Digital Products and Sales Tax: Does Your Online Business Need to Collect?
Picture this: You're immersed in the process of making your remarkable digital product, pouring your heart and soul into its creation.
As you prepare to launch and share your masterpiece with the world, a nagging question emerges: "Do I need to charge sales and use tax on this?"
The answer is not as straightforward as we might hope.
Laws regarding the taxability of digital products and what constitutes a digital product are changed and reinterpreted constantly.
For that reason, it is highly recommended that you speak with a CPA, tax professional and/or your state’s taxing authority to discuss guidelines and determine your own sales tax compliance obligations.
With that said, we will try to navigate this complex topic and equip you with the knowledge needed to ensure you sell your digital products confidently and legally.
What qualifies as a digital product?
The definition of what qualifies as a digital product varies from state to state.
Digital Downloads v. Electronically Accessed Online (But No Download)
Some states will differentiate between digital products that you download to your own device versus a digital product that you only access online and do not download.
For example, some states will consider you buying and downloading a movie online (digital download) as taxable because you electronically transferred possession to you or your online account, while simply renting the movie (having electronically accessed it online but no download) is not taxable.
Tangible Personal Property vs. Digital Downloads
Some states will make a tax distinction between a products physical versus digital format.
In some states, products purchased in its physical form (i.e. you buy a physical DVD movie at the store) is taxable while the same movie purchased online in a digital form (i.e. you buy and download the movie) is not taxable. Other states will consider a digital product to be taxable if it has an equivalent physical product that could be purchased, and thus regardless of physical or digital format, both are taxable.
Products That Are Tax Exempt in Physical Form will be Non-Taxable in Digital Form
We also noticed that some states will classify the digital product as the same taxable classification as its physical counterpart. That is, a digital product will be taxable, but only if its physical form is taxable.
So, the first question you need to answer is, does your digital product qualify as a digital good/product in your state?
If so, keep going.
What States Charge Sales Tax on Digital Goods/Products?
As of November 14, 2023, the chart above illustrates which states currently tax digital goods/products.
Find your state:
If it shows that digital goods/products are non-taxable, then celebrate. But then also verify that that is still the case.
If it shows that digital goods/products are taxed in your state, then do a little bit of research to see if your digital goods/products fall within an exception (like, educational purposes that is discussed below). You’ll also want to look at that state’s Department of Revenue Services to verify.
If you do need to collect sales and use tax, then you will likely need to apply for a Seller’s Permit or Sales and Use Tax Permit as well.
Is my Digital Product Exempt if used for Educational Purposes?
Some states will allow certain digital goods to be exempt from sales tax.
This means that if the e-book/other digital product is used for the purposes of instruction, education or training, then you do not have to obtain a permit or collect/remit sales tax (so long as it is not used for professional development or continuing education).
To be considered educational, a product usually needs to meet the following criteria:
It must be used for the purpose of instruction, education, or training.
It must be designed to teach or convey information.
It must be of a general educational nature, not specifically designed for a particular course or program.
If a digital product meets these criteria, it is generally exempt from sales tax.
Some taxes that apply the educational material exception, include for example:
Alabama
Arkansas
Connecticut
Georgia (when tax law goes into effect Jan 1. 2024)
Iowa
Indiana
Kentucky
Maine
Minnesota
Mississippi
Nebraska
New Jersey
North Carolina
Rhode Island
South Dakota
Tennessee
Texas
West Virginia
Wyoming
It is important to look to see if your state defines “education” as K-12 education, college or any type of online learning to ensure this exemption applies.
Sales Tax Nexus
In the U.S. you are also required to collect sales tax in states where your business is found to have an economic nexus.
A nexus occurs when a business has either a physical presence or economic connection to that state - a nexus.
The physical nexus is obvious. But, the economic nexus often leaves business owners scratching their heads.
An economic nexus with a state is established when you start making a certain number of sales (in dollar amount or number of transactions) from buyers who reside in that state.
What happens when I have a sales tax nexus?
If you meet that state’s threshold and you have an economic nexus, then you must collect sales tax from buyers in that state.
The sales tax will vary depending on the state, county, and city taxation obligations.
States that are Origin-Based: If you are selling from an origin-based state, you will charge your customer’s the amount of state and local sales tax for your business’s location to everyone who purchases your digital product (if digital products are taxed in the state you operate).
States that are Destination-Based: This one sucks. It sucks because you are required to calculate the sales tax rate based on your customer’s location. Meaning, you may end up charging multiple sales tax rates based on the buyer’s tax rate and whether that state charges taxes on digital products or not.
Ready for that brown paper bag to upchuck in?
If your head is spinning….you are not alone.
This is why we highly recommend selling your digital products on a platform that allows you to assign a product tax code to the products that you sell so the platform can track this all for you.
With the right third-party payment processor, they will automatically charge your customers in any state or country the right amount of sales tax at checkout based on that state’s or country’s particular tax laws.
If you don’t have this feature, then the next best thing is to make sure that you collect the customer's location information (city/state) and then speak to a tax professional to keep track of it manually.
Just remember to include any potential sales taxes into the cost of your digital product so that you’ll have the funds to pay the sales tax later.
VAT- what?
And….if that wasn’t enough, don’t forget about VAT (Value-Added-Tax).
If you are based in or selling to customers located in countries that require the VAT tax - then, well, just start drinking. Jk.
You’ll likely need to collect VAT as well.
VAT is a consumption tax levied on the value added to goods and services at each stage of production or distribution. VAT is typically borne by the end consumer, as it is included in the final price of the product or service.
VAT rates can vary between countries and can be different for various types of goods and services. Some items may be exempt from VAT or subject to reduced rates, depending on the country's tax laws and policies. It's important to note that VAT is commonly used in many countries around the world, but not all countries have implemented this tax system.
Principle to Remember
Navigating the taxation of digital goods/products can be challenging for an online business owner.
It is ever-changing as new tax laws go into effect.
One essential principle to guide you is this: comply with the state (or country) in which you are operating from and for which holds jurisdiction over your business.
But you didn’t hear it from us. 😉
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DISCLAIMER: The information provided in this blog post is for informational and educational purposes only. This is not a substitute for customized legal advice - if you need legal advice, please consult with an attorney. This is not a law firm.
