Kentucky Put It in Writing: Calling Your Software 'AI' Does Not Make It Custom

Kentucky's Department of Revenue used its Winter 2025/2026 edition of Sales Tax Facts to answer a question that a lot of agent builders would rather not have answered: does wrapping software in artificial intelligence change how it is taxed? The Department's answer is no. AI-enabled software is taxable as prewritten computer software, and the fact that an AI model adapts its output based on the data a customer feeds it does not turn that software into exempt custom software. The guidance is short, and it is worth reading precisely because it is not surprising once you understand how prewritten software has been taxed all along.

This is not a new statute. It is the Department putting a plain-English gloss on rules that have been on Kentucky's books since 2023. But it is the clearest statement I have seen from any state revenue agency on the specific point that matters to the agent economy, so it is worth walking through.

What Kentucky actually taxes

Kentucky has taxed prewritten computer software as tangible personal property for years, regardless of how the software is delivered. That treatment comes from the definition of "prewritten computer software" in KRS 139.010, which reaches software transferred on physical media, downloaded electronically, or delivered by "load and leave" alike. Delivery method does not matter; the character of the software does.

The 2022 tax legislation (House Bill 8) then extended the base to a list of previously untaxed services effective January 1, 2023, including "prewritten computer software access services." That is the statutory hook for taxing what the rest of the industry calls SaaS. If a customer pays to access prewritten software that sits on the seller's servers, the charge for that access is taxable in Kentucky, whether it is billed as a license, a subscription, or a per-call fee. The buyer never takes possession of the code, and it does not matter.

Custom software is the narrow exception. Software designed and built for a single customer can fall outside the prewritten definition, but Kentucky treats that exemption the way most states do: it is narrow, it is fact-specific, and it generally requires the customization charges to be separately stated on the invoice. If you cannot point to a line item, you do not have an exemption.

The AI gloss

Here is the part the agent economy needs to internalize. The Department acknowledged that AI-powered software may change its response or output based on the data a user provides, and then said that this adaptivity does not make the software custom. Prewritten software that adjusts its behavior at runtime is still prewritten software. It was built once, it is sold to many, and each customer is buying access to the same underlying product. That the product produces different tokens for different inputs is a feature of the software, not evidence that it was hand-built for one buyer.

Read that against how a lot of agent companies describe themselves. "We are not a SaaS company, we are an AI company." "Our model is different for every customer because it learns from their data." "There is no fixed product; the agent writes its own behavior." These are reasonable engineering descriptions. They are not tax arguments, and Kentucky just said so in about as many words. The exemption for custom software turns on how the software was procured and invoiced, not on whether the software is clever.

I want to be careful about what this guidance is and is not. It is an administrative publication, not a statute or a regulation, and it does not create new law. What it does is tell you how the Department reads existing law, which is exactly the thing an auditor will rely on. When a state DOR writes down its interpretation and then examines your returns, the burden is on you to show why the published position does not apply to your facts. "But we call it AI" is not that showing.

Why this generalizes past Kentucky

Kentucky is not an outlier here, which is the real point. The states that tax SaaS or software access services almost uniformly define the taxable thing by reference to whether the software is prewritten, and almost uniformly limit the custom exemption to bespoke, separately invoiced work. Kentucky simply had the candor to apply that framework to AI in a public bulletin. Utah did the same thing structurally when SB 162 codified "seller-hosted prewritten computer software" earlier this year, and New York reached the same result through its appellate courts. The vocabulary differs; the conclusion converges.

For an agent operator, the practical takeaway is that your product's taxability is decided by the substance of the transaction, not by the marketing category you have chosen for yourself. If a customer in a state that taxes software access pays your company to use a model or an agent that runs on your infrastructure, you should assume that charge is taxable there until you have a jurisdiction-specific reason to conclude otherwise. Adding an AI layer does not reset that analysis. In several states, it strengthens the case against you, because "adapts to the user" is close to the statutory description of the very thing they tax.

What to do about it

If you sell agent access into Kentucky, or into any of the roughly two dozen states that tax SaaS or prewritten software access, three things are worth doing now. First, classify each product line by what it actually is: prewritten software access, a data processing or information service, or something genuinely custom. Do not let the AI label do the classifying for you. Second, if you are relying on a custom-software position anywhere, confirm your contracts and invoices actually separate and state the customization charges. The exemption lives or dies on the paperwork. Third, map the states where you have economic nexus against the states that tax software access, because the intersection of those two lists is your real exposure, and it is almost certainly larger than you think.

The comfortable story that AI products live in some untaxed frontier is not holding up. State revenue departments are not writing new AI taxes; they are pointing at the software rules they already have and telling you those rules already fit. Kentucky just did it in plain language. Read it as a preview of the audit conversation, not as a Kentucky curiosity.

AgentTax classifies each agent transaction by its actual character and applies the correct rule in every state where you have exposure, so you are not betting your compliance on a marketing label. See how it works at agenttax.io.

This analysis is for informational purposes only and does not constitute legal or tax advice. Consult a licensed tax professional for compliance decisions.