How to Utilize Drop Shipping and Maintain Sales Tax Compliance

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Drop shipping can facilitate order fulfillment at any time of year, especially during the busy seasons. Unfortunately, drop shipping can also complicate sales tax compliance.

With drop shipping, a retailer purchases product from a supplier (also called a drop shipper) after receiving an order, rather than purchasing inventory in bulk ahead of time. The supplier then ships the order directly to the consumer. This reduces overhead for the retailer, and it’s an easy model to scale.

Despite it’s simplicities, drop shipping also complicates sales tax compliance because it involves three parties, two sales transactions, and often multiple states (which have different tax rules). It’s not always apparent who’s responsible for collecting and remitting sales tax — the retailer, the supplier, or the consumer.

Determining nexus

To figure out who’s on the hook for tax when drop shipping is involved, it’s first necessary to determine where the retailer and the supplier have nexus. Nexus is the connection between a business and a state that establishes a tax collection obligation. While traditionally based on physical presence, some states have broadened the definition of nexus to include economic activity, referrals, relationships with affiliates, and other connections.

Clearly, one tax policy definitely doesn’t fit all. In fact, there are at least three drop shipping scenarios, and each impacts tax differently.

Scenario 1: The Retailer has Nexus.

Generally, when a retailer has nexus in a consumer’s state, it’s 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 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.

Use tax compliance is difficult for states to enforce and compliance is quite low. However, some states now require non-collecting vendors to inform consumers that use tax may be due. These vendors may also have to report consumer purchase ac vity to the customer (so they’ll know how much use tax they owe), and to the state (so they’ll know how much use tax the consumers owe).

Scenario 3: The supplier (drop shipper) has nexus, but the retailer doesn’t.

When the retailer doesn’t 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 exemp on 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 don’t allow suppliers to accept out-of-state exemp on certificates. Sales tax compliance is trickiest in these states.

Some of these states require the supplier to collect tax on the wholesale price paid by the vendor. For example, the Maryland Comptroller stipulates that the supplier either “require the vendor to obtain a Maryland sales and use tax license and provide a valid resale cer cate,” 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 share the retail price with their suppliers, there’s usually a Plan B.

In California, for example, if a supplier doesn’t know the final retail price, it’s required to add 10 percent to the wholesale price and charge the retailer tax on that amount (wholesale plus 10 percent).

Yet in Connecticut, if the supplier doesn’t know the retail selling price, it should charge the retailer tax on the wholesale price, whereupon “the customer is liable for payment of the remainder of the tax directly to the State of Connecticut as a use tax.”

Takeaways

The complexities surrounding sales tax and drop shipping can be simplified with these three steps:

Communicate with your drop shipper. Communication is vital to the success of any partnership. When drop shipping is involved, it can help prevent negative audit findings for both retailers and suppliers.

Determine who has nexus where. States have been working to broaden nexus beyond physical presence for years. Affiliate relationships, referrals, software, and inventory can now trigger nexus in some states.

This year, for example, both Georgia and Iowa adopted economic nexus and non-collecting seller use tax reporting (they take effect in both states on January 1, 2019). Connecticut has new economic nexus rules and new obligations for referrers and marketplace facilitators as of December 1, 2018, and Washington, Oklahoma, and Pennsylvania require large marketplace facilitators (e.g., Amazon, eBay, Etsy) to collect and remit tax on third-party sales as of January, July, and April 2018, respectively. Several other states have also broadened their nexus laws.

Yet understanding where all involved parties have nexus is only half the battle — it’s also necessary to understand how each state’s sales tax laws apply to drop shipping.

Develop a systemized approach to tracking rules, etc. Sales tax rates, rules, and regulations are a moving target. Once nexus has been determined and communicated, it’s important to systematize your approach to tracking changes.

The last thing retailers need to worry about come holiday season is sales tax. Automating sales tax compliance frees time and resources for more revenue-generating activities, like boosting sales.

Drop shipping can help grow your business, but unfortunately, it can also grow your nexus. Thus its necessary to learn how to survive busy seasons compliantly, even with drop shipping.


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