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What is drop shipping and how does it affect my sales tax obligations?

This post has been contributed by Avalara.

Nexus Scenarios

For retailers like you, drop shipping means using a third party to deliver an order that was placed online through your eCommerce store. There are three scenarios in which drop shipping can affect your tax obligations. Chiefly, for retailers using drop shipping services, determining nexus is key because it will help you determine the tax obligation scenario that fits each unique transaction. So, let’s go over the scenarios.

Scenario 1: If the sale occurs in the state where you have nexus, you must collect sales tax from the customer.

Scenario 2: When neither you nor your drop shipper has nexus in the state, the customer must remit use tax.

Scenario 3: The final case is the most confusing and varies greatly between states, so let’s break this one down:

If you don’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, depending on whether a resale certificate is accepted, the definition of which can vary by state. Most states accept resale certificates and in these, you will be required to collect sales tax. However, if resale certificates aren’t accepted, like in California, Connecticut, Florida, Hawaii (and others), the drop shipper will be required to collect. 

The important take away from this scenario is if you don’t have nexus in a state, you’re not necessarily off the hook and it is imperative that you and your drop shipper determine who will collect on a state-by-state basis.  

Are you confused yet? 

With over 12,000 taxing jurisdictions in the US and each with its own set of rules and rates, there’s no wonder why new business methods like drop shipping are a constant conversation for businesses and lawmakers. The problem for business owners and retailers especially is that these laws are diverse and ever-changing and you must keep up to remain compliant. 

For example, some jurisdictions accept resale certificates so that they may treat the transaction as non-nexus-creating. This means the jurisdiction is sure that the transaction is truly for resale, ensuring it is tax-exempt. There are around 11 states that do not participate in the programs that work to this effect (Multi-State Sales & Use Tax Exemption Certificate, the allowance of out-of-state certificates, and the Streamlined Sales Tax Exemption Certificate are the most popular). 

Another divergence point between states is the valuation of the taxable amount. In some states, the full retail price would be taxable, whereas others use the wholesale amount as the tax base. California is even more confusing, as sales tax is applied either to the full retail price or the wholesale price plus 10%. 

Recommendations for Retailers

  1. Determine Nexus: Find out which states you will be required to collect sales tax, provide your drop shipper with a resale certificate, or make sure your drop shipper is collecting on your behalf. To do this effectively, use Nolo’s 50 State Guide to help you decide. 
  2. Communicate with your drop shipper: Lawmakers, wholesalers, and shippers are in the same state of confusion that you are. Don’t let miscommunication augment your problems, talk it out with your partner. 
  3. Systematize: Once you’ve determined nexus and collection obligation, all that’s left to do is systematize an approach to updating the applicable tax rules and track rates because rules change, rates change, and you must too!
  4. Consider an easier way: You’ve already migrated your sales process online and that was the easy part, why not automate your taxes? An automated system enables employees to spend their valuable time on more revenue-generating activities. 

If you found this post interesting, check out The Sales Tax Implications of Drop Shipping whitepaper to dive deeper.

About the Author: Robby Burns is a tax automation writer with Avalara, specializing in content that helps medium-small businesses.

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