The popularity of the drop shipping business model has taken off as a result of e-commerce. Consequently, states have turned their attention to auditing companies engaged in drop shipping and remote sellers are now responsible for collecting sales taxes when they have met certain thresholds.
Drop shipping is a business model in which the retailer does not keep products in stock but instead transfers customer orders and shipment details to a third-party supplier or manufacturer. The supplier then directly ships the products to the customer. Drop shipping allows retailers to offer a wide range of products without the need for inventory management or upfront costs.
The use of drop shipment in a delivery model presents potential administrative hurdles related to sales tax for both the retailer and drop shipper.
Considerations for businesses using a drop shipper include determining:
- Who is responsible to charge, collect, and remit sales tax;
- What documentation is necessary to support a sale for resale;
- Whether the retailer has nexus in the state where the product is delivered
Generally, a sale between the retailer and drop shipper can be a sale for resale with proper documentation. Documentation can be dependent on factors such as whether the drop shipper has nexus in the state where the product is being delivered. It can also be dependent on state-specific rules. For example, some states require their own resale certificate be provided. To understand who has what responsibility, all parties must understand where each one has nexus for sales tax purposes.
Retailers engaged in drop shipment transactions should evaluate their own sales tax reporting and collection responsibilities in states beyond their home state. To determine whether a business is required to collect and remit sales tax in a particular state, the concept of "nexus" needs to be considered. Nexus refers to a significant connection or presence that a business has in a state, which triggers its obligation to comply with that state's tax laws. Traditionally, nexus was established through physical presence, such as having a brick-and-mortar store or employees in a state.
With the landmark Supreme Court case South Dakota v. Wayfair in 2018, the rules surrounding nexus were updated to include economic factors. Almost all states have implemented economic nexus laws, which require businesses to collect and remit sales tax based on their sales volume or the number of transactions in the state, regardless of physical presence. Each state has its own threshold for economic nexus, which can vary based on sales revenue or transaction count over a defined period.
When it comes to drop shipping, sales tax obligations can become complex due to the involvement and responsibilities of multiple parties. The key factors to consider for sales tax compliance in drop shipping include the location of the retailer, the location of the supplier, and the location of the end customer.
Understanding state sales tax regulations and how they apply to drop shipping is crucial for businesses, especially those that utilize drop shipping to expand and fulfill contracts across the country. The evolving landscape of economic nexus and the involvement of multiple parties in drop shipping make it essential to stay up-to-date with state laws. By complying with sales tax obligations, businesses can ensure legal compliance, avoid penalties, and maintain a positive customer experience in their drop shipping operations – all while growing revenue and mitigating risk.
If you would like to discuss this topic in further detail, please reach out to Matt Romig, Senior Accountant, State and Local Tax, or any member of our State and Local Tax group.