distinct rules to each category based on their legislative and regulatory frameworks. These distinctions affect the software's taxability and the SaaS providers' broader compliance obligations.

New York

In New York, theNew York State Department of Taxation and Finance delineates clear taxability rules for software types under Tax Bulletin ST-128 (TB-ST-128).

• Canned Software: Defined as prewritten software available for general purchase, canned software is taxable as tangible personal property, regardless of delivery method. This includes SaaS subscriptions using prewritten platforms, subject to a 4% state sales tax plus local rates, sourced to the purchaser’s primary use location.
• Modified Software: Prewritten software adapted for a client. For example, a CRM with custom billing workflows, stays taxable under TB-ST-128. Only transformative changes shifting it to a unique product avoids the 4% state tax plus local rates.
• Customized Software: As explained in TB-ST-128, fully customized software, designed and developed for a specific customer, is exempt from sales tax as a nontaxable service, provided no prewritten components dominate the transaction. This exemption applies mainly to electronically delivered custom software, per Tax Bulletin ST-121 (TB-ST-121), though providers must substantiate the custom nature during audits with detailed documentation.

Pennsylvania

The Pennsylvania Department of Revenue governs Pennsylvania’s software taxability under Act 84 of 2016, detailed in Sales and Use Tax Information on Canned Computer Software and Digital Goods.

• Canned Software: Prewritten software, including updates and support, is taxable as tangible personal property at the state rate of 6%, with local taxes in Allegheny (1%) and Philadelphia (2%), and tax applies based on user location.
• Modified Software: Software that starts as prewritten but is modified for a client remains taxable unless the modifications are extensive enough to qualify as custom. For example, adding payroll APIs to QuickBooks modifies the software but doesn’t serve as the complete overhaul necessary to avoid sales taxation.
• Customized Software: Software created specifically for a single customer is exempt as a nontaxable service, perRevenue’s Taxability Guidelines. Like New York, this exemption hinges on the unique software. For example, a hospital’s custom scheduling app, built specifically for the needs of the given hospital, may escape tax entirely provided there is audit-ready proof that the software is original and unique to the specific purchaser.

California

California’s approach, managed by theCalifornia Department of Tax and Fee Administration (CDTFA), emphasizes delivery method and tangibility, as per Regulation 1502, Computers, Programs, and Data Processing.

• Canned Software: Prewritten software is taxable only if delivered on tangible media (e.g., CD), subject to a 7.25% state rate plus local taxes. Electronically delivered canned software, including SaaS platforms, is not taxable.
• Modified Software: If it is based on prewritten software but modified, it follows the same rule as canned software in CA—it is taxable if on tangible media and exempt if electronic. For example, if the SaaS provider ships the software on a USB (tangible property), that will trigger the 7.25% state rate plus applicable local taxes.
• Customized Software: Software designed for a specific customer is exempt, whether delivered electronically or on media, classified as a nontaxable service under Regulation 1502(f).

Texas

Texas taxes software underTax Code Section 151.0035 and Rule 3.330.

• Canned Software: Prewritten software, whether on media or downloaded, is taxable as tangible personal property at a 6.25% state rate plus local taxes (average 8.19%). SaaS using canned software is taxed as data processing at 80% of the sale price, perPublication 96-259, Taxable Services.
• Modified Software: Software modified from a prewritten base remains taxable as tangible property or data processing unless it qualifies as custom. For instance, adapting a prewritten ERP system like SAP with supply chain modules keeps it taxable, either fully as tangible property or at 80% as data processing under Rule 3.330
• Customized Software: Exempt if designed for a specific customer and exclusive rights are transferred, per Rule 3.308. This requires documentation (e.g., transfer agreements) proving the software is not resold or based heavily on prewritten code, a stricter standard than in other states.

Ohio

Ohio’s software taxation, regulated by theOhio Department of Taxation, depends on use and type, perOhio Revised Code Section 5739.01.

• Canned Software: Prewritten software is taxable as tangible personal property for business use, at a 5.75% state rate plus local taxes (up to 8%), whether on media or electronic, perSales and Use Tax: Digital Products FAQs. Personal use is exempt.
• Modified Software: Taxable for business use if based on prewritten software, perORC 5739.01(B)(5). Modifications must result in a custom application, designed for a specific user, to be exempt as a service underOAC 5703-9-46. As an example, imagine a prewritten HR platform with custom reports for a business client; the custom element of the report function does not tweak the prewritten software enough to avoid taxability.
• Customized Software: Exempt for application software (e.g., business tools) designed for a specific user, but taxable for system software (e.g., operating systems), perOhio Administrative Code 5703-9-46. Providers must distinguish software type and use, with contracts and certifications critical for exemption claims.

Taxability of Standalone Services

The taxability of standalone services sold alongside Software as a Service presents a critical compliance consideration. These services, often invoiced as separately stated line items, raise questions about whether they are taxable independently or as part of a bundled transaction with taxable SaaS. The tax treatment across New York, Pennsylvania, California, Texas, and Ohio hinges on state definitions of taxable services, the relationship to SaaS, and invoicing practices.

In states where SaaS is taxable—New York, Pennsylvania, Texas, and Ohio—standalone services are frequently subject to sales tax when bundled with the SaaS subscription. New York’sDepartment of Taxation and Finance guidance, per Tax Bulletin ST-128 (TB-ST-128), indicates that services integral to taxable software are taxable unless separately stated and reasonable in cost.

Pennsylvania similarly taxes support services tied to canned software, though separately invoiced consulting post-October 30, 2017, may be exempt. Texas, per the Comptroller of Public Accounts Rule 3.330, includes integration fees in the taxable data processing service if not distinctly separated. Ohio taxes such services for business use underOhio Revised Code Section 5739.01, absent clear delineation as nontaxable professional services.

Conversely, California exempts services, as SaaS is not taxable under Regulation 1502. Fees for integration or training escape taxation unless tied to a taxable tangible software sale, offering a clear advantage for providers. Across all five states, the key determinant is whether the service is incidental to the SaaS or a distinct offering (potentially exempt).

Below, please find a sales tax guide that simplifies the general laws and regulations promulgated by the various states in question.

Sales Tax Helper Can Support Your SaaS Compliance Needs

SaaS providers are often faced with complex challenges in determining the taxability of its products and services. Our sales tax professionals help to identify sales tax risks in your business, avoid costly audit mistakes and strategize about adopting your business to current legislature prolonged by the states. To learn more about how we are able to help your SaaS business with its compliance needs, audit defense or appeal representation, schedule a consultation with us today.