Sales tax 101: I’m in a drop shipping relationship. Now what?
by November 6, 2023
Please note: This blog was originally published in 2021. It’s since been updated for accuracy and comprehensiveness.
Third-party drop shipments are becoming one of the most common ways that eCommerce companies use to fulfill their customer’s orders.
What is drop shipping?
As a refresher, this “drop-shipment” relationship occurs when your vendor ships the product directly to your customer and bills your company for the purchase you made from them. In a traditional drop-shipment transaction, two separate sales occur simultaneously at the point the goods are delivered to your customer.
The first sale to occur is between your vendor and your company. This first sale is, most likely, a “sale for resale” from your vendor’s perspective. Your vendor is billing you for the purchase price of the items your company has purchased and had delivered to your customer. There is a transfer of title from your vendor and your company at the moment the goods are delivered to your customer. Upon delivery, the second sale occurs. That sale is between your company and your customer. This sale is documented by the sales proceeds you receive from your customer for the goods they purchase. Assuming that your customer is the end-user of the products sold, this second sale is a retail sale and is taxable as dictated by the laws of the state where your customer is located.
This all sounds very convenient and as an easy way to manage inventory and meet your customer needs in a timely fashion. It also presents a myriad of sales tax challenges that the states are willing to capitalize on whenever possible to make sure that taxes are paid by someone on these transactions. With two separate sales occurring in a drop shipment transaction, there are two separate sales tax decisions that need to be made. Each of these sales tax decisions requires that two questions be answered: (1) do either of the sellers (your vendor and your company) have nexus in the destination state? and (2) is the sale to either customer a “sale for resale”?
Why sales tax nexus matters
Of the two questions, the issue of nexus is vital to determining the responsibility each party has for sales tax in the destination state. As noted above, the first transaction involves the sale of the property from your vendor to your company. If your vendor has nexus in the state where the property is delivered to your customer, then some type of resale certificate must be provided by your company to your vendor to prevent your vendor from charging your company sales tax on the wholesale cost of the goods sold to you.
If your company has nexus in the state where the drop shipment occurs, then your company will need to obtain an exemption certificate from your customer or your company will need to charge your customer sales tax on the retail cost of the property and any delivery charges that may be taxable.
Find your drop ship scenario here
There are several scenarios to evaluate. For simplicity, these scenarios assume that each party to the drop shipment is located in a different state and that the goods are shipped from outside of the destination (i.e. end-customer’s) state.
Scenario 1: Neither your vendor nor your company has nexus in the destination state. In this case, your vendor does not have a legal obligation to obtain exemption certificates that are valid in the ship to state and your company does not have the legal obligation to charge sales tax to your customer (assuming they are the end user). In this situation, the customer will be obligated to pay use tax to the destination state.
Scenario 2: Your vendor has nexus in the destination state but your company does not. In this scenario your vendor should be asking your company for a resale certificate that is valid in the destination state. What is valid in the destination state will vary. Many states will accept your company’s “home” state certificate or will accept your “home state” registration number on the certificate issued by the destination state. Some states, however, are very rigid and will only accept a resale certificate from the destination state with a registration number issued by the registration state. If the ultimate customer is not taxable, some states will allow a “flow through” of your customer’s resale certificate. This option is normally available only when your company does not have nexus. Your failure to provide your vendor with the appropriate resale certificate could legally obligate them to charge your company sales tax on the wholesale price of the property based on the tax rate at the destination location.
Scenario 3: Your vendor does not have nexus in the destination state but your company does have nexus in the destination state. In this scenario, your obligation is to collect the appropriate sales tax from your customer based on the tax rate at the destination location.
Scenario 4: Both your company and your vendor have nexus in the destination state. In this case your vendor will be expecting to receive a resale certificate from your company that is valid in the destination state and your company will be obligated to collect tax from your customer if the sale is taxable. If the sale is not taxable, your obligation is to obtain a valid resale certificate from your customer.
In states like California that have a very rigid structure around resale certificates, vendors with nexus in that state will be expecting your company to provide them with a certificate that is valid in California. Your company’s failure to provide that certificate will cause your vendor to charge your company sales tax on the transaction. Your failure to provide a resale certificate turns this “resale” transaction into a taxable “retail” transaction. This can pose a real dilemma for companies that don’t have nexus in the ship to state (such as California) but have drop-shipments made to these customers. If your customer is a wholesaler and your company does not have nexus in California, then your customer can provide your vendor with a resale certificate directly.
To avoid being charged tax in situations like this the company has limited choices. First, the company can register with the ship-to state so that it can provide the requisite resale certificate. By virtue of registering for tax, the company is now accepting responsibility for collecting tax on these ‘drop shipments’ even though it may not have nexus in the state. Another option is to break the drop-shipment structure. In some situations, the tax cost is substantially greater than the additional shipping costs that would be incurred if the property were shipped to your company in the “home state” and then your company re-shipped the product to the customer in the destination state. The final option is to pay the tax charged by the vendor and just consider it an additional 8 percent to your cost-of-sales.
As a retailer using drop-shipments to fulfill orders your company may be facing some additional and unexpected sales tax obligations based on the nexus footprint of your vendors. Thankfully, most of the states will accept the “home state” certificate or the “home state” number on destination state’s exemption certificate. In those few state which don’t accept ‘home state’ certificates, your company may be confronted with some unexpected tax costs or some unexpected administrative costs related to registering and collecting tax from customers in state where your company does not have nexus.
As states become more aggressive on audits, your vendors will likely be the first ones to feel the sting when they determine under audit that they don’t have a valid resale certificate from your company in a state where they have nexus and have ‘drop shipped’ products to your company’s customers. Don’t want to keep up with tricky sales tax legislation? Get started with TaxJar today.
