Taxable vs. Non-Taxable: What SaaS and Digital Service Providers Need to Know

Understanding U.S. sales tax is essential for SaaS and digital service providers. With each state setting its own rules, knowing what’s taxable and where can be complex.

This article breaks down which digital services are taxable, why states treat them differently, and what businesses need to know to avoid compliance issues or audits.

What Is Sales Tax in the U.S.?

Sales tax is not federal; it’s imposed and enforced by individual states. Originally, sales tax was applied to physical goods like furniture, electronics, or clothing. However, as services became a larger part of the economy, many states expanded sales tax to cover them, especially digital services.

Each state sets its own tax rules. Some states don’t tax services at all, while others tax specific types, such as SaaS or digital content. This means two businesses offering the same product in different states could face very different tax obligations.

What Digital Services Are Typically Taxable?

While many digital services remain untaxed in most states, others are often subject to sales tax, especially if they involve digital delivery or automated functions. Here are some common examples:

• SaaS: States like New York, Texas, and Pennsylvania consider SaaS taxable. These states view SaaS as a substitute for packaged software and treat it similarly under tax law.
• Digital products and subscriptions: Think eBooks, music downloads, cloud storage, or video streaming - these are taxed in many states because they are considered tangible equivalents of physical products.
• Data processing or information services: In Texas, for example, data processing (e.g., data entry, database management) is specifically listed as taxable.
• Website hosting, maintenance, and design services: These may be taxed if the end result is seen as a tangible deliverable. In Connecticut, for instance, website creation is taxable if it uses canned (prewritten) software.
• Consulting services tied to a deliverable: Some states tax consulting if it includes a physical or digital deliverable, such as a report or software file.
  

TIP - Even if your service seems intangible, how it’s delivered matters. Depending

on the state, a report emailed to a client may make a non-taxable service taxable.

What Digital Services Are Often Non-Taxable?

While the rules are expanding, many digital services remain non-taxable in most states:

• Custom software development: Creating fully custom software for a client is non-taxable in many states. Customization often removes the “tangible” classification that would otherwise make software taxable.
• Pure consulting or strategic advice: Services that involve expertise, guidance, or planning (with no physical product or standardized output) are often exempt.
• Education and training services: Whether offered in person or online, training is often tax-exempt. However, some states, like Washington, may tax on-demand or pre-recorded training.

IMPORTANT - Even non-taxable services can come with responsibilities. You may

still need to register for a tax permit or file reports if you meet a state’s threshold.

Why Are Some Digital Services Taxed and Others Not?

State tax laws were originally written when most commerce involved physical goods. Back then, taxing digital services didn’t make sense because few people sold them at scale. However, the economy has changed. Services now dominate, and many states look to these as new revenue sources. That’s why some states have expanded their tax laws to include software subscriptions, streaming, and even data storage.

Each state defines taxable services based on what it considers “tangible,” “useful,” or “delivered.” And their definitions don’t always match.

KEY POINT - There’s no standard across the U.S. What’s

exempt in one state may be fully taxable in another.

How Do States Vary?

Sales tax rules differ significantly by state. Below are examples of how different states treat SaaS and digital services:

Is SaaS taxable in New York?

New York taxes most Software-as-a-Service (SaaS) offerings, as well as information services like databases, research tools, and other data access platforms.

Are digital services taxable in California?

Generally, no. California exempts most services from sales tax. However, if your service includes physical goods, like printed reports or packaged software, you may be required to collect tax.

Does Texas tax digital services and SaaS?

Texas has broad tax rules that apply to data processing, IT services, and SaaS. If your service involves storing, managing, or manipulating data, it’s likely taxable in Texas.

Is SaaS taxable in Illinois?

Not usually...well, Illinois is a pain. Illinois generally does not tax SaaS. However, while the state of Illinois is one thing, the city of Chicago has its own separate tax policies.

How Can I Stay Compliant?

To avoid penalties or back taxes, take these steps:

1. Know where your customers are

Keep accurate records of where your final users are (which may not necessarily be the billing address). This helps determine where you may owe sales tax.

2. Determine nexus

Check if you’ve triggered nexus in any state. This includes both physical and economic nexus.

3. Classify your services accurately

Break down what you’re offering: SaaS, consulting, digital downloads, or custom development.

4. Research each state’s rules

Visit official state tax websites. Rules can change from year to year.

5. Register to collect tax where required

Don’t wait. Once you cross a nexus threshold, you may owe back taxes.

6. Keep detailed records

Track tax collected, exemptions claimed, and filing deadlines.

If you sell digital services, especially SaaS, subscriptions, or digital tools, it’s important to understand U.S. sales tax. Not every digital service is taxed, but many are, and the rules vary by state. Don’t assume that just because you’re online, you’re exempt.

Not sure where to begin? Orbiss can help you assess your exposure and set up the right tax system from day one. Contact us and stay compliant.