Washington state legislators, searching for ways to resolve a $2.8 billion budget shortfall, aren't making many friends in the software industry these days. Except, perhaps, for one.

A proposed sales tax on "custom software" is raising objections from software firms and consultants that work on web sites, business applications, and other specialized programs. They say the tax would make it tougher to land business and recover from the recession.

The provision could affect more than 2,500 firms that have traditionally been considered service providers, not developers of products subject to sales tax. The fact that legislators would consider such a move -- aiming to raise an extra $250 million over the next three years -- underscores the severity of the financial crisis.

Rep. Ross Hunter, a former Microsoft general manager and author of the broader House tax package, acknowledged in an interview this week that the custom software provision is the most undesirable element of the bill, in his view. He offered a glimmer of hope for opponents, saying he hopes to find a way to avoid it before the legislation is finalized.

Microsoft's programs, such as Windows and Office, are already subject to sales tax, so the company is not directly embroiled in the custom-software debate. But critics of Microsoft's licensing practices say a separate provision of the financial overhaul -- changing the way the state taxes royalty income on software licenses and other intangible goods -- would all but eliminate a $100 million yearly tax obligation that they believe Microsoft is wrongfully avoiding by routing large chunks of business through an office in Nevada.

And in that way, they say, the state is targeting the wrong part of the software industry in its quest for new revenue.

"I believe we’ve got an issue of justice and fairness here," said Rep. Maralyn Chase, a Democrat from Shoreline who says she believes Microsoft is improperly avoiding the state royalty tax. "Most of the custom software purveyors are small businesses. It’s a question for me of how we fairly distribute the tax burden."

Others say they don't believe the state has legal grounds to charge Microsoft that additional tax. Hunter, chairman of the House Finance Committee, said he defers to the state Department of Revenue and the Attorney General's Office, which have decided not to pursue the issue.

"We don’t think we’d win a court case on this," Hunter said, noting that losing a lawsuit against Microsoft could jeopardize other potential cases involving what the state might consider more legitimate claims.

Hunter, who worked at Microsoft for 17 years, disagreed with any implication that he's improperly influenced by his former employer.

"I grew up at the company. Do I have long-term, personal ties? Yes," he acknowledged. "But if I thought I could get that royalty revenue under today’s law, I would do it. I don’t think I can do that and have it hold up in court. They have hundreds of employees in Reno. They have a real operation. It’s really hard to argue that that is not a substantive organization."

Another former Microsoft employee, Jeff Reifman, has been leading a campaign to get the company to pay the tax, and he's not persuaded by Hunter's contentions about the company.

"The substance of what they're doing is tax avoidance," said Reifman, who estimates that the company has avoided $757 million in Washington state taxes over the past 13 years through its Nevada subsidiary. Microsoft of course isn't hurting for money, with more than $36 billion in cash and short-term investments.

Reifman is raising concerns about one provision of the pending legislation that would change the way the state levies business-and-occupation taxes on some corporate gross receipts, including royalties from software licenses. Currently, Washington requires companies with a "physical nexus" in the state to pay those taxes, regardless of where the sales take place.

Under the new proposal, the tax would be levied based on sales to Washington customers, no matter where the selling company is based. Supporters in the Legislature want to eliminate a disadvantage for companies based in the state -- potentially reducing their tax burden by limiting the geographic scope -- while collecting new taxes from out-of-state companies that generate royalties from sales to consumers here.

The problem, from the perspective of people who challenge Microsoft's licensing practices, is that even if state officials were to reverse their interpretation of the law, the proposed change would reduce Microsoft's potential royalty tax obligations dramatically, by levying tax only on its sales inside the state.

In an email this week, Rep. Chase urged Hunter to leave the royalty tax law unchanged and add "strict enforcement language" to spur the Department of Revenue to "aggressively apply the current tax code." Previous versions of the legislation included stricter enforcement provisions but also could have granted amnesty to Microsoft for back taxes if the state were to decide that it owed royalty taxes under the law.

Microsoft, which is separately among the companies expected to benefit from the state's recent data center tax break, responded to an interview request this week with a statement.

“Microsoft is proud to be headquartered in Washington," it said. "The company generates a significant amount of direct and indirect tax revenue for the state. As a global company we pay all due taxes in all jurisdictions in which we operate.”

Meanwhile, smaller companies are grappling with the implications of the proposed custom-software tax, saying it would reduce the incentive for their clients to hire them.

The proposed custom-software tax is not included in the state Senate's version of the legislation. However, under the version of the legislation passed last weekend by the House, companies in Washington that hire firms to work on custom software would be required to pay state and local sales tax on those services.

"It means that a 5 person team of entrepreneurs building a cool custom software suite, or a group of system integrators, would face a 10% tax on their services while keeping the exact same project in-house would not be taxed," wrote Rep. Reuven Carlyle, a Democrat from Seattle, in a blog post this week. "It would be a massive blow to the entrepreneurial community in our state."

According to the text of the latest House bill (PDF, 129 pages) revenue generated from the sales tax on custom software would be used to help fund higher education. The state's projections estimate that the tax would generate $77 million in revenue in the next fiscal year and $180 million in the 2011-2013 biennium.

In one respect, the change would benefit custom software makers, reducing state business-and-occupation tax from the 1.5 percent charged to service providers to the 0.471 percent charged to retailers.

But Ken Myer, outgoing president of the Washington Technology Industry Association, called the custom software sales tax a slippery slope, with implications for other professions: "This is a fundamental change in how a whole class of professional services might be viewed moving forward, with custom software being the first change," he said.

The WTIA contends that these firms are more properly considered service providers, with the creation of software being only a small part of a much broader engagement with clients. In some cases, Myer said, some operators of small software firms may decide to shut down and work as employees for larger companies, rather than deal with the fallout from the tax.

Hunter, the House Finance Committee chairman, was sympathetic with that view, acknowledging that there's a wide spectrum of work conducted by custom software companies, ranging from complete professional services to the actual creation of a software product.

Speaking via phone Thursday afternoon, Hunter declined to disclose details of any behind-the-scenes discussions taking place during the current special session. However, he described himself as uncomfortable with the custom-software tax proposal and said there's a "huge chance" that the Legislature will find an alternative solution.