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The Sales Tax Implications of Drop Shipping

  • May 9, 2015 | Ryan O'Donnell

It's human nature to seek opportunities for less input and more output. A day doesn't go by that I don't hear someone utter the phrase, "working smarter, not harder". The almost infinite reach of the internet has given rise to a new kind of "middleman". The concept of taking orders, skimming off a small profit and passing the responsibility of picking, packing, and shipping on is wildly enticing.

However, drop shipping doesn't shield a business from the legal responsibility to collect and remit sales tax. It turns out, drop shipping is one area businesses run a high risk of improper sales tax collection and remittance potentially resulting in fines and penalties.  Let’s take a look.

What is Drop Shipping?

Drop Shipping is a way of fulfilling orders for customers from inventory not held by the store.  For example, when you order an item online, the seller you are purchasing the item from may not physically have the item you are purchasing. The seller takes your order and turns around and purchases the item from a drop shipper (potentially a wholesaler) who delivers the item to you, often making the packaging look like it came from the seller you purchased it from.

Why is Drop Shipping so Popular?

Did you know Zappos started as a drop shipping business? It's true. As we mentioned before, there are some advantages to working with drop shippers. They include:

  1. Lower Risk: As a drop shipping seller, you don't house any inventory. Rather, you purchase only when you've made a sale.
  2. No Inventory: The seller doesn’t need to carry inventory, bear associated inventory storage expenses or maintain packing and shipping services.
  3. Limited Capital Expenditures: If the seller purchases the goods from the drop shipper via credit card there is no capital outlay.
  4. Low Startup Costs: A seller can start their business with less risk and less capital.
  5. Focus: As a drop shipping seller, you're focus is squarely on sales and marketing. Numerous distractions are removed. Services like DropShippers.com even provide ecommerce store templates to get drop shipping sellers up and running quickly.

Some Drawback of Leveraging Drop Shipping

To be clear, drop shipping isn't all fun and profit. There are some pretty serious challenges drop shipping sellers have to overcome including:

  1. Competition: As a result of the popularity of drop shipping, it's naturally competitive. With competition comes lower margins. Don't expect to get rich overnight at a drop shipping seller.
  2. Inventory: With no control over inventory, it's can be difficult to know what is available for sale. Setting up feeds to allow for real time inventory data can solve this issue, but it take knowledge to set up such a system (or money to pay for it).
  3. Differentiation: If you're selling the same products as everyone else, it's very difficult to differentiate yourself as a seller. Search engines are very good at awarding rankings to sites that add value with unique content. A tough goal with no control over inventory or access to goods.
  4. Logistics: Any time another step is added to a sales process, there are bound to be more issues. What is a drop shipping seller to do should the drop shipper run into issues in their warehouse or with employees?

Nexus and the Drop Shipping Seller

Currently the definition of nexus varies widely state to state. When you create nexus in a state, you need to be filing and remitting taxes in that state.  In some states like California, New York, Texas and Florida one drop shipment creates nexus.  In other states drop shipments over a certain dollar amount constitute nexus.   In addition the drop shipper is responsible for tax remittance in Connecticut and Hawaii if the seller does not have nexus in these states.

Drop Shipping and Your Wholesale License

Drop shippers generally require the seller to have a wholesale license or proof that you are a legitimate reseller.  Here are some scenarios you might face.   

  1. You have a wholesale license: If you are a seller and you purchase from a drop shipper, sometimes it is as easy as providing the wholesaler your wholesale license.  The drop shipper keeps a copy of your license on file and you collect and remit the sales tax.
  2. Some drop shippers require a wholesale license for the state you are drop shipping to.  Again, the seller would be collecting and remitting tax.
  3. Some states use the MTC Multi-Jurisdictional Exemption Certificate in lieu of a wholesale license.  The Streamlined Sales Tax Exemption Certificate, the ship-to state resale certificate with the home state number or a no nexus statement or other alternative documentation that demonstrates that the transaction truly is a sale for resale may also be required.  Generally the seller is collecting and remitting tax in these instances.
  4. Some states do not have sales tax and therefore do not have whole sale licenses.  The seller needs to be aware of nexus and where they might owe tax and incorporate that into their invoicing.

Sales Tax Questions for Drop Shipping Sellers

  1. Does delivering an order to this state create nexus for me?
  2. Does delivering this order create nexus for the seller?
  3. Does the seller have a wholesale license or other required documentation and is that applicable to the state I am delivering to?
  4. Is my agreement with the seller clear regarding who is responsible for remitting the tax?

Drop Shipping and States That Don’t Have Sales Tax

The NOMAD states (Alaska, Delaware, Montana, New Hampshire and Oregon) do not have a sales tax. If you purchase from a company in these sales-tax-free states, you, the purchaser, are responsible for remitting the sales tax. Here’s an example. You purchase a desk from an online retailer in Oregon.  They drop ship the item from Delaware.  You, the purchaser live in California.  You are responsible for paying the sales tax on your purchase.

How Much Sales Tax Should I Pay?

The cost basis (the tax basis) varies between states. For example, in some states, the full retail price of $10,000 for large equipment would be taxable. In others, only the $5,000 wholesale price is taxable.

In California, it’s even more complicated. When drop shippers have nexus in California, sales tax is applied either to the full retail price ($10,000 in the example above) or the wholesale price plus 10% ($5000+500).

Is Drop Shipping to Nonprofits Taxable?

If the purchaser is a non-taxable entity (like a school or other 501c(3) ) no tax need be remitted provided the purchase is in support of their mission. The drop shipper should have copies of their nonprofit papers on file.

What are My Responsibilities as a Drop Shipping Seller?

Given the varying requirements, it is important that drop-shippers consider the exemption requirements on a state by state basis.

California, Connecticut, District of Columbia, Florida, Hawaii, Maryland, Massachusetts, Mississippi and Tennessee require the drop shipper to collect sales tax from the seller. Each of these states handles taxation differently.

In Connecticut and Florida, tax is collected on the actual sales price to the purchaser; if the sales price is unknown, tax is collected on the seller’s cost.

Massachusetts guidelines require the drop shipper to collect tax on the actual sales price to the purchaser; if the sales price is unknown, tax is collected on the sales price to the seller plus the industry standard markup.

D.C., Hawaii, Maryland, Mississippi and Tennessee require drop shippers to collect tax on the seller’s cost.

If you have nexus in a state, as a drop shipper, you need to be very clear with your customer who is remitting tax. Both the retailer and the drop shipper could be charging tax. Or worse, neither of you could be charging nor remitting tax when you need to be.

Future of Drop Shipping and Nexus

Forty-four states have banded together to create the Streamlined Sales and Use Tax Agreement in an effort to simplify sales and use tax collection and administration by retailers and states.

The Market Place Fairness Act requires that states simplify their sales tax laws in preparation for multistate sales tax collection.  Once states get their sales tax systems simplified, businesses will be required to collect sales tax on the behalf of many states, even states where the business or the drop shipper does not have nexus.

Sales tax rates, rules, and regulations change frequently. Although we hope you'll find this information helpful, this blog is for informational purposes only and does not provide legal or tax advice.
Avalara Author
Ryan O'Donnell
Avalara Author Ryan O'Donnell