Digital Products Sales Tax: What You Need to Know

Are You Ready for the Digital Tax Revolution?

Digital products are everywhere—from music downloads and streaming services to software subscriptions and e-books.

But have you ever wondered why these products are taxed differently across states?

In the evolving digital economy, understanding how states tax digital goods has become crucial for businesses and consumers.

As states adapt their tax policies, it’s vital to know how these changes impact your business operations or purchasing decisions. Whether you run an online business or shop for digital content, staying informed about digital product sales tax can help you navigate compliance requirements and maximize your financial efficiency.

How Do You Define Digital Products for Sales Tax?

Digital products are intangible goods delivered or accessed electronically. Examples include:

• E-books (e.g., Kindle)
• Music downloads (e.g., iTunes, Spotify)
• Streaming services (e.g., Netflix, Hulu)
• Software and apps (e.g., Microsoft 365)
• Digital subscriptions (e.g., newspapers, magazines)

Despite widespread consumption, the classification of these products varies significantly by state, making compliance challenging for businesses.

How Do You Calculate Sales Tax on Digital Products by State?

Sales tax rates on digital products differ significantly between states. Some states tax these goods at the same rate as physical products, while others exempt them altogether. For example:

• Maryland taxes digital products at a flat 6% rate.
• Colorado classifies digital goods as tangible personal property, with rates starting at 2.9%, but this can increase significantly with local taxes.

Digital goods sales tax rates range from 2.9% in Colorado to 7.25% in California at the state level. However, local taxes can further increase these rates, leading to significant variations across the country.

What is the State Sales Tax on Digital Goods?

Digital sales tax rates vary greatly by state. Below is a quick snapshot of key states:

• California: 7.25% (statewide), with additional local rates that can push the total higher.
• Colorado: 2.9%, plus local taxes from home-rule cities.
• New York: 4%, with local taxes as high as 4.875%.
• Maryland: 6% flat rate on all digital products.
• Texas: 6.25%, with local sales taxes that can push the rate above 8%.

As of 2023, 34 states tax digital goods, while 16 states exempt or do not tax them. Understanding these differences is essential for businesses operating across state lines to maintain compliance and avoid penalties.

States That Generally Tax Digital Goods

With the increasing importance of digital products, many states have updated their tax laws to include them. Key states that tax digital goods include:

• California: Applies a 7.25% statewide tax on digital goods.
• Washington: Imposes sales, use, and business and occupation (B&O) taxes on digital products.
• Colorado: Treats digital goods as tangible personal property and taxes accordingly.
• Maryland: Imposes a 6% sales tax on digital products and services.

These states aim to capture revenue from the growing shift towards digital commerce, making it essential for businesses to stay informed and compliant.

States That Generally Exempt Digital Goods

Despite the trend of taxing digital products, some states still choose to exempt them:

• Delaware
• Montana
• Oregon
• New Hampshire

These states do not have state-level sales taxes, which provides a simpler compliance environment for businesses selling digital goods. However, companies must still be cautious when selling outside these tax-free states.

How Do You Source Sales of Digital Products?

Sourcing refers to determining where a sale takes place for tax purposes. This can be tricky for digital products, as buyers and sellers may be located in different states.

• Destination-based sourcing: The tax is based on the buyer’s location (e.g., California).
• Origin-based sourcing: The tax is based on the seller’s location (e.g., Texas).

Most states use destination-based sourcing for digital products, which means businesses must collect and remit sales tax based on the buyer's location. This adds complexity for companies selling across multiple states, requiring careful tracking of customer locations.

Recent Developments in State Tax Laws

Colorado’s Expansion of Digital Goods Taxation

In January 2021, Colorado expanded its tax laws to classify digital goods as tangible personal property. This move makes digital products subject to the state’s 2.9% sales tax, plus local taxes, affecting the $2.1 billion digital goods market in Colorado. This change could raise the effective tax rate to over 8% in some areas, impacting businesses significantly.

Maryland’s Bold Moves on Digital Goods and Advertising

Since March 2021, Maryland has imposed a 6% sales tax on digital products, including videos, music, and e-books. The state also introduced the nation’s first digital advertising tax, targeting companies based on revenue from digital ads within Maryland.

This tax has sparked legal controversy but could generate up to $250 million annually in state revenue (Maryland Department of Revenue).

Kentucky’s Focus on SaaS

Starting in January 2023, Kentucky extended its sales tax laws to include digital services like SaaS, which are now taxed under the state’s 6% sales tax rate. This move aligns with a broader national trend of taxing digital services, impacting software providers and users across various industries.

The Emergence of Digital Advertising Taxation

With U.S. digital ad spending reaching $189 billion in 2022, several states view this as a new revenue opportunity:

• Maryland: Pioneered the digital advertising tax with a tiered rate based on revenue.
• New York and Connecticut: These states are considering similar measures to tap into the digital advertising market.

Despite these initiatives, digital advertising taxes are controversial and face legal challenges from major tech firms.

Cryptocurrency and NFT Taxation: The Next Frontier

As digital currencies and NFTs gain traction, states are exploring how to tax these emerging assets. By 2022, over 50 million Americans owned or traded cryptocurrency, prompting states to clarify their tax policies:

• Wisconsin: Taxes NFTs if the underlying product or service is taxable.
• Washington: Provides comprehensive sales and use tax guidance for digital assets, emphasizing the importance of compliance in this growing market.

Staying Informed and Compliant

The U.S. digital economy was valued at $1.7 trillion in 2023, and as it continues to grow, states are likely to update their tax codes further. Emerging technologies like cryptocurrencies and NFTs will also shape future tax regulations, with more states expected to establish clear policies for these digital assets.

Staying up-to-date with state tax laws is crucial for businesses engaged in digital transactions. Regularly checking state revenue websites, consulting tax professionals, and using tax compliance software can help businesses avoid penalties and remain compliant.

Conclusion

Understanding the taxability of digital products is vital for any business operating in the digital marketplace. Keeping up with developments in states like Colorado, Maryland, and Kentucky ensures compliance while minimizing tax liability.

As states continue to adapt their tax laws, staying informed will be key to maintaining a successful digital business strategy.