The drop shipment model works like this: A retailer offers X for sale but doesn’t keep X in stock. When a consumer purchases X from the retailer, the retailer tells the supplier (aka, the drop shipper) to send X directly to the consumer. This is easy to scale; it works whether the retailer sells 10 or 10,000 X in a year.
Yet drop shipping can complicate sales tax compliance because it involves two businesses, two sales transactions, one consumer, and often multiple states with unique sales tax rules and regulations. Which state’s rules govern the transaction? Which business is liable for collecting and remitting the tax due?
There’s no one answer: It depends on the location, role, and responsibilities of each business and the location of the consumer. A key consideration is nexus, the connection between a state and a business that allows the state to impose a tax collection obligation on the business.
There are at least three common drop shipping scenarios, each of which impacts tax differently.
Scenario 1: The retailer has nexus.
Generally, when a retailer has nexus in the consumer’s state, the retailer is required to collect sales tax from the customer and remit it to the tax authorities. This is true even if the supplier ships the product to the consumer.
In this case, the supplier’s sale to the retailer is generally exempt as a sale for resale. To validate the exempt transaction, the retailer would give the supplier an exemption or resale certificate.
Scenario 2: Neither the retailer nor the supplier has nexus.
If neither the retailer nor the supplier has nexus in the consumer’s state, neither can be required to collect and remit sales tax. The obligation to report and remit tax falls on the consumer.
Instead of sales tax, consumers are responsible for remitting the equivalent consumer use tax to the tax authorities. In some states, consumer use tax can be reported annually on a state income tax return. In other states, it’s necessary to file a separate consumer use tax return.
Scenario 3: The supplier (drop shipper) has nexus, but the retailer doesn’t.
When the retailer does not have nexus in the state where the sale occurs, but the supplier does, the supplier may be obligated to collect tax on its sale to the retailer — unless the retailer can supply a valid exemption or resale certificate. This tends to be the most challenging scenario.
Approximately 30 states allow suppliers to accept exemption certificates from out-of-state retailers. In this case, since tax isn’t collected on the supplier’s sale to the retailer or the retailer’s sale to the consumer, the customer is generally required to remit consumer use tax.
Approximately 16 states do not allow suppliers to accept out-of-state exemption certificates. Sales tax compliance is trickiest in these states. Some states require the supplier to collect tax on the wholesale price paid by the vendor. In Maryland, the supplier must either “require the vendor to obtain a Maryland sales and use tax license and provide a valid resale certificate,” or “charge the vendor the tax based on the amount of the sale.”
Other states require the supplier to collect tax on the retail price charged to the final customer. Since many retailers don’t typically share the retail price with their suppliers, there’s usually a Plan B.
In Connecticut, for example, the supplier should charge the retailer tax on the wholesale price if the supplier doesn’t know the retail selling price. The customer is then “liable for payment of the remainder of the tax directly to the State of Connecticut as a use tax.”
In California, a supplier can add 10% to the wholesale price and charge the retailer tax on that amount (wholesale plus 10%) if it doesn’t know the final retail price.
