Drop shipping and sales tax compliance

Whether you use or provide drop shipping, there are sales tax rules you need to get right.

Drop shipping solves a lot of retail problems. Chief among them: Sellers don’t have to maintain giant warehouses and manufacturers don’t have to manage retail outlets.

Unfortunately, it can also complicate the already confusing area of sales tax compliance. Who owes what to whom can seem even more nebulous when transactions create indirect relationships between sellers, suppliers, and customers.

But before we get into all that, let’s start with some of the basics when it comes to drop shipping.

What is drop shipping?

The hive mind that is Wikipedia describes drop shipping as “a supply chain management method in which the retailer does not keep goods in stock but instead transfers the customer’s orders and shipment details to either the manufacturer, another retailer, or a wholesaler, who then ships the goods directly to the customer.”

("Drop Shipping," Wikipedia: The Free Encyclopedia)

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Two sales in one

With drop shipping, there really are two sales occurring:

The customer

The customer makes a purchase from the seller. Even though the seller owns the transaction and the customer relationship, the seller doesn’t fulfill the order.

The seller

The seller makes a purchase from the supplier. The supplier fulfills the order but doesn’t typically have a relationship with the end customer.

The drop shipping experience: three roles, three points of view

The customer

From the customer’s perspective, the experience is like any other remote transaction. Customers browse a catalog or site, choose their goods, and pay the seller, including all applicable taxes. They receive their shipment, ideally within the specified delivery period.

The seller

The seller receives an order request and payment from a customer. For any items not in stock, the seller places an order with the supplier. Along with payment, the seller provides the supplier with the customer’s shipping information.

The supplier

The supplier receives an order and payment from the seller. The supplier then locates the item or items ordered, packs them up, and ships the order directly to the customer.

How is all this taxed?

As with all things sales tax, the answer depends on multiple factors, including the locations of all three parties, the taxability of the goods, and where the seller or supplier has nexus (an obligation to collect sales tax).

In most cases:

The customer pays sales tax to the seller.
The seller remits the tax to the state and provides a resale exemption certificate to the supplier.
The supplier maintains the certificate as proof of sales tax exemption.

However, various factors can lead to different tax scenarios. Recent changes have had substantial effects on who collects; sometimes the supplier is responsible for sales tax, sometimes the customer is on the hook for use tax.

Our guide to navigating new tax regulations and drop shipping is a visual reference designed to help sellers and suppliers more easily determine who collects and remits sales tax. Of course, we highly recommend discussing your specific tax obligations with your tax professional.

Sales tax exemption certificates: the silent hero of drop shipping

One key factor for sales tax compliance with drop shipping is the exemption certificate.

With three parties involved in a drop shipping transaction, there’s a very high likelihood at least one is reselling. If a seller or supplier has nexus, they’re required to collect either sales tax or a valid resale exemption certificate. They’re responsible for managing and maintaining these certificates to produce in the event of an audit.

The same holds true for any qualified purchases by tax exempt groups. A valid certificate is required to verify the purchaser’s status, and maintained in case there’s an audit.

Sales tax compliance solutions for drop shipping

If all this feels overwhelming, you’re not alone. But fortunately, you have options when it comes to addressing your specific sales tax issues. You can hire a sales tax professional or assign a team of people to ensure compliance. However, it’s a time-intensive process and requires a great deal of specialty — quality professionals often command a hefty fee. And keep in mind, the rules are frequently changing and even the best employees are susceptible to human error.

Another option is automating your sales tax compliance. For complex tax scenarios like drop shipping, automated solutions handle sales tax calculations and exemptions as the transaction takes place, applying the latest rules and regulations. Avalara AvaTax is designed to integrate with multiple systems, including supply chain software. And Avalara CertCapture greatly simplifies storing, managing, and maintaining exemption documentation.