California Taxes the Cloud: The New Sales Tax on Software, with Neil Bass

California Taxes the Cloud: The New Sales Tax on Software, with Neil Bass

Starting January 1, 2027, California will apply sales and use tax to prewritten software, including software as a service, no matter how it is delivered. In this episode of Wealth Actually, I talk with Neil Bass, CPA and managing member of Bass Tax Group, about what changes, who pays, and what buyers and sellers should do before the deadline.

For decades, California taxed software sold on a disk but not the same software downloaded or used in the cloud. Senate Bill 122, signed June 29, 2026, closes that gap. Neil saw it coming and wrote about it on LinkedIn, which is how this conversation started.

We cover why the physical-versus-digital line existed, which products are taxable and which are excluded, how bundling can pull exempt items into the tax, and how invoices that straddle January 1 get split. We also get into the $5 million rule that shifts the tax to large buyers, economic nexus for out-of-state vendors, sourcing based on where the user sits, the stakes for AI companies, Colorado’s parallel change, and whether this pushes more businesses out of California.

Key takeaways

• Delivery method no longer matters. Beginning January 1, 2027, prewritten (“canned”) software is taxable in California whether it arrives on a disk, by download, or through the cloud. Custom software remains exempt.
• Bundling can make everything taxable. Certain digital items are excluded, but Neil warns that bundling different types of software together can expose the whole package. Sellers should separate what they sell on the invoice.
• Taxability follows the period of use. Use on December 31 is not taxable; use on January 1 is, regardless of the invoice date. An invoice covering December 15 to January 15 may be half taxable.
• The $5 million rule shifts the tax to big buyers. When a seller’s sales of these products to one customer exceed $5 million in a year, the seller stops collecting and the buyer remits use tax directly.
• Out-of-state vendors are not off the hook. A vendor with no physical presence in California still has economic nexus once its California sales exceed $500,000.
• Follow the user, not headquarters. The key question is where the software is actually used, which can be hard to track for distributed teams.
• Model the cost now. At 9.5%, a $1 million software purchase carries roughly $95,000 of tax. Customization claims will matter, and they will be tested on audit.
• AI revenue is a likely target. Neil does not see how AI companies avoid charging the tax to their California customers.
• The end user pays. Whether or not it is itemized, the tax ultimately shows up in the price of software.

Episode timestamps

00:00 Preview: why delivery method no longer matters
00:20 Introduction and disclaimer
00:46 What California changes on January 1, 2027
01:41 Why physical and digital software were taxed differently
03:20 What Senate Bill 122 changes
04:16 Which products are taxable, and why bundling matters
05:18 Timing: use dates, invoices, and the transition period
05:58 The $5 million rule: when the buyer pays use tax
07:25 Out-of-state software providers and economic nexus
08:26 Sourcing: follow the user, not headquarters
09:14 Modernization or a headwind to innovation?
10:19 Before the deadline: model the impact
11:46 Customization, unbundling, and audit risk
13:32 AI companies and the new tax base
14:59 Will other states follow California?
16:13 Will this push businesses out of California?
17:16 Could a federal standard simplify sales tax?
18:28 Can offshore IP avoid the tax?
19:23 Out-of-state buyers of California software
20:32 Who ultimately pays, and avoiding double tax
21:40 How to reach Neil Bass and Bass Tax Group

Notable quotes

“California doesn’t fool around when it comes to their sales tax.” — Neil Bass

“As soon as you start bundling different types of software together, all of it is potentially subject to tax.” — Neil Bass

“When you use the product on January 1, it’s taxable. If you use it on December 31, it’s not taxable, regardless of when you may be invoiced for the product.” — Neil Bass

“At the end of the day, the end user is going to be paying this additional tax.” — Neil Bass

About Neil Bass

Neil D. Bass, CPA, founded Bass Tax Group (formerly SmarTax) in 2006 and serves as its managing member. The firm advises companies on ASC 740 income-tax accounting, corporate tax strategy, international tax, mergers and acquisitions, and tax examinations, working with U.S. multinationals, inbound groups, and middle-market companies. Before founding the firm, Neil worked at a Big Four accounting firm, in banking, and at a regional accounting firm. He holds a B.S. in Accounting and a Master’s in Taxation from Rutgers University. (Bass Tax Group) He is regularly quoted on corporate tax matters, most recently by CFO Dive on FASB’s income-tax disclosure rules.

Editor’s notes

These notes add context to points made in the recording. The conversation itself is unchanged.

• The agency. The conversation refers to the Franchise Tax Board. California sales and use tax, including the new tax on digital products, is administered by the California Department of Tax and Fee Administration (CDTFA). The Franchise Tax Board handles income tax. (CDTFA)
• The rate range. Neil’s 9.5% example is illustrative. As of October 1, 2026, combined California rates run from the 7.25% statewide rate up to 11.75% in Palmdale and Lancaster, which would mean about $117,500 on a $1 million purchase. (CDTFA rates; CDTFA notice L-1037)
• The $5 million rule. As enacted, the rule applies when a seller’s receipts from one buyer exceed $5 million in the current calendar year, and beginning January 1, 2028, in the current or preceding year. The buyer must obtain a use tax direct payment permit, and CDTFA can grant a waiver that returns collection to the seller. Neil’s caution reflects regulations that were still in draft when we recorded. (PwC; CDTFA notice L-1036)
• Subscriptions that cross January 1. CDTFA’s proposed regulations apply tax to subscription periods on or after January 1, 2027, regardless of when the contract was signed or invoiced, which matches Neil’s description. (Legal 500)
• Which states already tax SaaS. Neil says most major state economies already tax this software, with Florida a possible exception. New York, Texas, Pennsylvania, Washington, and Ohio tax SaaS in some form, but Florida, Georgia, Virginia, and Illinois at the state level generally do not; Chicago taxes it locally. (TaxCloud survey)
• Colorado. Neil’s point about Colorado checks out: House Bill 26-1223 makes most software, including SaaS, subject to Colorado sales tax beginning January 1, 2027. (Colorado Department of Revenue)

Frequently asked questions

What does California SB 122 do?
It expands California’s definition of tangible personal property to include prewritten computer software, whether it is delivered on physical media, downloaded, or accessed remotely as SaaS. Sales and use tax applies beginning January 1, 2027.

What is excluded from California’s new software tax?
Custom software is exempt. The law also excludes digital assets such as cryptocurrency, digital audio, audiovisual and visual works, digital books, digital video games, and digital infrastructure such as IaaS and PaaS.

Does the tax apply to an out-of-state software company?
It can. A seller without a physical presence in California has economic nexus once its California sales exceed $500,000, and the sale is sourced to the customer’s California location.

How are subscriptions that span January 1, 2027, handled?
Tax follows the period of use. Charges for periods before January 1, 2027, are not taxable; charges for periods on or after that date are, even under a contract signed earlier.

What is the $5 million rule?
When a seller’s sales of electronically delivered or remotely accessed software to one buyer exceed $5 million in a calendar year, the seller is relieved of collecting the tax and the buyer reports and pays use tax directly under a direct payment permit.

Who ultimately pays California’s SaaS tax?
Neil’s view is that the end user pays, either as a line item on the invoice or built into a higher price.

Interesting links

• Bass Tax Group — Neil’s firm
• Neil Bass on LinkedIn
• California’s Next Tax Frontier: The Cloud — Neil’s article that prompted this episode
• CDTFA Tax Guide for Retailers and Purchasers of Digital Products — the state’s official guidance
• CDTFA Special Notice L-1036 — two-page summary of the new rules
• PwC: California imposes sales and use tax on digital products and SaaS
• Colorado Department of Revenue: Computer Software — Colorado’s parallel 2027 change

This podcast is for educational and entertainment purposes. It is neither investment, legal, nor tax advice.

Transcript

[00:00] Neil Bass (preview): A lot of software, if not most software, is delivered electronically. And so if you’re a software company and you have a client in California and you deliver that software to them electronically today, you could avoid having to collect sales tax on that transaction. And so beginning in January, that all changes.

[00:20] Intro: Welcome back to the Wealth Actually podcast, the show that features experts, entrepreneurs and commentators that will give you the right knowledge, planning and guidance so you can preserve your assets and enjoy your wealth. Learn more and subscribe today at WealthActually.com. This podcast is for educational and entertainment purposes. It is neither investment, legal, nor tax advice. It does not represent the opinions of the employers or the host or guests.

[00:46] Frazer Rice: Welcome aboard, Neil.

[00:47] Neil Bass: Thank you. Good to be here.

[00:48] Frazer Rice: Well, you’re here because one of the posts you put out on LinkedIn around tax policy really raised my eyebrows. It’s something I hadn’t really heard about, and it got me on the emails to you as fast as possible to see if we could get into it a little bit. What exactly is California doing that starts January 1, and why is it significant from a digital tax policy perspective?

[01:18] Neil Bass: Well, what California is doing beginning January 1, 2027, is they’re going to tax software that is delivered electronically. Whereas in the past you could deliver software to a customer in California and avoid sales tax, that will no longer be the case beginning January 1. So it could be a pretty big revenue raiser for California, for sure.

[01:41] Frazer Rice: So the difference between delivering it physically and delivering it digitally makes sense for all of us who sort of traffic in that. Why did California delineate between the two in terms of taxation?

[01:55] Neil Bass: Well, I don’t think California was so unusual from a historical perspective. Historically, sales tax, which I think started way back in the 1930s, was based on tangible products. And so when companies started to sell software, which, I don’t know, maybe was in the 1960s or ’70s, everything was on a physical disk. Everything was in a physical format.

And at some point there was a change. It might have started in the 1990s, where companies were able to deliver software electronically over, say, a modem, over a dial-up connection, way back in the ’80s or ’90s. And states generally did not tax that because it didn’t fit the definition of tangible property. It was an over-the-air service, if you will. And so it escaped taxation.

States started to tax it really beginning in the early ’90s. New York was actually the first one to start taxing it, and other states followed suit. And I think California might have just had a strong enough lobby in terms of software that they were able to avoid it. But no more.

[03:20] Frazer Rice: So what does the new Senate Bill 122 do? What is different now, as opposed to 2026 — well, we’re here now — but in 2027, when it kicks in?

[03:34] Neil Bass: Well, what’s different is, I think these days, a lot of software, if not most software, is delivered electronically. If you’re a software company and you have a client in California and you deliver that software to them electronically today, you could avoid having to collect sales tax on that transaction. Beginning in January, that all changes.

And again, specifically, we’re talking about canned software. There are exceptions for certain types of, for example, custom software. But if it’s prewritten software, that’s going to trigger taxation regardless of the delivery method in California as of January 1.

[04:16] Frazer Rice: So that gets to my next question: Which digital products become taxable, and why is product classification going to be so important going forward, and how things are bundled?

[04:27] Neil Bass: The digital products that are taxable are going to be the ones that are prewritten. Software as a service is generally taxable. But if you have certain types of things like audiovisual works and artwork and games and certain things that are custom, you can carve it out and treat it as exempt.

So it’s important, as a software company, if you’re selling a bundle, to bifurcate what you’re selling. Because as soon as you start bundling different types of software together, all of it is potentially subject to tax.

[05:04] Frazer Rice: Oh, wow. OK, so for the software people, they have to be careful of that. And then for the people who are buying it, I’m sure there may be some weird surprises in their invoice when they see it next year.

[05:18] Neil Bass: Correct. And it really goes by use. There’s a lot of confusion over the timing, and the regs still have to be worked out. Even though we’re already in November, the specific regulations are not totally worked out yet. But when you use the product on January 1, it’s taxable. If you use it on December 31, it’s not taxable, regardless of when you may be invoiced for the product.

So it can create some complications for that period of time, or for invoices that may cover, let’s just say, December 15 through January 15, for example. Half of it could be taxable and half of it may not be.

[05:58] Frazer Rice: Interesting. So there’s a provision where, for software purchases over $5 million, the burden of reporting shifts to the purchaser. How does that work, and what’s involved for the purchaser at that point in terms of the sales tax component, versus if it stayed with the software company?

[06:17] Neil Bass: Yeah. So what’s really interesting about this $5 million rule is that if you’re selling more than $5 million in a calendar year to a particular customer, you as the seller are no longer required to collect sales tax. Even though it may be a taxable sale, now the burden goes on the buyer to remit it as use tax.

Now, again, the regs haven’t been totally worked out yet. So it’s very possible that this $5 million rule may not take effect until the following year. That’s still up for debate, I guess you can say, because there may be a look-back period where you look back over the prior year, and if you sold more than $5 million of product to this particular client, you no longer have to collect. But again, there may be some new regs or advice that come out over the next couple of months that will clarify whether this $5 million rule is going to kick in in 2027, or will kick in in 2028 based on a look-back to the year 2027.

[07:25] Frazer Rice: Let’s say I’m a software provider based in Nevada or Texas or Florida or even New York, and I touch California in some ways but not in others. What do those types of out-of-state software providers have to worry about in terms of registering, doing business in California, or having operations in California?

[07:49] Neil Bass: Well, I don’t think those particular rules are necessarily changing. So if you’re out of state, if you don’t have a physical presence in California, you do have to look at whether or not you have economic nexus. So, for example, if you have half a million dollars of sales to California, you automatically have economic nexus. If you’re in that situation, then you’re going to have to worry about it. Regardless of the fact that you’re not physically located in California, you’re going to have to be concerned with, “Hey, is this taxable or not?” And the rules are changing as of January 1.

[08:26] Frazer Rice: And so I guess it gets to concepts like sourcing, with employees in different states but contracts centralized in one particular area. How does this bill touch that?

[08:40] Neil Bass: You really have to look to see where the software is being used. That’s really the key. That’s really the focus. So regardless of where it’s being billed out of, or regardless of your headquarters, you really have to focus on the location of the user, which may be easier said than done. But that needs to be the focus. And maybe now that certain sales are going to be taxable that are not currently taxable, there needs to be a greater focus on where my software is really being used [unclear].

[09:14] Frazer Rice: Some people are going to say this is modernizing the tax system, in the sense that it’s taxing tools where they’re being used [unclear] where they’re being generated. And others are going to say that this is a headwind to productivity and innovation and creates complexity around who owes the tax and where. On what side of the fence do you sit, or are you straddling the fence?

[09:37] Neil Bass: Oh, I’m straddling.

[09:40] Frazer Rice: Frankly, I think it’s both.

[09:41] Neil Bass: It is both. There’s no doubt that it is a revenue raiser, and it may hurt businesses. It may encourage a California-based business that has to purchase a lot of software to move to a different state where it may be more tax-friendly. I think we’re seeing a lot of that anyway. But on the other hand, the truth of the matter is that I think most of the states in the country that have a sales tax are already taxing this type of transaction. So there’s an argument that California is catching up to the rest of the country.

[10:19] Frazer Rice: If I’m a business and I’ve now got a month and a half, two months before this kicks in, and I’m looking at my tech stack, my software, billing systems, resale transactions and maybe multistate agreements, what should I be thinking about in terms of understanding what this impact is going to be on me?

[10:41] Neil Bass: Well, I think you need to model the impact. We’re talking about a high rate of tax. California doesn’t fool around when it comes to their sales tax. They’ve got a 7.25% base rate, and it could go up to nine and a half percent depending on where you’re located. So on a million-dollar purchase, you’re talking about possibly an extra $95,000 of tax that you have to pay.

So this is something that I think buyers and sellers need to focus on. They need to make sure that their invoices properly unbundle whatever is being sold, to the extent that anything being sold may be customized, so that it may avoid sales tax. I think there needs to be a greater focus on what’s exempt and what positions you could take to try to do that. Whereas prior to 2027, you may not have had to worry about it too much, as long as you were delivering the product through the cloud.

[11:46] Frazer Rice: On this customization idea — obviously, Microsoft Office is not going to be customized. So that will probably be something where, as the updates are delivered, that sales tax, if it were California-sourced, would flow through. And at the enterprise level, that’s probably going to be a lot. Where does the customization come in? Is this something where unbundling is going to be important to show what is the base software versus what is the customization?

[12:18] Neil Bass: It could be. It could be critically important, and it could be up for debate in the event of an examination, for sure. But it’s important to demonstrate that you are providing a different type of software for different clients and that you are customizing it. There may be some new rules coming out with respect to how much it must be customized, versus just making little changes here and there. So that’s something you need to keep an eye out for, to see what they’re going to do about it. But yes, customization is something that I think needs to be a big focus, because that could result in a very big difference in the cost.

[13:03] Frazer Rice: I look forward to the Franchise Tax Board audit where they’re going through code and sort of parsing what’s standard and what’s nonstandard, and whether that turns into a $90,000 bill or not.

[13:18] Neil Bass: Exactly.

[13:19] Frazer Rice: And I’m sure there are some aggressive taxpayers out there that take some chances.

[13:22] Neil Bass: But I’m also sure that the California Franchise Tax Board has enough experts on board to understand this better than the layperson.

[13:32] Frazer Rice: So as it relates to AI, for instance: If I’m a large language model and I’m starting to pull from different software packages in order to solve different problems, I imagine that gets complicated in terms of unwinding whether there should be payment for software in that case. And if so, how do you sort out what’s happening or not happening there as far as a California nexus? Where do you think this goes for those AI companies that had sort of assumed that if it’s, quote unquote, out there, there isn’t any monetary ramification to their use of it?

[14:16] Neil Bass: Well, I think it changes in a big way for the AI companies. I don’t see how the AI companies are going to get around not taxing this to their California customers. I don’t see a way around it. It’s going to be pretty tricky to take a position that it’s tax-exempt. And maybe that’s part of the reason why this law came into play, because there’s so much revenue now for AI, and projected revenue for AI, that I think California is going to try to tax it all.

[14:49] Frazer Rice: Yeah, that would be, in my opinion, the correct knee-jerk response. If it’s a pot of money, they’re going to try to get their hooks into it one way or the other.

So to that end: If this model becomes, let’s call it, successful — meaning it has its showy debut at the turn of the calendar — the states that have already started these types of initiatives are going to say, “Yeah, we did that,” [unclear] other cash-strapped states, maybe even municipalities, may start to think about this. Do you think this has the real potential to be a model going forward?

[15:24] Neil Bass: One hundred percent. I think this has become the norm, where it used to be unusual. California was more or less a standout in that it didn’t tax it. But all of the major state economies, as far as I can tell, tax this type of software. Florida may be an exception, but Florida is an exception in a lot of ways. But I think the remaining states may follow suit, just because it is the future. People are not buying software on physical disks anymore. It hasn’t been the case in a very long time. And so it just makes sense for whatever remaining states are out there to follow suit. In fact, I believe Colorado is also following suit in 2027 with this type of transaction.

[16:13] Frazer Rice: Got it. I used to work for the New York State Department of Economic Development, so I’m used to businesses threatening to leave, leaving, not coming here in the first place, tax burdens, et cetera. What do you think this does from a California perspective in terms of competitiveness, in terms of keeping businesses there? Is this enough to tip the balance for a software company starting up in California, talent issues and Silicon Valley aside?

[16:42] Neil Bass: It could be. The important thing here is that the tax is based on where the user is located. So it may not necessarily matter whether the software company is based in Florida versus California. That being said, I do think this could be one of those things that could tip the scales. A lot of businesses are moving out of California for tax reasons, and this could be just yet another reason why they may decide to move to Nevada or wherever.

[17:16] Frazer Rice: With different states treating things differently, do you see an opportunity for the federal government to look at this and say, “Hey, we have our own deficits to worry about. Is this something we should levy,” maybe under the guise of making it easier for the whole country by having one set of rules?

[17:36] Neil Bass: Well, that would make things easier. And I think the federal government has been talking about a national sales tax for a long time. Ever since I’ve been working as an accountant, which has been quite a long time, that’s been discussed, and it just never seems to happen. But who knows? One day it may happen. One day they may solidify the rules.

Sales tax is probably one of the most complicated things in taxation. We have a lot of clients that are based overseas, and they say this is the most complicated piece of doing business in the United States: dealing with all the different jurisdictions and different sales tax rates. So it would be nice if we could have one set of rules. But I’m not optimistic that I’m going to see it in my lifetime.

[18:28] Frazer Rice: To that end, you talk about offshoring and other countries. Is there potential that this sales tax in particular drives some of the intellectual property certainly to other states, but maybe offshore, where there’s some sort of arbitrage to be had? Or is it set up so that if the user is using it and there’s a California nexus for, let’s say, the operations of the company, but the IP or the software is held in Ireland or Luxembourg or somewhere like that, there’s some gamesmanship that can go on there?

[19:01] Neil Bass: I’m not aware of any gamesmanship that can go on there if the IP is located someplace else. I think the key is: Where is the user? But if people can move around the user — if they can somehow move them out of California — then there can be a tax savings there. So I think we may see some of that happening, and we probably already are seeing some of that.

[19:23] Frazer Rice: One last question here. For people who live in Texas or Illinois or wherever, and they are buying software that’s created in California and digitally sent to the user in these outside states, how does that work exactly? Will they see the California tax on their invoice, or are they purely taxed at the level of the state they’re in?

[19:49] Neil Bass: It’s a good question. They should not see the California tax on their invoice unless somebody makes a mistake, which is possible [unclear]. It should be based on where they’re located, so it should not impact someone in that scenario. But I wouldn’t be surprised if it inadvertently does impact somebody, because the reality is that some mistakes are made. Sometimes you don’t know where your user is. Sometimes the company may tax the customer based on some other factor that may not be totally accurate. So I wouldn’t be surprised if we see additional revenue coming California’s way that really doesn’t belong to them.

[20:32] Frazer Rice: Got it. And so it’s likely what ends up happening is that the California firm absorbs the tax and then passes the bill on. They won’t itemize where it’s going, but they’ll pass the cost on to the end user, and it just ends up in a higher price paid for software.

[20:49] Neil Bass: Correct. At the end of the day, the end user is going to be paying this additional tax. That is ultimately going to be the reality.

[20:58] Frazer Rice: Just to go back to your comment before: If you were taxed with Illinois sales tax and a California tax was incurred by the company, in theory that tax has been paid twice. You should be able to go back and make the argument that it’s got to be netted somewhere.

[21:20] Neil Bass: Oh, yeah. There are mechanisms to do that. Sometimes it’s difficult to do and to convince the state that it was paid in a different way. But for sure, you should not be paying the same tax twice to two different jurisdictions. There are typically mechanisms to avoid that.

[21:40] Frazer Rice: Really interesting stuff. Neil, how do people find you? And maybe give us a quick rundown on the services you provide.

[21:48] Neil Bass: OK, sure. The company is Bass Tax Group. We’ve been around for over 20 years. We are a corporate tax consulting firm. We focus on tax accounting mainly for larger public companies, and we help corporations with cross-border transactions and whatnot. You can find us on our website at BassTaxGroup.com, or on my LinkedIn page, which is Neil Bass.

[22:18] Frazer Rice: And as someone who saw this come up on your LinkedIn page, you come out with really good information very frequently, so you are a good follow on that front. I encourage everyone to keep an eye out. Fantastic. Neil, thanks for being on.

[22:31] Neil Bass: All right. It was great to see you, and great to be here. Thank you.