California’s 2026-2027 approved budget includes two significant tax trailer bills, S.B. 122 and S.B 125, which are expected to generate billions of dollars in additional state revenue over the next several years. Among the most significant provisions are the expansion of California sales and use tax to electronically transmitted or remotely accessed prewritten computer software, as well as the extension of the state’s business tax credit limitation.

Notably, the legislation does not extend the state’s net operating loss (NOL) suspension. As a result, the NOL suspension is scheduled to expire at the end of 2026, allowing taxpayers to utilize NOL deductions beginning once again in 2027.

Expansion of California Sales and Use Tax to digital products

Effective Jan. 1, 2027, S.B. 122 will significantly expand California’s sales and use tax base by broadening the definition of tangible personal property to include certain digital products, as well as related copyright and patent interests.

Under the legislation, a digital product includes prewritten computer software that is transferred on tangible storage media, delivered electronically, or accessed remotely. As a result, many software-as-a-service (SaaS) offerings and cloud-based software solutions will become subject to California sales and use tax. Common examples include subscriptions to platforms such as Microsoft 365, Shopify, and various cloud-based accounting software applications.

Custom software is still exempt along with transactions involving the right to reproduce or copy a digital product for resale or distribution to third parties for consideration, or certain electronic services that primarily involve human effort and are in response to a customer’s request.

S.B. 122 also establishes sourcing rules for determining the place of sale or purchase of a digital product. For in-person transactions, the sale is sourced to the seller’s place of business. For transactions that are not conducted in person, the legislation applies a cascading set of rules based primarily on the purchaser’s location information. In certain circumstances, a sale may be treated as occurring outside California.

In addition, S.B. 122 shifts the responsibility for remitting tax from the seller to large purchasers of digital products transferred electronically or accessed remotely. Beginning Jan. 1, 2027, purchasers whose aggregate digital product purchases exceed $5 million during the calendar year will be required to self-report and remit the applicable tax on their sales and use tax returns. Beginning Jan. 1, 2028, the threshold will be measured based on purchases made in either the current or preceding calendar year.

Finally, the legislation provides relief for multistate users of digital products by allowing a credit against California sales or use tax for legally imposed sales or use tax paid to another state, a political subdivision of another state, or the District of Columbia on the same digitally transferred or remotely accessed product.

Business tax credit limitations

S.B. 122 extends California’s existing limitation on the utilization of business tax credits by three additional years. The limitation prohibiting taxpayers from using more than $5 million of business tax credits in a taxable year is now extended to taxable years beginning before Jan. 1, 2030.

The legislation also extends the availability of the irrevocable election that allows taxpayers subject to the credit limitation to convert certain unused business tax credits into refundable credits. Under this provision, taxpayers may elect to receive annual refundable credits equal to 20% of their qualified credit balance over a five-year period, beginning in the third taxable year following the election.

In addition, S.B. 122 establishes a permanent business tax credit limitation for taxable years beginning on or after Jan. 1, 2030. Beginning in 2030, the total amount of business tax credits that may be utilized in a taxable year will be limited to the greater of 70% of the taxpayer’s net tax liability; or $5 million.

Annual tax reduction for newly formed pass-through entities

S.B. 122 provides tax relief for newly formed pass-through entities by reducing the annual tax imposed during their first taxable year. Specifically, the annual tax for newly formed limited liability companies (LLCs), limited partnerships (LPs), and limited liability partnerships (LLPs) will be reduced from $800 to $400. The reduced annual tax applies to entities formed during taxable years 2027 through 2029.

Managed Care Organization Provider Tax

S.B. 125 establishes a revised Managed Care Organization (MCO) Provider Tax for certain health plans for calendar years 2027 through 2029. Under the legislation, the tax will be imposed at a rate of $8.85 per employee per month.

The measure was enacted in response to changes in federal Medicaid funding and is intended to help support California's ongoing Medi-Cal funding obligations. However, the tax will not take effect unless and until the Director of Health Care Services certifies that the tax qualifies as a federally permissible healthcare-related tax under applicable federal law.

What does CohnReznick think of these tax changes?

California taxpayers should carefully evaluate the potential impact these budget trailer bills may have on their state tax positions. Given the breadth of the changes, taxpayers are encouraged to consult with their tax advisors to assess how the new provisions apply to their specific facts and circumstances and to identify any available planning opportunities.

In particular, taxpayers with significant California business tax credit carryforwards should model the impact of the extended and future permanent credit limitation rules, as these provisions may affect the timing and realization of deferred tax assets and future tax liabilities.

Likewise, businesses that sell, license, purchase, or use software, SaaS offerings, and cloud-based technology solutions should evaluate the implications of the expanded sales and use tax base. Companies may need to review contracts, billing practices, sourcing methodologies, tax collection procedures, and multistate use patterns to determine the extent of their compliance obligations and potential tax increase because of the changes.

With planning, taxpayers have an opportunity to proactively assess the impact of the legislation and implement strategies to mitigate potential tax costs before the new rules become effective.

Any advice contained in this communication, including attachments and enclosures, is not intended as a thorough, in-depth analysis of specific issues. Nor is it sufficient to avoid tax-related penalties. This has been prepared for information purposes and general guidance only and does not constitute legal or professional advice. You should not act upon the information contained in this publication without obtaining specific professional advice specific to, among other things, your individual facts, circumstances and jurisdiction. No representation or warranty (express or implied) is made as to the accuracy or completeness of the information contained in this publication, and CohnReznick, its partners, employees and agents accept no liability, and disclaim all responsibility, for the consequences of you or anyone else acting, or refraining to act, in reliance on the information contained in this publication or for any decision based on it.