Drop shipping and sales tax compliance

• 1. What is drop shipping
• 2. Why businesses use drop shippers
• 3. How drop shipping works
• 4. How drop shipping is taxed
• 5. Where tax automation can help

Simply put, drop shipping is a fulfillment process in which sellers send orders to customers directly from a manufacturer or distributor, rather than keeping stock on hand.

Drop shipping has quite a few benefits for retailers, including the seller’s ability to:

• Eliminate the cost of maintaining giant warehouses 
• Improve cash flow by not investing capital in inventory
• Reduce the risk of amassing unsold inventory

But drop shipping can also complicate the already confusing area of sales tax compliance. Who owes what to whom can seem even more nebulous when transactions create indirect relationships between retailers, suppliers, and customers.

In a typical online purchase, there’s a buyer and a seller. A customer buys something and a retailer sends them the purchase from the store or warehouse, depending on their business model.

With drop shipping, there are three roles, with two purchases:

• Role 1: The customer

  From the customer’s perspective, the experience is essentially the same as the purchase outlined above. Customers browse a catalog or site, choose their goods, and pay the seller, including all applicable taxes. This is purchase #1.

   

• Role 2: The retailer

  The retailer receives the order request and payment from the customer. For any items not available on hand, the retailer places an order with the supplier. This is purchase #2.

   

• Role 3: The supplier

  The supplier receives the order and payment from the retailer. But rather than sending the goods to the retailer to pass on to the customer, the supplier ships the order directly to the end customer.

Sales tax must still be remitted on drop shipping sales, but it isn’t typically collected at every stage of the transaction. In most cases:

• The customer pays sales tax to the seller
• The seller remits the tax to the state and provides a resale exemption certificate to the supplier
• The supplier maintains the certificate as proof of a valid exemption

But as with all things sales tax, there are different liability scenarios. Sometimes the supplier is responsible for sales tax or the customer is on the hook for use tax.

The correct scenario for any transaction depends on multiple factors, including the locations of all three parties, the taxability of the goods, and where the seller and supplier have nexus, or an obligation to collect sales tax.

We highly recommend discussing your specific tax obligations with your tax professional.

With all taxable sales, sellers are required to collect sales tax, an exemption certificate, or a resale certificate.

With the nature of how drop shipping functions, it’s almost guaranteed one party is functioning as a reseller. For instance, a retailer who purchases goods to be delivered to the customer is the reseller. They’ve already collected the tax on the purchase price, and would not owe additional tax to the supplier.

However, the retailer must provide the supplier with a valid resale certificate in lieu of tax. If a supplier doesn’t have proof of the exemption, they’ll be out of sales tax compliance.

The same holds true for any qualified purchases by tax-exempt groups. A valid certificate is required to verify the purchaser’s status, and maintained in case there’s an audit.

Determining tax liability and managing exemption documents can be a time-intensive process and requires a great deal of specialty. Not only do quality professionals often command a hefty fee, but the rules are frequently changing and even the best employees are susceptible to human error.

Fortunately, automated solutions can handle sales tax calculations and exemptions as the transaction takes place, applying the latest rules and regulations. Avalara offers multiple tax compliance products, including:

• Avalara AvaTax, which is designed to integrate with multiple systems, including supply chain software
• Avalara Exemption Certificate Management, which simplifies storing, managing, and maintaining exemption documentation

Avalara also offers dynamic solutions designed for retailers and manufacturers and distributors.