Sales tax rules in the U.S. are complicated enough — but throw software and SaaS into the mix, and it becomes a whole new level of complexity. States don’t agree on how software should be classified, whether SaaS counts as a product or a service, or whether custom software is taxable at all. In this alert, we explore how prewritten and custom software are treated differently, how SaaS is taxed across major states like New York and California, and why understanding the delivery method of software matters more than most businesses realize. For any company selling software — downloaded, hosted, or even customized — this blog breaks down what you need to know.
Background
Historically, sales tax in the U.S. was meant for physical goods. But that changed as technology evolved. Many states have now extended their tax laws to include services, digital products, and even cloud-based software.
The problem? There’s no uniform rule.
Some states consider software tangible. Others say it depends on how it’s delivered — on a disk or via download. SaaS is even more inconsistent: some treat it like a taxable service, others don’t tax it at all.
For businesses that sell or use software across state lines, this inconsistency can trigger surprise liabilities, especially after the 2018 Wayfair decision. That ruling gave states the power to tax businesses based on economic nexus — meaning companies can owe tax even without a physical presence in the state.
In short: knowing the tax treatment of your software product in every state you operate in isn’t optional — it’s necessary.
Taxability of Prewritten Software
Prewritten software (also known as canned or off-the-shelf software) refers to applications that are not tailor-made for a specific customer. Think of standard accounting tools, video games, or web browsers — the kind of products anyone can buy.
How this software is taxed depends on two key factors:
- Whether it’s prewritten or custom-built
- How it’s delivered — on physical media like CDs or electronically
In many states:
- Prewritten software sold on a CD or USB is treated as tangible personal property and taxable
- Prewritten software downloaded electronically is also taxable in some states, because they classify it as tangible, despite having no physical form
State Examples:
- New York: Taxable, regardless of delivery method
- California: Taxable only if delivered on physical media. Electronic delivery is not taxed
This distinction means businesses need to document how software is delivered — not just what it is.
Taxability of Custom Software
Custom software is built specifically for a single client. Whether it’s a custom ERP, a tool for internal workflows, or a specially-built analytics platform, it’s considered custom when it’s tailored to one user’s needs.
And in most states, custom software is exempt from sales tax.
But there’s a twist: if that software is later sold to another customer — meaning it’s no longer “custom” for just one person — it may lose its exemption and become taxable.
State Examples:
- Illinois: Custom software is not taxable
- Tennessee: Custom software is treated as tangible personal property and taxable
So even within custom builds, states differ. Businesses must be able to justify their exemption with documentation, and be careful if reselling the product later.
Taxability of SaaS
SaaS (Software as a Service) brings its own set of challenges.
SaaS products are accessed online — customers subscribe or license access to software that is hosted in the cloud. They don’t download or own the software, they simply use it via login credentials.
This has led to a split in how states treat SaaS:
- Some see it as renting a service — and tax it
- Others treat it as intangible, and don’t
State Examples:
- New York: Taxable
- California: Does not tax digital goods
- Iowa: SaaS is not taxable if it’s for business use
- Connecticut: SaaS is taxed at a reduced rate if it’s for business use
The takeaway? SaaS providers must not assume their service is tax-exempt. Instead, they should check state-specific rules — especially if they’re growing across borders.
Why This Matters
For software vendors and SaaS businesses, tax compliance is no longer a back-office issue — it’s a frontline concern.
Between different treatments of:
- Prewritten vs. custom software
- Physical vs. electronic delivery
- Tangible goods vs. services
- State-by-state classifications of SaaS
… the risk of getting it wrong is high.
Thanks to economic nexus laws, even small businesses can suddenly find themselves owing taxes in multiple states. And the penalties for late registration or undercollection can add up fast.
Conclusion
When it comes to software and SaaS, there’s no one-size-fits-all approach to sales tax. From how your product is delivered to whether it’s custom or off-the-shelf, each detail plays a role in determining taxability — and each state draws the line differently.
For growing businesses, especially those operating online or across borders, staying compliant means staying informed. Taking the time to understand how your software is taxed today can save you from costly surprises tomorrow.
