States Are Expanding Sales Tax to SaaS and Digital Products: What Businesses Need to Know

The sales and use tax landscape is undergoing a fundamental shift as states aggressively expand their tax bases to capture modern, digital revenue streams. Historically, sales tax taxation focuses on tangible goods, with many digital products and services particularly cloud-based offerings falling outside the scope of taxation. That is changing. States are redefining “tangible personal property” to include digital products, software accessed remotely, and even AI-driven tools, effectively pulling Software as a Service (SaaS) and similar offerings into the tax net. For businesses, this shift introduces new compliance obligations, increased audit exposure, and the need to reassess how contracts, billing systems, and revenue streams are structured across jurisdictions.

Colorado

Colorado House Bill 26-1223, signed into law on June 4, 2026, fundamentally reshapes Colorado’s digital tax landscape by adding computer software directly to the statutory definition of taxable tangible personal property, effective January 1, 2027. This change eliminates the state’s long-standing requirement that software must be delivered via a physical medium to be taxable. Instead, the law expands the tax base to include software delivered by any means, explicitly targeting software accessed remotely through the internet or the cloud. Under this new framework, Software as a Service (SaaS) business become subject to the state’s 2.9% sales and use tax. The bill leaves narrow exemptions only for custom software developed for a single user and software transferred under a negotiated license agreement.

The carve-outs for custom software and negotiated license agreements in HB 26-1223 are designed to draw a clear line between mass-market, commercial off-the-shelf software and tailored corporate enterprise contracts.

Understanding how the Colorado Department of Revenue differentiates these categories is crucial for structuring compliance or identifying non-taxable transactions:

Custom Software Exemption: The law retains an exemption for custom software, but it applies to a strict definition. To qualify, the software must be developed for use by a single, particular user.

Negotiated License Agreement Exemption: This is the most critical exemption for business-to-business (B2B) transactions, but it places a massive documentation burden on sellers. The law explicitly contrasts “negotiated” licenses with standard, boilerplate terms.

What does not qualify: The statute explicitly excludes click-through, browse-wrap, and similar non-negotiable agreements from qualifying for the exemption. If a user buys software by checking a box, clicking “I Accept,” or signing an unalterable, off-the-shelf Master Services Agreement (MSA) or End User License Agreement (EULA), the transaction is fully taxable.

What qualifies: To prove a license agreement is genuinely “negotiable,” there must be evidence of a back-and-forth legal review and modification of terms. For example, the agreement is individually bargained and executed by authorized representatives of each party.

California

Expanded Definition: Signed into law on June 29, 2026, SB 122 fundamentally alters California’s tax landscape by expanding the definition of tangible personal property to include digital products.

SaaS Inclusion: Under this expanded scope, digital products are explicitly defined to include prewritten computer software that is transferred on physical media, downloaded electronically, or accessed remotely, effectively subjecting cloud-based Software as a Service (SaaS) to the state’s sales and use tax. Also included are AI tools.

Effective Date: The new tax treatment goes into effect on January 1, 2027, giving businesses and software vendors a short window to map their digital revenue streams and update billing configurations.

Exclusions Remain: While prewritten software and SaaS subscriptions will now face full state and local sales tax rates, the law explicitly excludes custom software tailored to a single client, infrastructure as a service (IaaS), and other digital goods like eBooks, video games, and streaming media.

Large Purchaser Rule: The bill introduces a unique remittance shift: if a purchaser buys more than $5 million in digital products annually from a single retailer, the seller is relieved of collection liability, and the buyer must self-remit the use tax directly to the California Department of Tax and Fee Administration (CDTFA).

How Source Advisors Can Help

As states like Colorado and California lead the expansion of sales tax into digital services, proactive planning and execution are critical. Source Advisors supports clients through every phase of this transition:

• Nexus analysis and multistate exposure assessments.
• SaaS and digital product taxability studies by jurisdiction.
• Contract and licensing structure review to evaluate exemption opportunities
• Voluntary disclosure agreement (VDA) strategy and execution for historical exposure.
• Sales tax registration and compliance implementation.
• Billing system and tax engine configuration (Avalara, TaxJar, Vertex, etc.).
• Exemption certificate strategy, collection, and audit defense.
• Ongoing compliance outsourcing and managed services.
• Audit support and controversy management.
• Transaction structuring for enterprises and large purchaser scenarios (including use tax obligations).