Drop shipping is a great way for e-commerce businesses that have limited or untested inventory to expand their customer offerings. By retailing products that are carried and housed by a third party distributor, such as a manufacturer, wholesaler, or fulfillment house, retailers can use drop shipping as away to grow their customer base, bring in more income and test out new inventory. However, drop shipping can have an adverse affect on sales and use taxes and thus, negatively impact the return on investment.

How Drop Shipping Complicates Sales and Use Tax

Because a third party is now involved, sales and use tax become more complicated. First of all, drop-shipping purchases are meant for resale, which is normally exempt from sales tax. However, when the retailer, supplier and customer (or the package’s destination) are not located in the same state, sales and use tax rules change as nexus laws may come into play.

Sound confusing? It is. Here is how it works:

  • Case 1: If the retailer and the shipping destination are in the same state, sales and use tax must be collected by the retailer, regardless of where the distributor is located.
  • Case 2: Now if neither the retailer nor the distributor are in the destination state, then the customer is generally responsible for any tax or exemption.
  • Case 3: The distributor and shipping destination are in the same state but the retailer is not. In this case, the distributor would be responsible for sales and use tax but because this is technically an item for resale, the distributor must provide acceptable proof of exemption in order to avoid the tax. However, there are some conditions and exceptions to this rule because each state handles this obligation differently.

As we see, complications arise from Case #3. Proof of exemption can be handled in most states with a formal out-of-state exemption certificate from the distributor on file with the retailer. In many cases, states accept “alternate documentation” proving the distributor qualifies for an exemption with the state determining what’s acceptable. Other states require an in-state exemption, but without a nexus in that state, the retailer may not be able to obtain this certificate. However, states have different standards of what documentation they accept. Distributors need to know what states accept what documentation.

Recent Challenges with Drop Shipping

Drop Shipping and Sales Tax

That said, Michael J. Fleming reported last October at SalesTaxSupport.com that things are changing. (page has been removed) He reports that distributors and manufacturers are being audited based on improper paperwork and are getting hit with huge fines, so they are going back to retailers requiring exemption certificates from all possible ship-to states. If not, they are attempting to charge the sales tax back to the retailer. That’s a sticky situation because without a nexus, the retailer cannot charge that tax back to the customer unless they are registered to collect sales tax in that state even if they don’t have a nexus there.

Over at the Houston Chronicle, Ashley Mott writes about this all as the retailer’s responsibility: “If you cannot provide the drop shipper with your sales tax authorization information, the drop shipper must charge you sales tax based on the final destination of the item.”

State-by-State Complications

It gets even more complicated as some states have stricter rules than others. While this does not include every state, tax expert Diane Yetter claims there are “approximately 11 states” that require sellers who would like a resale certificate to be registered in that state. (article has been removed) Those states require the drop shipper to collect sales tax from the retailer.

California is particularly complicated, having just updated their drop ship exemption rules in spring of 2014. California requires the collection of sales and use tax when a drop shipped item is sold by an out of state retailer without a nexus there because a seller’s permit or certificate of registration is required to avoid the tax. In addition, if it is not known how much the retailer charged the customer, the sales tax is configured on the drop shipper’s retail selling price, plus an additional 10% markup. As of this the date of this post, only California charges a markup. According to the accounting firm BKD, most states will collect based on the retailer’s cost if the price is unknown but practices vary from state to state. (page has been removed)

Best Practices for Drop Shipping

It’s important to consider drop shipping when choosing sales tax software, if you currently participate in an drop-ship program or plan to in the future. Drop shipping may change your sales tax determination. We’ve listed some of the pitfalls a retailer can experience with drop shipping, but there are other steps that can protect businesses from tax liabilities when drop shipping.

  1. Drop shipping can be a welcome source of additional income for online retailers, but smart shopping and thorough research is required before making a commitment. While an online search seems to support drop shipping as an “easy” way to build a lucrative business, retailers need to be aware of the complexities especially with regard to sales tax.
  2. Select a reliable supplier for a drop shipping. Retailers must learn to select trusted, established companies to provide drop-shipping services for their customers. Companies that have been in the news or involved with tax lawsuits should be avoided. In addition, Jeremy Hanks, at Practical Ecommerce recommends finding a supplier that can do single-item fulfillment in a way that matches the retailer’s requirements. Retailers need to consider several issues when contracting a drop shipping firm, such as high set up fees, monthly minimum orders, pricing that is not in line with their inventory, shipping times, who is responsible for returns and taxes.
  3. Retailers should consider the supplier’s return policy and how it compares to their own, as well as how they handle tax charges for returned items. Customers should be ensured a seamless process, and the retailer can feel confident about tax difficulties if the supplier has good policies in place to handle this.
  4. Hanks also recommends retailers get started with drop shipping by working with existing wholesalers. In addition, they should test out a few few items with new suppliers before committing to longer, larger partnerships. This can help a company determine if a new product is bringing in more sales.
  5. Ask for their tax practices. If a supplier doesn’t understand the basics of nexus and who is responsible for sales and use taxes, they may not be trustworthy or may hold a retailer accountable for tax liabilities that are their own responsibility.
  6. Use robust e-commerce software to track drop shipped orders. Tracking orders can be one of the major complications with drop shipping. Be prepared to give up some control as you may not be able to track inventory as you now do.
  7. Engage a reliable tax accounting firm. Because state laws vary so much, it’s critical to engage a reliable firm and trustworthy tax tracking software.

Drop shipping is a great expansion option for new businesses that can bring in extra income, but it takes commitment, compromise and time to ensure finding a supplier that is a good fit and that it is worth the investment. Sales tax requirements will become more complicated but reliable accounting and e-commerce software can ensure proper compliance within every state. For more information on sales tax and maintaining your compliance, read our complete guide to sales tax.

Need help understanding your sales tax requirements, as well as calculating and collecting sales tax? Contact us today.

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