Sales Tax Management for Digital Goods

Sales tax is complicated. Many businesses find it so overwhelming they simply ignore it completely. But ignoring sales tax compliance can lead to monetary penalties, collection fees, and in the most extreme cases, criminal charges.

Things only get more confusing when sales tax is applied to intangible, digital goods such as music, ebooks or software. From iTunes to Netflix to Steam, we can all agree more online shoppers are turning to digital versions of traditionally tangible items.

Understanding when and how to collect sales tax on these purchases can be complicated for small business owners with limited accounting resources. In this post, we aim to explore this topic and offer a foundation to help you think more strategically about achieving and sustaining sales tax compliance.

Sales Tax Overview

Other than property and income tax, sales tax is the largest source of state tax revenue. As state and local taxing authorities are always on the lookout for new sources of revenue, the rise of digital goods sales has placed them fully under the microscope. Twenty-five states currently require sales tax to be collected on sales of downloadable digital goods. However, we can say with confidence that more states will join this group in the future.

In Tennessee, for example, the enactment of the Revenue Modernization Act led to cloud computing and downloadable games being subject to sales tax as of July 1, 2015.

The Sales Tax Compliance Process

What does it mean to be sales tax compliant? In short, it means you are collecting and remitting the appropriate sales tax to state and local tax authorities in locations where your business has nexus and where you are selling taxable goods or services.

It should be pointed out that the seller is responsible for sales tax, not the buyer. This is because state and local tax authorities aren’t interested in where the tax comes from. If you choose not to collect it from the buyer, then it is up to you to pay the required sales tax out of your own pocket.

This can be dangerous for small business owners. If you’ve turned a blind eye to sales tax collection in locations where you have nexus, then you’re on the hook for the sales tax associated with every ‘tax-free’ sale you’ve made. Moreover, if you haven’t taken that responsibility seriously, it’s likely you have missed filing deadlines and are accumulating late fees and interest on the outstanding tax.

Digging into nexus

Nexus is defined as “a physical connection to a state or local jurisdiction” and is triggered by such common business events as opening an office, hiring an employee or storing inventory.

As an online seller of downloadable software, you may be wondering where you have nexus. Let’s start with your home state. You have nexus based on wherever your business is located.

What about other states? This depends on your business activities. If you’re leveraging remote servers or a content delivery network (CDN), you’ll want to check with the state where those services are located to see what their policy is (every state may be different).

In Washington state, for example, storing digital content on a server in the state does not constitute a nexus triggering event. Owning, renting or leasing server equipment, however, “may be considered as a factor in determining nexus.”

Taxation of software

The world has yet to fully embrace the digital revolution. Netflix offering streaming services as well as DVD rental is a clear example of the split between the old and the new. Software is in the same boat. It is still regularly delivered in both  tangible and digital form. It’s fair to say old habits die hard.

There are two key criteria to consider when attempting to determine if software is taxable.

Software type

In many states, whether software is canned or custom has an impact on its taxability. Like other tax issues, this is unique to every state. Software vendors should check with the appropriate state taxing authority for specific details.

Method of delivery

The software delivery method combined with the software type, impacts the taxability everywhere in the U.S. Canned software delivered on tangible personal property, for example, is taxed everywhere. But if that same software is delivered through an electronic download, it is only taxed in some states. Again, software vendors should check with the appropriate state taxing authority for specific details.

As you can see, determining where and if the software you are selling is taxable is complicated. We didn’t even mention software hosted in the cloud. Don’t make assumptions here. Do the necessary research. The longer you wait, the more difficult and costly it becomes to get right with states and local tax authorities.


As we move closer to an all digital world, the line between taxable and tax-exempt goods and services is becoming ever more blurry. Don’t turn a blind eye to sales tax compliance. Failure to collect and remit taxes places the burden squarely on your shoulders. Missed deadlines and late payments carry the risk of late payment penalties, collection fees, and interest payments.

Be proactive about sales tax management today by taking advantage of cloud tax management solutions like Avalara TrustFile.

Ryan O’Donnell is the Director of Marketing for Avalara TrustFile, a sales tax management SaaS. An engineer by training, Ryan has spent his career leveraging technology to support marketing efforts at various Seattle startups.