What is a drop shipper and how does drop shipping affect sales tax?

• Sales tax nexus affects taxes for drop shipping. Whether the retailer or supplier (drop shipper) is liable for sales tax in a drop shipment may depend on which party has a sales tax obligation with the customer’s state. 

• The supplier may be liable for tax on drop shipment sales if the retailer does not have nexus in the customer’s state. States may require the supplier to collect sales tax from the end consumer if the supplier does not receive a valid resale certificate from the retailer. 

• Exemption certificates are key in drop shipment sales. To avoid paying retail sales tax on wholesale transactions, the drop shipper must obtain a valid resale or exemption certificate from the retailer. Automating exemption certificate management can help businesses comply with the complex sales tax rules for drop shipping. 

Drop shipping is a retail fulfillment method that allows retailers to sell products they don’t keep in stock. It works like this.

1. The customer purchases a shirt from a retailer’s website or catalog. 

2. The retailer receives the order and payment from the customer then orders the shirt from its supplier.

3. The supplier (aka, drop shipper) receives the order and payment from the retailer and ships the shirt to the customer.

With traditional retail transactions, the retailer typically collects sales tax from the customer and remits it to the appropriate taxing authority. With drop shipping, sales tax compliance is more complex.

Businesses are generally responsible for collecting and remitting sales tax in states where they have nexus, which is a connection substantial enough to establish a tax obligation. A state cannot impose a sales tax collection obligation on a business that doesn’t have nexus.

There are several ways for a business to establish sales tax nexus with a state, but the two most common are through physical presence (physical nexus) or economic activity (economic nexus) in a state. Our sales tax nexus resources offer more details.

Drop shipping is tricky for sales tax because 1) both the retailer and the supplier can have nexus with the customer’s state (or not), and 2) there are two separate transactions: the retailer’s sale to the end consumer and the supplier’s sale to the retailer.

Sales tax obligations for a drop-shipping retailer

If you’re the retailer, you’re generally required to collect sales tax from your customer only if you have nexus with the customer’s state. 

But that’s just one side of the transaction.

Sales tax obligations for a drop-shipping supplier

If you’re the supplier and you have nexus with the state where your customer (the retailer) is located, you’ll need to do one of two things:

• Charge your customer (the retailer) sales tax, or

• Collect a valid resale or exemption certificate from your customer (the retailer).

As the drop shipper, you may also be required to collect and remit tax from the end consumer in states where you have nexus, but the retailer does not. This is generally the case in California, Connecticut, and several other states that require a business to register for sales tax to obtain an exemption or resale certificate.  

Tennessee used to require suppliers to collect Tennessee sales tax unless the retailer could provide a Tennessee resale certificate or a Streamlined Sales Tax Certificate of Exemption with a Tennessee sales tax ID number, but it now accepts exemption and resale certificates issued by other states.

A supplier’s sale to a retailer is usually an exempt wholesale transaction because the retailer is purchasing goods to resell them. Nevertheless, the supplier must obtain a valid resale certificate from their customer (the retailer), or the supplier could be held liable for the uncollected tax on their sale to the retailer. 

Additional documentation may be needed if the supplier has nexus with the ship-to state (where the end consumer is located), and retailer does not. When the retailer isn’t registered for sales tax in the ship-to state and so doesn’t collect sales tax from their customer, and the supplier has nexus, the ship-to state could come after the supplier for the tax due on the retail sale. To prevent that, the supplier needs documentation proving they’re not responsible for the tax.

Many states will accept an out-of-state resale certificate, multijurisdictional form like the Multistate Tax Commission uniform sales and use tax resale certificate or Streamlined Certificate of Exemption, or alternate documentation in a drop-shipping situation.

However, in California and other states that have stricter requirements for resale certificates, a seller must register with the state to obtain a valid exemption certificate from that state. Since businesses are obliged to collect sales taxes from customers in that state once registered, a retailer may opt to remain unregistered if it doesn’t have sales tax nexus. In that case, their drop-shipping supplier would be responsible for reporting and paying sales tax on the retail selling price.  

If neither the retailer nor the supplier has an obligation to collect sales tax, the consumer would be liable for consumer use tax.

Drop shipping can be a smart option for retailers, but it can also add new layers of sales tax complexity. And suppliers that drop ship for hundreds or thousands of sellers can end up having to collect and store hundreds, thousands, tens of thousands, or even hundreds of thousands of certificates — each of which could need to be produced in the event of an audit.

Avalara Agentic Tax and Compliance™ solutions help retailers, drop shippers, and other businesses comply with sales and use tax obligations nationwide.

“We are a rapidly growing ecommerce business that very quickly went from having nexus in three states to having nexus in over 20 states,” says Jere Allen, Vice President at The Lab Depot. “We could not have managed the sales tax implications of that growth without Avalara and Exemption Certificate Management (ECM)!”

Visit avalara.com to discover how Avalara can streamline compliance for your business.