Tax Implications of Drop Shipping
For drop shippers and the companies that use them, sales tax rules can be more confusing than a Rubik’s Cube. A drop shipment is a sale of tangible personal property (TPP), in which the seller accepts an order from a customer, places the order with a third party (such as manufacturer or wholesaler), and directs the third party to deliver the item to the customer. The third party may deliver the item using its own truck, arrange for delivery by common carrier, or arrange for the customer to pick up the item from a warehouse location.
When it comes to sales tax, the complexity of the drop shipping equation is made more so by issues of nexus, product sourcing, customer location, and drop shipper location. For purposes of simplicity, this paper discusses sales tax issues at the intersection of the retailer, the wholesaler or manufacturer, and the drop shipper. In today’s economy, the wholesaler or manufacturer might also be the drop shipper, and customers can skip retailers and buy directly from wholesalers, but for purposes of clarity, these entities are defined more narrowly here.
Simplified, the drop shipment sales tax triangle is:
- Retailer takes the customer order;
- Retailer places the order with the wholesaler or manufacturer who holds the inventory; and
- Wholesaler or manufacturer contracts with a third-party drop shipper to deliver the product to the customer.
The problem with the drop shipping scenario is that it carries very high risk of sales tax errors. The complexity and changeability of the rules regarding sales tax and drop shipping is mind-boggling. And increasingly, sales tax errors lead to more aggressive audits and expensive fines and penalties.
Things may/will become even more complicated if a federal proposal to allow states to require out-of-state sellers to collect sales tax becomes law. Under the Marketplace Fairness Act, states that don’t currently require out of state manufacturers, distributors, wholesalers, or drop shippers to collect sales tax would likely begin to. By expanding definition of nexus to capture more revenue from sales tax, states are poised to hone in on industries--such as drop shipping--that have typically avoided the sales tax compliance nightmares faced by others.
The following questions will help drop shippers, wholesalers, manufacturers and retailers determine when and where sales tax is owed, and whether or not a reseller certificate should be submitted.
1) In a drop shipping scenario, when is there a sales or use tax obligation?
- If the retailer has nexus in the state where the sale occurs, the retailer collects sales tax from the customer, even if the retailer engages a third-party drop shipper to deliver the product.
Even when drop shipping is used as the method of delivery, the retailer collects sales tax from the customer, unless the transaction is exempt.
- If the retailer and the drop shipper do not have nexus in the state in which the sale occurs, the customer is subject to use tax.
The retailer and the third party drop shipper cannot be required to collect sales or use tax on the retail sale, but the customer is required to remit use tax unless the transaction is tax-exempt.
- If the retailer doesn’t have nexus in the state in which the sale occurs, but the drop shipper does, the drop shipper could be responsible for collecting sales tax.
Most states do not consider the transaction between the retailer and the drop shipper a taxable transaction, as long as proper documentation is provided to the third party drop shipper (namely, a resale certificate—see #3 below).
Several states do hold the third-party drop shipper responsible to collect sales tax on the sale when the out-of-state retailer lacks nexus. To varying degrees, these include California, Connecticut, Florida, Hawaii, and others.
2) Do states consider drop shipping a nexus-creating activity?
In some states, use of an in-state drop shipper by an out-of-state retailer is sometimes considered a nexus-creating relationship. In CA, NY, TX, and FL for example, if a drop shipper delivers goods on a remote seller’s behalf, that seller could be obligated to collect sales tax on the taxable sale.
As if all of the above weren’t enough to confuse you, the valuation of the taxable amount (the tax basis) also varies between states. For example, in some states, the full retail price of $50,000 for large equipment would be taxable. In others, only the $45,000 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 or the wholesale price plus 10%.
3) What constitutes a valid resale certificate?
As stated above, most states do not consider the transaction between the retailer and the drop shipper taxable, as long as the retailer provides the proper documentation to the drop shipper.
States that are members of the Streamlined Sales and Use Tax Use Agreement can use the SST certified exemption certificate. Many other states allow out-of-state certificates. For example, if a drop shipper is in New York and the retailer is in Washington, New York will accept the retailer’s Washington State resale number.
4) How can drop shippers, retailers, wholesalers, and manufacturers get drop shipping related sales tax right?
Given the complexity of sales tax rules regarding drop shipping, many manufacturers, wholesalers, retailers, and drop shippers need sales tax assistance.
And it’s no wonder. There are over 12,000 taxing jurisdictions in the U.S. Then there are the sales tax rates and rules themselves, which address everything from how and when to file and remit sales tax to whether or not a product is taxable. These are particularly complex for direct sellers dealing with a wide range of products over a large geographical area. It is virtually impossible to accurately determine sales tax rates manually using rate tables and zip code look-ups—especially given sales tax holidays, exemptions, and rate and rule changes.
Once a company identifies the states in which it has nexus, it can implement a system for automatically updating and tracking applicable sales tax rates and rules. Without an efficient process in place, companies drain valuable resources by tasking employees with the herculean task of managing this process. An automated system enables employees to spend their valuable time on more revenue-generating activities.
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