All Software is Not Created Equal

by Micah Kindred, Associate Member, University of Cincinnati Law Review Vol. 91

I. Introduction

In today’s world, software is an ever-growing and constantly changing area of business. This also means that regulations and laws are rapidly evolving to keep up. Taxation is often an afterthought for new software-based companies because software is software, right? Well, not really, at least in terms of taxation. One piece of software may be taxed two different ways depending on who is buying it; one piece of software may be taxed as a service while another is taxed as a good and, therefore, subject to sales tax. So, how do you know what is what? This article will explore section 5739.01 of the Ohio Revised Code (“R.C. 5739.01”) to help answer this question. Part II will lay out R.C. 5739.01 as it discusses software. Part III will examine the gray areas of R.C. 5739.01 and where the lines might be drawn among varying types of software. Part IV concludes the likely distinction between software subject to sales tax and its counterpart, with recommendations on the best routes for developers.

II. Applicable Law

In Ohio, sales tax applies to “each retail sale made in this state.”1Ohio Rev. Code Ann. § 5739.02 (LexisNexis 2022). R.C. 5739.01 provides definitions for terms implicated in sales tax.2Ohio Rev. Code Ann. § 5739.01 (LexisNexis 2022). This section provides guidance on what software is subject to sales tax. However, several subsections scattered through the statute must be utilized to discern exactly what software is subject to sales tax, making this a difficult task—especially for those who do not have a legal background.

R.C. 5739.01(B)(1) defines a “sale” for tax purposes to include “[a]ll transactions by which title or possession, or both, of tangible personal property, is or is to be transferred, or a license to use or consume tangible personal property is or is to be granted.”3Id. § 5739.01(B)(1). The statute further describes “tangible personal property” to include “prewritten computer software” among other things.4Id. § 5739.01(WW).

Next, R.C. 5739.01(B)(3)(e) states that a sale includes a transaction by which:

Automatic data processing, computer services, or electronic information services are or are to be provided for use in business when the true object of the transaction is the receipt by the consumer of automatic data processing, computer services, or electronic information services rather than the receipt of personal or professional services to which automatic data processing, computer services, or electronic information services are incidental or supplemental.5Id. § 5739.01(B)(3)(e).

R.C. 5739.01(Y)(2)(e) further explains that “custom software” is considered a “personal or professional service.”6Id. § 5739.01(Y)(2)(e).

Therefore, automatic data processing, computer services, and electronic information services––when provided for business use––and prewritten computer software are subject to sales tax.7Ohio Rev. Code Ann. § 5739.02 (LexisNexis 2022). However, custom software and other “personal or professional services to which automatic data processing, computer services, or electronic information services are incidental or supplemental”8Id. § 5739.01(B)(3)(e). are not subject to sales tax.9Sales and Use – Applying the Tax, Ohio Dep’t of Tax’n, (last visited Sept. 9, 2022).

III. Discussion

A. Defining Custom Software

R.C. 5739.01 may seem straightforward: prewritten computer software is subject to sales tax and custom software is not. But a problem that often arises is the determination between what makes software custom.

R.C. 5739.01(BBB) gives some guidance on this by describing what makes software prewritten, thus explaining what is not custom software.10Id. § 5739.01(BBB). This section states that upgrades to software that are not written for a specific purchaser, combinations of prewritten code, and software written specifically for one purchaser but then sold to another are prewritten computer software and subject to sales tax.11Ohio Rev. Code Ann. §§ 5739.01(BBB), 5739.02 (LexisNexis 2022). However, modifications or enhancements to software made by someone who did not originally create the software are not considered prewritten only as to the modifications or enhancements.12Id. § 5739.01(BBB). Prewritten software that is modified or enhanced, where the modification is “designed and developed to the specifications of a specific purchaser” is still considered prewritten computer software, unless there is a reasonable, separate charge for the modification or enhancement.13Id.

Since this section does not offer guidance on what constitutes custom software, the definition of custom software must be derived from the definition of prewritten computer software. From R.C. 5739.01(BBB), custom software seems to be any software created for a specific customer and tailored to the customer’s needs.14Id. The statute also states that any upgrades written that are not created for a specific customer’s specifications are considered prewritten.15Id. For a developer, this likely means that any software not created for and specifically tailored to a purchaser is going to be subject to sales tax.

This is where things can get a bit gray. What happens when a developer creates software for one customer that can be utilized for others with some changes? How much of the software needs to be changed to make it entirely custom for a new purchaser? What if the changes are made to fit the specifications of the new purchaser? Seemingly, for software to be considered custom, the overall functionality would need to be distinct from the original software’s functionality. Developers often build on software written by others or old software they have written themselves previously. To say that all software not written from a blank slate is prewritten would negate loads of hard work put in by developers to build on, change, and innovate previously created software. However, software that has new and distinct functionality created to fit a specific purchaser’s specifications is likely what R.C. 5739.01 means by custom software.

B. Identifying the Software Purchaser

Another important consideration when deciding whether software is subject to sales tax is the identity of the purchaser. R.C. 5739.01(BBB) specifies that software created to the specifications of a specific purchaser but sold to someone who is not the original purchaser is considered prewritten software.16Id. This means that one piece of software can be taxed differently depending on the buyer. Critically, developers often create software for one purchaser then realize it may be useful to others. Under R.C. 5739.01, this would likely lead the first transaction with the original purchaser to be taxed as a “personal or professional service” not subject to sales tax, but any transaction with subsequent purchasers to be taxed as a sale and subject to sales tax.17Id. §§ 5739.01(BBB), 5739.02 (LexisNexis 2022); Sales and Use – Applying the Tax, supra note 9.

C. Breaking up Software Taxation

Last, the ability to break up the taxation of one piece of software into smaller taxable pieces is an important way for developers to minimize sales tax. R.C. 5739.01 states that “where there is a reasonable, separately stated charge or an invoice or other statement of the price given to the purchaser for the modification or enhancement, the modification or enhancement shall not constitute prewritten computer software.”18Id. §§ 5739.01(BBB), 5739.02 (LexisNexis 2022); Sales and Use – Applying the Tax, supra note 9. This allows developers to pay sales tax only on the pieces of software that they did not modify or enhance, while charging separately for the modifications or enhancements as a service not subject to sales tax.

This statute is likely confusing for developers without a legal background, and statutes like this one can make or break tech startups. If a developer starts a software company and misclassifies something as a service not subject to sales tax when it is not, there could be major implications. A new company could be hit with a huge, unexpected tax bill that it is not prepared for simply because it misunderstood the law.19Sales and Use – Information for Vendors (Licensing and Filing), Ohio Dep’t of Tax’n, (last visited Sept. 9, 2022). This can ruin new companies, and often new startups cannot afford counsel, especially prior to an issue arising. So, statutes like R.C. 5739.01 need to be accessible. Many developers likely do not understand the implications of this statute. Yet, tax can truly bankrupt a company if the issue gets large enough.20John Bonk, Software Licensers Must Address Sales Tax Before it’s too Late, Bloomberg Tax (July 6, 2022, 4:45 AM), To avoid any major issues, the best route for developers when they are unsure if the software they have created is prewritten and subject to sales tax is likely to break apart the software charges into: (1) prewritten for the elements they did not alter and (2) custom elements they did alter or create themselves, and calculate taxes accordingly. This allows the developers to minimize the sales tax charged on a transaction without foregoing it altogether in favor of charging strictly as a personal or professional service. This option likely would prevent any major sales tax bills from popping up because the developers would be paying sales tax on a decent amount of transactions even if they sometimes miscategorized the software as custom when it was not. The company may still get a tax bill that includes payment for transactions they mistook for a service when it was a sale, but the bill would likely be smaller and more manageable. 

IV. Conclusion

Companies selling software may be required to pay sales tax, but this depends heavily on whether the software is considered custom or prewritten. The determination as to which category the software falls under is often dependent on the level of customization the creators put into the software and the buyer of the software. Since these elements can change from transaction to transaction, it is critical for software sellers to be aware of both the buyer and the level of modifications or customizations made for each transaction. One piece of software may be subject to sales tax in one transaction while the next, even if the same software is being sold, may not. Statutes like R.C. 5739.01 can be difficult for those outside of the legal field to comprehend and thus comply with. For developers, compliance with statutes like this one can have major implications, so a solid understanding of this is important. For now, developers likely should break apart any software that may contain prewritten elements into prewritten software subject to sales tax, and modifications or enhancements not subject to sales tax on the bill sent to the purchaser to navigate more safely what can be a confusing area.

Cover Photo by Desola Lanre-Ologun on Unsplash


  • Micah Kindred graduated from the University of Louisville in 2021 with a degree in Computer Science and Engineering with a minor in Business Management. Micah spent her undergraduate co-ops working in software development, enterprise architecture, and data science. Micah hopes to pursue a career in patent and corporate law after law school.


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