As the modern economy continues its rapid transformation toward digital delivery of goods and services, state tax systems are struggling to keep pace. Products that once existed only in tangible form—books, movies, music, software—are now delivered digitally, streamed through platforms, or accessed via the cloud. At the same time, services once provided in person or via phone are increasingly powered by applications, data analytics, and automated systems.

This technological shift has profound consequences for state and local tax regimes. Many states continue to rely on legal definitions drafted for a pre-digital economy, leading to uncertainty, compliance burdens, litigation, and aggressive enforcement. States differ on the tax treatment of digital goods, cloud-based services, and data transactions—creating a patchwork of rules that can trip up even the most diligent taxpayers.

This article examines key trends, case developments, and policy considerations in the state taxation of digital products, including software-as-a-service (SaaS), platform-as-a-service (PaaS), infrastructure-as-a-service (IaaS), digital advertising, and data monetization.

The Digital Tax Landscape: What’s at Stake

Digital product taxation spans a wide array of goods and services, including:

• Downloaded and streamed music, videos, and books

• Prewritten software (delivered physically or electronically)

• Cloud-based applications and platforms (SaaS, PaaS, IaaS)

• Data storage, analytics, and processing

• Digital advertising and platform services

• DNA reports, online genealogy subscriptions, and virtual experiences

States vary significantly in how they categorize and tax these transactions. Some tax digital goods as tangible personal property, while others tax them under newly enacted digital-specific statutes or under longstanding service categories such as data processing.

Digital Advertising and Data Tax Proposals

A growing number of states have proposed or enacted taxes on digital advertising and data monetization. These often target large technology companies, but can have broader effects on businesses using third-party digital services.

Emerging Digital Tax Models:

1. Gross revenue taxes on digital advertising (applied to platform providers)

2. Per-user taxes based on platform usage or account numbers

3. Data mining or “data severance” taxes, treating personal data collection as an extractive activity

4. Journalism fees or surcharges on platforms that monetize news content

These taxes raise constitutional questions under the Commerce Clause, First Amendment, and the Internet Tax Freedom Act (ITFA). Litigation has already begun in some states, particularly around discrimination against digital commerce and ambiguous sourcing standards.

Digital Product Definitions and State Approaches

The definitions of “digital product” and “software” differ widely among states. Many follow the Streamlined Sales and Use Tax Agreement (SSUTA) definition of “specified digital products,” which includes:

• Digital audio-visual works

• Digital audio works (e.g., music, ringtones)

• Digital books

However, states diverge on how they treat access, delivery method, and service bundling. A service may be taxed differently based on whether software is:

• Downloaded (electronically delivered)

• Accessed remotely (vendor-hosted)

• Streamed (live or on-demand)

This leads to significant complexity in determining taxability, especially where software is bundled with services or provided through a cloud platform.

SaaS, PaaS, and IaaS: Characterization Challenges

Software as a Service (SaaS)

Under SaaS, users access software hosted on a vendor’s infrastructure. States treat this inconsistently:

• Taxed as software or tangible property: NY, MA, MD, AZ

• Taxed as a service: TX (data processing), CT (computer services)

• Not taxed or unenumerated: FL, CA, MI, NE

Platform as a Service (PaaS)

PaaS allows customers to deploy their own applications on a vendor’s platform. The taxability depends on whether the platform is treated as leased infrastructure, a service, or software access.

Infrastructure as a Service (IaaS)

IaaS providers offer raw computing resources (storage, networking, processing). Most states do not tax IaaS as the sale of tangible property or software, though a few view it as a lease or service.

Bundled Transactions and the “True Object” Test

In transactions that combine software access, data analytics, and consulting or service components, states often apply a “true object” or “primary purpose” test. This test determines whether the taxable or nontaxable element of the transaction predominates.

• If the core value lies in taxable software or data, the entire charge may be taxed.

• If the true object is a nontaxable service, like professional advice or personalized consulting, then the transaction may be exempt—even if software or analytics tools are used to deliver it.

Some states have moved away from this doctrine. For example, Texas has adopted an “ancillary test” that considers what the vendor does—not what the buyer wants. This distinction increases the likelihood of taxation when data or software are embedded in services.

Recent Developments: Regulations, Rulings, and Cases

Several states have issued new guidance or court decisions affecting digital transactions:

Louisiana

Enacted a law taxing broad categories of digital goods and services, including maintenance and support. Custom software and newspaper exemptions were repealed.

Rhode Island

Declared that genetic health reports accessed via subscription constituted taxable vendor-hosted prewritten software—even though the DNA analysis occurred out of state.

Indiana

Ruled that in-game purchases and subscriptions for online video games were not taxable, as they did not meet the definition of tangible personal property or specified digital products.

New York

Courts have applied the primary function test inconsistently:

• Some bundled services involving portals or dashboards were taxed as software access.

• Others, such as skin treatment devices offered under usage agreements, were treated as tangible personal property despite including service components.

Texas

Adopted changes to Rule 3.330, broadening the scope of taxable data processing services and applying a new “ancillary” test. Marketplace commissions, analytics, and photo hosting services were specifically flagged as taxable.

Procedural and Legal Risks

Beyond statutory ambiguity, digital tax issues present significant procedural risks:

• Overcollection can lead to class actions

• Undercollection can result in false claims (FCA) liability

• States like Florida, New York, and California permit whistleblower claims for alleged tax undercollection

• The ITFA prohibits states from imposing discriminatory taxes on internet access and electronic commerce

These risks are magnified in industries where bundled transactions, cloud-based delivery, and data monetization are standard.

Compliance Tips for Taxpayers

Taxpayers dealing with digital products and services should consider the following:

1. Contractual Clarity: Ensure contracts clearly define whether the transaction involves software, services, or data—and how each element is priced.

2. Invoice Separately: Unbundle taxable and nontaxable charges to avoid entire transactions being taxed.

3. Track State Positions: Maintain a matrix of how each state treats SaaS, PaaS, and IaaS, as well as digital goods.

4. Use Exemption Certificates Properly: Some states allow exemptions for business-use software or software used in production.

5. Monitor Regulatory Changes: Proposed rules in Massachusetts, Texas, and elsewhere may shift standards midstream.

Conclusion: A Moving Target in State Tax Law

State taxation of digital products is dynamic, disjointed, and often unpredictable. As states seek new revenue and struggle to apply outdated rules to modern technologies, taxpayers face growing exposure. Businesses that deliver or purchase digital goods, software access, or data services across state lines must stay proactive, document their transactions carefully, and be prepared to challenge mischaracterizations.

In an age when everything is connected and delivered through the cloud, digital tax planning is no longer optional—it’s essential.

© 2025 Jeanette Moffa. All Rights Reserved.