Drop Shipments and Sales Tax
Shifting responsibility to third parties happens in all aspects of life. In business, small and medium sized companies leverage the economies of scale owned by large specialized companies every day. Specialized providers beat the in-house cost to complete all kinds of traditional and not-so-traditional functions; the use of third party providers for order fulfillment and shipment needs is a common expression of this trend.
Most retail vendors call these providers “drop shippers.” Drop shippers are those third parties who accept an order from a vendor, bill the vendor for the item, and then ship the item directly to the vendor’s retail customer. The vendor collects cash from the retail customer and pays the drop shipper for their time and the item they shipped, usually at a wholesale price.
So far, so good, right? Well for business purposes, the drop ship arrangement is a match made in MBA heaven: the vendor expands their geographic and time boundaries without investing in new facilities, and the drop shipper makes more sales without the hassle of actually dealing with customers. Cool for everyone, right? Actually, the model even works for the sales tax collector some times.
If the retail customer is in a state where the vendor already collects sales taxes, no worries. The vendor collects sales taxes on the customer invoices, and the drop shipper invoices the vendor without tax because the vendor gives the drop shipper a valid re-sellers exemption certificate. The tax is collected on the retail sale, and as long as you have your rates and rules in order, an auditor somewhere sighs and moves on to their next target.
The sales tax collector has a problem though, if a few facts are apparent in your scenario. Ironically, the auditor’s concern isn’t directly related to a drop ship model, but instead relates to re-seller’s exemption certificates. The ability of a drop shipper to accept a vendor’s reseller’s certificate, or not, impacts sales tax collection in these transactions.
The Tax Collector’s Problem
Exemption certificates? Wait, are we talking about drop shippers or resale exemption certificates? Actually, both. There are two sales here that a sales tax collector might look at: the retail sale from the vendor to the customer and the wholesale sale from the drop shipper to the vendor. Sales tax is not typically collected on wholesale sales due to a reseller’s certificate. But when the wholesale sale is made between a drop shipper who is obligated to collect in a customer’s state on behalf of a vendor not obligated to collect, the drop shipper might be put in a tight spot.
A drop shipper can exempt a wholesale sale to a vendor if the vendor gives the drop shipper a valid reseller’s certificate--this much we know. Problems arise when a state refuses to accept a re-sellers certificate from any other state. The logic is a little circular but tight and irrefutable: no vendor can issue a valid reseller’s certificate from a state in which they are not registered to re-sell. So a vendor who is not registered to collect in the same state as their customer cannot issue a valid re-sellers certificate for sales they make in that state either. Put another way: a vendor can only issue a valid reseller’s certificate from a state in which they are registered. Most states will accept an out-of-state reseller’s certificate or a Multistate form, so in those 33 states the issue boils down to simple effective certificate management.
There is a minority of sales tax states that refuse to accept out of state or Multistate re-seller’s certificates, yet all of these 16 states enforce collection of sales taxes by a drop shipper registered in their state. A drop shipper who is prevented from accepting a vendor’s out of state re-seller’s certificate is obligated to collect sales taxes from the vendor if they are registered in the state where the customer is located. The drop shipper has no valid basis to exempt the sale they make to the vendor when they do not hold a valid exemption certificate. Gotcha!
The price on which a drop shipper is required to collect sales taxes may be the wholesale price or the retail price if that amount is known to the drop shipper. In California, a drop shipper is required to add 10% to the wholesale price when calculating sales tax—a good example of the potential complexities in actually calculating and collecting sales taxes due in the drop ship scenario.
Drop shipping is important to many e-commerce businesses, and its use is expanding in all business models. It's practical. Yet third party fulfillment also entails a number of sales tax challenges for drop shippers and the vendors who use them. As with many labor and time saving devices and processes, drop shipping is fraught with new challenges. You can learn more about how to manage the sales tax challenges associated with drop shipping in the Sales Tax Implications of Drop Shipping white paper.
The 2021 sales tax changes report: midyear update
Your guide to navigating the complicated world of tax compliance and preparing for the future
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