Is SaaS Taxable? How Sales Tax Applies to Software Services

Software as a Service (commonly called SaaS) has become an increasingly popular model for delivering software applications over the internet. Since Salesforce launched their first customer relationship management (CRM) platform in 1999, SaaS has seen tremendous growth, with a market size valued at $237.48 billion in 2022 and a projected reach of $908.21 billion by 2030.

With all its benefits, the taxation of SaaS at the state level is complex. As is common in sales tax, states take different approaches on whether and how to tax SaaS. Some states tax SaaS as a service, others treat it as taxable software or digital goods, while some exempt it entirely. Determining when and where SaaS is taxable requires a detailed examination of each state’s laws.

This article provides an in-depth look at the taxability of SaaS across all 50 states. We cover the key criteria states use to determine is SaaS is taxable, an overview of each state’s laws on SaaS taxation, strategies to minimize SaaS tax liability, and the ongoing evolution of SaaS taxation. Understanding this complex patchwork of these tax rules is crucial for both SaaS providers and customers.

What is SaaS?

SaaS stands for Software as a Service. It is a software distribution model in which a third-party provider hosts applications and makes them available to customers over the internet. Rather than purchasing expensive software licenses or installing hefty software on computers or servers, customers can subscribe to an SaaS application to save money, manpower, and hard-drive or memory space.

Some key characteristics of SaaS include:

• Hosted in the cloud – SaaS applications are hosted in the cloud by the SaaS provider. Customers access the software over the internet, without needing to install anything on the server.
• Pay-as-you-go pricing – Rather than purchasing software licenses upfront, SaaS customers pay a subscription fee (typically monthly or yearly) to use the software.
• Scalability – SaaS providers manage the underlying infrastructure, enabling the application to scale easily as a business grows.
• Accessible from anywhere – Since SaaS applications are cloud-based, customers can access them from any internet-connected device.

Popular SaaS Examples

Common examples of SaaS applications include customer relationship management (CRM) software, email services, office productivity suites, accounting software, and more. To make the model of SaaS easier to understand, here are some of the most popular providers:

• Salesforce – The original, Salesforce is a customer relationship management (CRM) software, designed to blend sales, marketing, commerce, services and IT into one team to effectively manage business and customer relations.
• Adobe – Specifically Adobe Creative Cloud, Adobe provides cloud-based design, web development, video editing, and other creative programs like the popular Photoshop. Customers can build individual app subscriptions or subscribe to the Creative Cloud All Apps plan.
• Zoom – A boon during the COVID-19 pandemic, Zoom is a videoconferencing platform. With a multitude of applications to choose from, like Team Chat and conversational AI, Zoom is used worldwide by both companies and families.
• Intuit – Unless you’ve been living under the proverbial tax rock, you’ve probably heard of TurboTax and QuickBooks. Overall, Intuit is a global financial technology platform, offering financial management solutions for both businesses and individuals.

Why States Tax SaaS Differently

The taxability of software and digital goods like SaaS is still a complex and evolving issue. Unlike physical goods which are clearly taxed by most states, digital goods and services are less uniformly defined.

Some key reasons why states have different rules when it comes to taxing SaaS and other digital goods:

• SaaS blurs the line between a tangible product and an intangible service. Some states view SaaS as a taxable digital product or “canned” software, as it is meant to be sold and distributed. Others see it as a non-taxable service with no tangibility with which to tax.
• Technology has advanced faster than tax laws. Most state tax codes were written before cloud computing and SaaS became mainstream, and many of these codes have been slow to update in accordance with the digital economy.
• It’s complex for companies to implement digital tax policy. Factors like sourcing sales transactions and integrating with various billing systems creates implementation barriers.
• Each state has different tax bases and incentives. Some states rely more heavily on sales tax revenue than others, influencing their eagerness to tax digital goods. States also compete to attract tech business and wish to avoid appearing unfriendly to the industry.

All these examples only touch the surface of inconsistent taxation of SaaS and other digital goods.

SaaS Taxation Criteria

Whether or not a state taxes SaaS depends on several key factors and criteria:

• Residency – If the SaaS customer resides in the state, some states consider this sufficient reason to tax subscription costs and purchases of SaaS use.
• Taxability Matrixes – A taxability matrix is the documents and codes written in each state that defines the nuances of that state’s sales tax. Some states have incredibly specific taxability matrixes, while others use vague language like “may be taxable” or “depends”. Taxability matrixes change over time, adopting to new technology and consumerism.
• Type of SaaS – The specific type of SaaS matters. Typically, SaaS is only accessed online or via the cloud. For this reason, many states won’t tax SaaS because there is no exchange of tangible personal property, (which is something that can be felt, seen, or touched), and ownership of the service does not shift from the seller to the purchaser.
• Business or Personal Use – Some states will only tax SaaS if it is purchased for business use and exempt personal use purchases, or vice versa.
• Nexus – If an SaaS provider has offices, employees or property in a state, they have physical presence and therefore nexus in that state. This nexus will require sales tax to be collected in a SaaS-taxable state. On the other side, an SaaS provider can also create economic nexus in a state outside of their own if they exceed certain thresholds (or sales) in that state. Learn more about how nexus applies to out-of-state sellers here.

Understanding these basic criteria allows SaaS providers to better evaluate the risk of taxation within different states. Consulting the state’s taxability matrix is just the starting point. The nature of the SaaS and specific customer situations ultimately determine taxability in some U.S. locations. Ultimately, it is best to reach out to the state for a Private Letter Ruling.

SaaS by State

Minimizing SaaS Tax Liability

Even in states that tax SaaS, there are some strategies and exemptions companies can use to minimize their tax liability.

Reduced Rates

Some states that tax SaaS do so at a reduced rate. For example, if a business in Connecticut purchases SaaS for business use, it is only taxed at a rate of 1%. This is a significant difference from the standard state rate of 6.35%. Other states, like Maryland, omit sales tax on SaaS business purchases entirely. Knowing what states tax SaaS at reduced rates, or omit tax based on personal or business use, can ensure that you do not overcollect.

Server Location

Some states, like Pennsylvania, only tax SaaS if the user is accessing the software from within the state. If the user is accessing the software from out-of-state, it is not taxable, even if the server resides in Pennslyvania. This gray-area of SaaS use can be utilized by sellers to reduce liability, as long as they fully understand the implications and can back up location usage with invoices and receipts.

Partial or Full Exemptions

Similar to reduced rates, Texas takes an 80/20 approach to SaaS taxation. The Lone Star State exempts 20% of SaaS sales from tax, leaving the remaining 80% taxed at state and local rates.

While Texas’ approach is fairly unique, most states exempt certain businesses and organizations from all sales tax collection and charges with the use of exemption certificates. Common exempt organizations include:

• Religious
• Charity
• Government
• Educational

As long as a valid exemption certificate is shown, sales and purchases to and by exempt organizations are not taxable.

The Future of SaaS Taxation

The taxation of SaaS continues to evolve as states update their rules and definitions around digital products and services. Key things that continue to change the SaaS taxation landscape include:

• Ongoing policy debates – the taxation of SaaS remains controversial in some states. Policymakers continue to debate the right way to tax SaaS and other digital services, while others are slow to have the discussion. As these debates evolve, changes to taxability matrixes are expected.
• Possibility of more uniform rules – efforts to create more standardized rules around sales tax have been in the works since the South Dakota v. Wayfair case in 2018. The Multistate Tax Commission adopted a Uniform Sales & Use Tax Resale Certificate that is accepted in 36 states. Another specific effort is the Streamlined Sales and Use Tax Agreement (SSUTA), which tries to simplify sales tax collection across states. Getting states to agree to a uniform sales tax code can be challenging; however, growing pressure for simplicity continues.
• Court cases – just as South Dakota v. Wayfair changed sales tax across the United States, more court cases and lawsuits may challenge state approaches to sales tax, inclding SaaS.
• Technological advances – as technology continues to be developed and refined, taxability matrixes will follow suit.

SaaS taxation remains complex, but could see increasing clarity and consistency over time through policy changes, legal pressures, and industry demand.

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