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As states increasingly focus on taxing digital products, tax professionals need to be aware of how these changes will affect their clients and businesses. The Multistate Tax Commission (MTC) is at the forefront of efforts to create more uniform approaches to taxing digital goods, and their proposals could have far-reaching consequences for compliance, pricing strategies, and audit risks.
Here’s a breakdown of the major proposals under consideration and how they will impact sellers of digital products—and the tax professionals advising them.
The Proposals: Two Key Areas for Digital Product Taxation
The MTC is working on initiatives that could shape the future of digital product taxation, with two areas of focus:
- Developing Definitions of Digital Products: One of the MTC’s key efforts is to create standardized definitions of digital products, which would help state policymakers apply sales tax more consistently. Currently, states vary widely in how they define and tax digital products, making compliance a challenge for businesses that operate across state lines. The MTC is considering two approaches:
- Broad Approach: For states that want to tax digital products comprehensively, the MTC could propose definitions that bring a wide range of digital products into the tax base.
- Narrow Approach: For states that prefer to tax fewer digital products or exempt more of them, the MTC may develop narrower definitions, aligned with the Streamlined Sales and Use Tax Agreement (SSUTA), which takes a more incremental approach.
- Tax Treatment of Bundled Transactions: Bundled transactions—where taxable and non-taxable items are sold together at one price—pose unique challenges, especially when digital products are part of the package. The MTC is working on recommendations to help states determine how to apply taxes to these transactions. One area of focus is the true object test, a legal doctrine used by some states to determine the primary purpose of a transaction and whether it should be taxed.
Both projects will likely culminate in white papers and policy recommendations for state lawmakers, with important decisions expected in the coming months. For tax professionals, these changes could lead to clearer, more consistent rules—but they also mean keeping a close eye on new developments.
Who’s Leading the Charge?
The MTC represents a coalition of states working together to modernize tax laws, especially around digital products. Tax professionals advising businesses on multistate tax issues should know which states are involved and how their approaches may vary.
Full Members: These states have fully committed to the MTC’s initiatives and participate in the full range of programs, including audits and policy development.
- Alabama, Alaska, Arkansas, Colorado, Hawaii, Idaho, Kansas, Mississippi, Montana, New Mexico, North Dakota, Oregon, South Dakota, Texas, Utah, Washington, and the District of Columbia.
Associate Members: These states participate in some MTC programs but may not be as involved in all initiatives.
- Arizona, California, Connecticut, Florida, Georgia, Illinois, Indiana, Iowa, Kentucky, Louisiana, Maryland, Massachusetts, Michigan, Minnesota, Missouri, Nebraska, New Jersey, New York, North Carolina, Ohio, Oklahoma, Pennsylvania, Rhode Island, South Carolina, Tennessee, Vermont, Virginia, West Virginia, and Wisconsin.
These states are key players in shaping the future of digital product taxation, and understanding the variations in their tax policies will be essential for tax professionals advising clients with digital transactions.
Impact on Sellers of Digital Products—and Their Advisors
For tax professionals, the increasing taxation of digital products presents several challenges and opportunities. Here’s what you should be aware of:
- Increased Complexity and Compliance Requirements: As states adopt new rules for taxing digital products, businesses will face more complex compliance demands. Tax professionals will need to guide clients through the different definitions, tax rates, and exemptions applied to digital goods across multiple jurisdictions. Investing in technology and up-to-date tax software will be critical for staying compliant.
- Pricing Strategies and Client Advisory: Tax professionals must advise clients on how to handle the added tax burden on digital products. Should businesses absorb the costs or pass them onto customers? The decision will vary by market, but tax pros can help analyze the impact of these changes on overall profitability.
- Bundled Transactions—A Tax Puzzle: If your clients sell bundled services or products, determining the tax treatment of these transactions will be crucial. States that use the true object test may treat an entire bundled transaction as taxable if the primary purpose is a taxable component. This presents an opportunity for tax professionals to provide strategic advice on how to structure bundles to minimize tax exposure.
- Audit Risks on the Rise: As states expand their tax bases to include more digital products, the likelihood of audits will increase. Tax professionals need to be proactive in advising clients to maintain thorough documentation and adopt best practices to avoid penalties. Keeping up with each state’s evolving digital tax rules will be essential to reducing audit risks.
- Unintended Consequences: Changes in how digital products are defined could lead to reclassification of items like software, which is currently taxed as tangible personal property in some states. Tax professionals should monitor these developments closely to ensure that clients understand how their products might be affected.
Final Thoughts: A Time for Vigilance and Strategy
For tax professionals, the taxation of digital products presents both a challenge and an opportunity. As the MTC moves toward defining digital products and determining how states should treat bundled transactions, tax advisors must stay ahead of the curve. The potential for audit risks, pricing challenges, and compliance complexity means that this evolving landscape will require proactive guidance and strategic planning.
With states continuing to refine their approaches, the decisions made by tax professionals today will help businesses navigate these changes more effectively. Staying informed, maintaining open communication with clients, and being ready to adjust strategies as new rules emerge will be key to long-term success.
As we wait to see the final proposals from the MTC, one thing is clear—tax professionals need to prepare for the shift. Stay vigilant, stay informed, and be ready to adapt.
