California SaaS Sales Tax Guide (SB 122)
A software founder in San Diego has spent eight years selling subscriptions to California businesses without ever charging sales tax. Her billing system has no tax field. Her customer contracts say nothing about tax. Her finance team has never filed a California sales tax return.
And, as of January 1, 2027, every one of those subscriptions is taxable.
California has extended its sales and use tax to software as a service and other prewritten software, regardless of how it is delivered. For thousands of software companies, this is the first time California sales tax has touched their revenue. The companies that prepare over the next eleven weeks will treat it as a billing change. The companies that wait will likely meet it for the first time in an audit, with the tax, interest, and penalties coming out of their own margins.
What Is SB 122 and Who Does It Affect?
SB 122 is the California law that extends sales and use tax to software as a service and other prewritten software, starting January 1, 2027. Governor Newsom signed Senate Bill 122 on June 29, 2026, as part of the state budget.
For decades, California sales tax applied to tangible personal property, meaning physical goods. Software was taxable only when it came on a disk or other physical media. Software downloaded or accessed through a browser fell outside the tax, which is why most SaaS companies never registered with CDTFA.
SB 122 changes that by adding “digital products” to the definition of tangible personal property. A digital product is prewritten software, whether it arrives on physical media, is downloaded, or is accessed remotely. In practical terms, California now treats a monthly software subscription the same way it treats a box of office supplies.
The law affects three groups of businesses. California-based software companies feel it most directly, since a physical presence in the state generally means they must collect the tax starting January 1. Out-of-state software companies are affected once their California sales pass $500,000, even with no office or employees in the state. California businesses that buy software are affected as well. They will see sales tax on subscription invoices, and in some situations they will owe use tax directly to CDTFA (buyer-side guide coming soon).
This article focuses on the software companies that will now collect the tax. The sections below explain how to tell whether a product is taxable, which companies have to collect, and what to do before January.
The tax rate is the same one every California retailer charges: the 7.25% statewide rate plus any local district taxes, which push the combined rate above 10% in some cities.
The details are still being finalized. CDTFA released draft emergency regulations on September 1, 2026, held a public meeting on September 10, and accepted comments through September 24. Final rules may differ from the drafts, so any planning built on them should be revisited once CDTFA formally adopts them.
Does My Software Company Have to Collect California Sales Tax?
Two questions decide it: whether your product is taxable, and whether your company has enough connection to California to be required to collect.
Is my software product taxable?
If you sell the same software to many customers, it is almost certainly prewritten software and taxable starting January 1. That covers most SaaS platforms, downloadable software, and AI tools sold on a subscription basis. Under CDTFA’s draft regulations, mandatory maintenance, license fees, and other charges a customer cannot opt out of would generally be included in the taxable amount.
Several categories stay outside the tax. Custom software built to the special order of a single customer remains exempt, though CDTFA’s draft guidance reads that exemption narrowly. Software licensed to multiple customers is still prewritten even when its outputs look highly tailored. The draft rules also keep infrastructure as a service and platform as a service out of the tax, along with digital books, music, video, video games, and digital assets.
The gray areas are where problems tend to start. Configurable platforms, products sold with implementation or consulting services, usage-based pricing, and freemium models all deserve a careful look before January. A product classification that seems obvious to the engineering team may look very different to an auditor reading the invoice.
Does my company have nexus in California?
A California-based software company has physical presence and is required to collect. Out-of-state sellers are required to collect once their California sales exceed $500,000 in the current or prior calendar year, or if they have employees, an office, or property in the state.
An out-of-state company with no California office can still be fully responsible for collecting. Many software companies that have never dealt with CDTFA will cross that threshold on the first day the tax applies.
What about very large customers?
SB 122 includes an unusual rule for enterprise accounts. When a single customer’s purchases of digital products from one seller exceed $5 million, responsibility for the tax generally shifts to the purchaser, who must obtain a use tax direct payment permit from CDTFA. Sellers should not stop collecting on a large account until they have confirmed the customer qualifies and has the proper documentation in place.
How Should SaaS Companies Tell Customers About the New Sales Tax?
Start with your contracts, because they decide whether you can pass the tax on at all.
In California, sales tax is imposed on the seller. A seller may collect reimbursement for the tax from the customer when the agreement allows it. If a master services agreement says the subscription fee includes all taxes, or says nothing about tax, the company may have a hard time adding tax to the invoice mid-term. In that situation, the tax can end up coming out of the company’s revenue.
A common mistake is assuming the billing system will sort this out. Whether a customer owes the new tax line depends on the contract it signed. Before January, pull your standard terms, your enterprise agreements, and any customer-negotiated paper, and look for the tax language in each.
Once the contracts are reviewed, the customer message can be short and factual. Customers respond best when the notice explains three things: what changed, when it starts, and what they will see on the invoice. A notice along these lines works for most accounts:
Beginning January 1, 2027, California law requires software providers to collect state and local sales tax on software subscriptions used in California. Starting with your first invoice for service periods on or after that date, you will see California sales tax listed as a separate line. The rate depends on your business location. Your subscription price is unchanged. If your organization is exempt or purchases for resale, please send us a valid California exemption or resale certificate before January 1.
Showing the tax as its own line matters for more than customer relations. A separately stated tax gives the customer a clear record, gives your company clean documentation of what was collected, and keeps your subscription price stable in the customer’s mind.
Timing matters too. Enterprise customers often need weeks to add a new tax treatment in their accounts payable systems, and procurement teams will ask questions. Sending notices in November gives them room to respond before the first taxable invoice goes out.
Expect some customers to ask whether they can prepay 2027 in December to avoid the tax. Under CDTFA’s draft regulations, payments attributable to service periods before January 1, 2027, would not be taxable, while payments covering periods on or after that date generally would be, regardless of when the payment is made. A December invoice for a 2027 service year is likely to be taxable under that approach, and a company that skips the tax on it is taking on the exposure itself.
What Do SaaS Companies Need to Do Before January 1, 2027?
Most of this work takes longer than companies expect, because it touches finance, engineering, sales, and legal at the same time. These are the steps worth completing before the first taxable invoice:
- Confirm nexus. Map California sales for 2025 and 2026 against the $500,000 threshold, and note any California employees, offices, or contractors.
- Classify every product and price line. Decide which offerings are prewritten software, which are services, and which are bundles. Put the reasoning in writing.
- Get registered at the right time. A company that already holds a California seller’s permit can use it for digital products. A company that needs a new permit should apply close to the January start date, since CDTFA generally expects an application to reflect an imminent start of taxable sales.
- Fix customer location data. Local tax is generally based on the customer’s address kept in good faith in your records. Billing systems need a clean, current California address for every account to apply the correct district rate.
- Collect certificates. Customers buying for resale, exempt organizations, and customers using the software solely outside California each need documentation. Without a valid certificate on file, the sale is generally treated as taxable.
- Review contracts and renewals. Check the tax language in standard terms and enterprise agreements, and look closely at annual subscriptions that run past January 1.
- Identify large accounts. Track any customer whose purchases from you could pass $5 million, and confirm how the purchaser threshold will be handled before you stop collecting.
- Test the billing system. Run sample invoices for a California customer, an out-of-state customer, an exempt customer, and a bundled sale before go-live.
For classification questions that are genuinely close, CDTFA accepts written requests for advice. A business that relies on written advice from CDTFA in response to a complete and accurate request may be relieved of tax it would otherwise owe on that issue. For a product line that represents real revenue, that letter can be worth more than any internal memo.
Companies with customers whose users are spread across several states should also watch the final version of CDTFA’s multistate rules. The draft would let purchasers allocate software costs using a reasonable, consistent, documented method, with user-based allocation treated as presumptively reasonable.
How Should SaaS Companies Keep Records Before and After the Change?
The first audits under a new tax tend to focus on the transition, because that is where mistakes collect. An auditor reviewing a software company in 2029 or 2030 will want to see which revenue belonged to 2026 and which belonged to 2027, and why each invoice was or was not taxed.
In many sales tax audits, the starting point is a simple comparison. The auditor lines up the sales reported on the sales tax returns against revenue on the income tax returns, the financial statements, bank deposits, and payment processor records. When those numbers do not reconcile, the auditor will often treat the difference as unreported taxable sales until the company proves otherwise. For a subscription business, deferred revenue, annual prepayments, refunds, and credits can all create differences that look like underreporting if nobody documented them.
Records to lock down before January 1
Take a snapshot of the business as it stands on December 31, 2026. That means a list of every active subscription with its service period, billing frequency, and customer address, along with copies of the contracts in force and any December invoices covering 2027 service. Keep the written product classification analysis, the nexus calculation, and the date your seller’s permit became active in the same file.
This snapshot does a lot of work later. When an auditor asks why a December 2026 payment was not taxed, the answer should take minutes to produce.
Records to keep from January 1 forward
After the change, the goal is an invoice trail that explains itself. Each invoice should separate taxable software charges from nontaxable services and show the tax as its own line. The billing system should record the customer address used to set the rate. Exemption and resale certificates belong in an organized log that ties each certificate to the account it covers, with renewal dates tracked.
Reconcile what the billing system collected to what was reported on each sales tax return, every filing period. A company that finds a mismatch in March can fix it with an amended return. A company that finds it during an audit is negotiating over it.
Be careful in the other direction too. Charging California tax that is not actually owed, such as tax on a 2026 service period or on an exempt sale, creates its own problem. Tax reimbursement collected in excess of what is due generally has to be refunded to the customer or paid to the state, so overcollecting is no safe harbor.
Why the cost of getting this wrong grows over time
Sales tax is a liability the seller owns whether or not it was collected from the customer. CDTFA generally has three years to assess additional tax on returns that were filed. When a business required to file returns never filed any, that window generally extends to eight years. A software company with California nexus that never registers is building exposure every quarter, on tax it never charged and can rarely recover from customers later, plus interest and penalties.
What Should Software Companies Expect After the Rule Takes Effect?
New taxes follow a familiar pattern. The first year brings registrations, billing fixes, and customer questions. The audits arrive a few years later, once returns have been filed and CDTFA has data to compare. By then, the questions an auditor asks about January 2027 will be answered by whatever records a company kept at the time.
The open questions in the draft regulations will also get settled over time, some through final rules, some through CDTFA guidance, and some through appeals. Bundled pricing, usage-based billing, and the line between taxable software and excluded infrastructure are the issues most likely to end up in disputes. Software companies that document their reasoning now will be in the strongest position to defend it when those disputes arrive.
For companies that already sell into California, the eleven weeks before January 1 are the best window they will get to set up clean, defensible sales tax reporting from the first day.
Software companies with questions about California sales tax exposure, or that receive a CDTFA audit notice after the change, can contact Milikowsky Tax Law to discuss their situation.
Frequently Asked Questions About California’s SaaS Sales Tax
What is SB 122?
SB 122 is a California law signed on June 29, 2026, that adds prewritten software, including SaaS, to the products subject to California sales and use tax. It takes effect January 1, 2027, and applies to software sellers with nexus in California as well as businesses that buy taxable software.
Is SaaS taxable in California?
Starting January 1, 2027, yes. SB 122 makes prewritten software taxable in California whether it is delivered on physical media, downloaded, or accessed remotely. Before that date, SaaS and electronically delivered software are generally not subject to California sales tax.
Do I need a seller’s permit to sell software in California?
A software company with physical presence in California, or more than $500,000 in California sales, will generally need a seller’s permit to collect the tax. A company that already holds a California seller’s permit can generally use it for digital products.
What sales tax rate applies to SaaS in California?
The same combined rate that applies to other taxable sales: the 7.25% statewide rate plus any local district taxes. The rate depends on the customer’s location, generally based on the customer address kept in good faith in the seller’s records.
Is custom software taxable under the new law?
Software prepared to the special order of a single customer generally remains exempt. CDTFA’s draft rules read that exemption narrowly, so software licensed to multiple customers is likely to be treated as taxable even when it is heavily configured.
Do annual subscriptions that started in 2026 become taxable in 2027?
Under CDTFA’s draft regulations, payments attributable to service periods before January 1, 2027, would not be taxable, while payments covering periods on or after that date generally would be. Final rules may change this, so annual contracts that run past January 1 deserve a close look.
Can I add the sales tax to my existing customers’ invoices?
That depends on your contracts. California imposes sales tax on the seller, and a seller can collect reimbursement from the customer when the agreement allows it. Agreements that say fees include all taxes, or that say nothing about tax, should be reviewed before January.
What happens if my company does not collect the tax?
The company generally remains liable for the tax, plus interest and penalties, even though it never collected the money from customers. If a company required to file never files returns, CDTFA can generally look back up to eight years.
Does the new tax apply to AI software tools?
AI tools sold as prewritten software or SaaS are generally covered. CDTFA’s draft guidance indicates that an AI product producing individualized outputs is still prewritten software when it is offered to many customers.
