A Primer on Drop Shipping and Sales Tax Exemptions (Part 2)

Any organization involved in a drop shipping relationship knows how problematic compliance can become when goods are delivered through a third party. As orders are rerouted from seller to supplier for delivery to the customer, the delicate matter of who is responsible for sales tax and resale documentation must be addressed.

To recap: A drop shipment occurs when a seller accepts an order from a customer for a product the company doesn't stock, which it then purchases from a third party supplier for delivery. The seller sells the item and charges the customer. Then the supplier ships it and charges the seller. As I explained in part one of this series, if the supplier has nexus in the state where the drop shipment occurs, that company is typically responsible for collecting sales tax.

However, many states do not consider the transaction between a seller and supplier taxable—as long as the drop shipper is supplied with a valid resale exemption certificate.

Exemption certificates are highly valuable and must not be overlooked. This tax compliance documentation is the proof you need to support non-taxed drop shipment transactions. Correctly identifying, submitting, collecting, verifying and storing certificates could someday be the difference between a smooth, seamless audit or a costly assessment—not to mention a positive, profitable business partnership versus a relationship that sours.

When to Collect Exemption Certificates
Although each state takes its own approach to drop shipment and how to collect exemption certificates, there are some commonalities. In many scenarios:

If you are the supplier and have nexus in the state where the drop shipment occurs, you will need to collect taxes or a valid exemption certificate from the seller.

If you are the seller in a state where you do not have nexus but your supplier does, you will be expected to pay taxes or supply a valid resale certificate.

Nexus usually helps bring clarity to when an exemption certificate is necessary and who in the drop shipment relationship is responsible for submitting and collecting it.

Usually.

Here’s what makes it tricky: Every U.S. state could define nexus its own way. For this reason, sellers and suppliers will need to ensure they’re following the unique nexus requirements of each one when claiming sales tax exemptions and selecting certificates.

It’s important to recognize that how nexus is created can vary drastically from state to state. In some states, warehousing a significant amount of inventory on behalf of a seller might create sales tax nexus. In others, nexus is declared when a supplier solicits business or advertises on behalf of a seller. Still others may base the definition of nexus on who accepts returns or whether referrals are made between the seller and supplier.

Once you understand who in the drop shipment relationship bears responsibility to each state, it’s time to select valid exemption certificates for each one.

Exemption Certificates by State
Once nexus is established there is also the delicate matter of how each state approaches exemption certificates for drop shipment transactions.

Many states assume drop shipped items are for resale and will accept an out-of-state resale certificate or multijurisdictional form. This is the most common scenario.

However, some states will require shipping or other information in addition to exemption certificates to prove out-of-state origination. And a handful do not accept exemption certificates at all, choosing instead to hold the drop shipper responsible for collecting sales tax when the out-of-state retailer lacks nexus.

Whether you use or provide drop shipping, it is critically important to account for these disparate rules when submitting or accepting resale certificates for drop shipment transactions.

Sometimes a company will erroneously assume a certificate isn’t necessary because it doesn’t have nexus in the state where the drop shipment occurs, which creates compliance problems. Other times taxes are collected on drop shipments unnecessarily, which can lead to customer service nightmares. Following the exemption certificate requirements for each state helps prevent these and other problems. Selecting, submitting and storing the correct certificates will both help ensure compliance and keep business relationships intact.

If you’re not sure where to start, a great resource is the Avalara CertCapture certificate library. This free library makes it easy to identify valid exemption certificates by state and lets you download blank exemption certificates that are ready to be filled out.

Next, you’ll need to begin the rather arduous process of verifying and maintaining drop shipment exemption certificates to ensure they’re audit-ready.

If you’d like to get my tips for this part of the compliance process, be sure to stay tuned for my next post when I wrap up this series with drop shipment audit prep recommendations.

SUBSCRIBE TO AVALARA CERTCAPTURE EMAILS