Drop shipping sounds like a convenient option for retailers as they are not burdened with carrying inventory or responsible for shipping the items they sell. While in theory, this may sound like a smart business practice, it is fraught with potential for sales tax violations.
What makes drop shipping so complicated is that there are multiple parties involved: the retailer, the supplier/shipper and the end user. In these situations, each state has its own regulations about charging sales tax.
The big question is … who is responsible for collecting and remitting sales tax?
The most common answer is that it is in the state where nexus exists. The situation becomes more complicated by the location of the parties involved. There could be as many as three states involved in the transaction.
If your company drop ships merchandise, it would be a wise decision to call me. Unless you keep on top of all of the various state sales tax regulations, you could find yourself in arrears to multiple states. It is very complicated to keep abreast of all of the ongoing changes in the states’ regulations and that is where Brotman Law can help.
What is Drop Shipping?
In a drop shipping transaction, there are three variables: a customer, a retailer, and a supplier. Drop shipping may occur in various configurations. For example, a supplier may be contacted by a seller, who then requests that the supplier ship a product directly to the seller’s customer.
With drop shipping transactions, the supplier or the retailer can potentially avail themselves to the taxation of the states in which their customers are located. The risk of unintentional availment is high for retailers and especially for suppliers.
Suppliers have the largest potential for liability in various respects because they are the middlemen in these transactions. When the retailer is purchasing a product from the supplier and shipping it somewhere else, that could create liabilities in the state of the retailer, supplier or customer. More than likely, however, it will create a liability in the state of the supplier or the customer.
Another configuration of drop shipping that businesses need to be aware of are those in which the supplier and customer are located in the same state while the retailer is in a different state. For example, a retailer, who is located in Florida and is purchasing from a supplier in California, ships the product to a customer in California.
This sale and shipping configuration is generally going to be considered an in-state transaction and thus, will be subject to California tax. See 2010 Cal. Tax LEXIS 330 (Cal. BOE December 1, 2010).
Even if the retailer is located in Florida and the product is originating, being shipped and going to a customer in California, that product would be subject to California state taxes. (Article 18 Regulation 1706(d)(1).) Regardless of whether the item is being shipped by a common carrier or delivered on a truck or via other means, the supplier would have an obligation to collect and remit California tax.
The problem that most suppliers encounter is that the retailer or customer insists that they do not have to pay tax in California because they have a reseller certificate for another state. In this scenario, the supplier may take the other state’s resale certificate believing that it actually proves that the product will be tax exempt because the retailer is purchasing something for resale.
The issue with this line of thinking is that California does not accept resale certificates from out of state. Instead, California requires the retailer to register in California and obtain a California resale certificate. For further guidelines on which items may qualify for use of resale certificates and how to document resale transactions, refer to the CDTFA’s Publication 103, Sales for Resale.
This scenario often creates conflicts between suppliers and their customers. Retailers may not understand that they have an affirmative requirement to register and potentially pay tax in California — or that they at least have a reporting requirement in California — based on engaging in transactions for resale in the state.
Suppliers must understand that if they are located in the same state to which they are shipping, they have an obligation to collect the tax.
Some states will accept resale certificates from other states or they will accept multistate resale certificates. Other states like California, however, are more particular and require resale certificates for each individual transaction. Some states allow batch transactions while other states allow only individual transactions and also require that the seller certify that each transaction is being done for resale.
The suppliers need to be cognizant of what the rules are in their particular state and of which transactions have drop shipping implications because oftentimes, the supplier will be the one on the hook for any resulting tax liability.
Guidelines for Suppliers and Retailers
The following are some questions that suppliers need to ask:
- Does the supplier have the obligation to collect tax?
- Is this a tax-exempt transaction?
- If there's a sale for resale, does the retailer have an obligation to preserve a resale certificate in the state where the supplier is located?
Two important questions for retailers are:
- If their transactions are truly exempt
- If their suppliers are acting as agents on their behalf. With respect to the second question, retailers must realize that their relationships with their suppliers may be considered nexus-creating activity if the supplier is perceived to be holding inventory on the seller’s behalf or is otherwise acting as their agent.
Drop Shipping and Nexus
Whether a business transaction constitutes nexus-creating activity will always be determined on a state-by-state basis because each jurisdiction approaches the question differently. For guidance, you may refer to state nexus law comparison charts as you put together your compliance plan.
Regardless of the jurisdiction, both retailers and suppliers must be aware of where taxes should be remitted.
Another possible drop shipping configuration presents itself when the retailer and supplier are in the same state, while the customer is in another. In these scenarios, both the supplier and retailer must understand what the nexus creating activities are with the state to which they are shipping.
If they ship using a common carrier such as USPS, FedEX or UPS, that would not normally be considered nexus creating activity. Rather, shipping through a common carrier would simply be considered an in-state transaction.
However, if a retailer uses a supplier who has nexus in the customer’s state, then that may give rise to nexus, especially if the state determines that the supplier is acting as the retailer’s agent.
In these scenarios, suppliers should ask themselves the following questions to determine whether or not they are in compliance:
- Is anything I am doing creating nexus?
- Am I shipping products with my company’s own trucks and driving them into the state of California?
- Where is the title to the goods passed?
- Is it passing in the state in which I am located?
- Or is it passing where the customer is located?
The question of where title passes is particularly important, especially with respect to determining whether it is the supplier or the retailer that is creating nexus. In scenarios where a supplier of State A ships via common carrier from their home state to a seller in State B, the supplier may be said to have passed title before the product crossed state lines. (Institute for Professionals in Taxation, Sales and Use Taxation Ed. 2, §8.04, 139.)
In a third configuration of drop shipping, the customer, supplier and retailer are all in different states. Typically, this configuration would be considered an interstate commerce transaction and thus, would not be subject to tax.
The customer’s jurisdiction will not impose a tax for the retailer and supplier but a use tax requirement would likely be triggered for the customer in this situation. Another consideration businesses must keep in mind is that in California, if the retailer does not do business in the jurisdiction in which the product is being delivered, the supplier will be categorized as a retailer. See Cal. Rev. and Tax Code §6007(2).
The calculus changes depending on where inventory is being held. If inventory is being held in the state in which the customer is located, then it will be necessary to look at the sales and use tax laws for the customer’s jurisdiction.
If the inventory is being held at the supplier’s location, it will be necessary to look at the laws for supplier’s jurisdiction. Following the same logic — although a more uncommon scenario — if inventory is located where the retailer is, the law of that state would apply.
Suppliers grapple with the most risk when it comes to drop shipping transactions because they are shipping to people who may not be their customers. The state may take the position that suppliers must collect a resale certificate from the retailer's customer, leaving suppliers to wonder how they can even do that.
This creates a lot of friction between suppliers and their customers because the retailers do not understand the tax implications of what they are doing when they engage in drop shipping transactions.
Most of the time, the employees who work in the sales department are not going to be aware that there can be very serious consequences for carrying out drop shipping transactions while failing to take into account their tax implications.
Drop Shipping and Interstate Commerce
When it comes to determining whether a state may impose taxes, the question that must always be raised is whether the transaction the state is attempting to tax constitutes interstate commerce. Under the Dormant Commerce Clause, It is unconstitutional for states to levy taxes if doing so will “unduly burden” interstate commerce.
Various other state laws garnered attention for what some perceive to be their potential challengability. However, taxpayers should operate with the mindset that nexus, even in drop shipping transactions, is formed fairly easily.
As to what type of transactions are and are not considered non-taxable interstate commerce, many states (and likely all, in some capacity) provide examples on their respective state tax websites.
The following are some examples:
- “Items kept in a public warehouse remain in the stream of interstate commerce. No Minnesota sales tax is due because the purchaser does not take possession of the items in Minnesota.” Minnesota Department of Revenue, Items for Use Outside of Minnesota (2018)
- “The interstate commerce exemption applies to sales made by Illinois businesses when the property is shipped or delivered by those Illinois businesses to a location outside Illinois and is not returned to Illinois for use. This exemption does not apply to sales made by Illinois businesses to an out-of-state buyer who takes possession of items in Illinois.” Illinois Department of Revenue.
- Michigan gives examples of various configurations of drop shipping transactions and explains which of them constitute interstate commerce. See Michigan Department of Treasury, Revenue Administrative Bulletin 1988-34.
Helpful Resources for Drop shipping
- California Resale Certificate Form: https://www.cdtfa.ca.gov/formspubs/cdtfa230.pdf
Balancing Tax Requirements of Drop Shipping
While drop shipping may be a workable solution for your business, the downside is the myriad of state sales tax laws, nexus and resale matters. Suffice it to say, drop shipping is a source of chaos for the shipping and sales departments of many businesses.
If you are running a company you must keep an eye out for drop shipping transactions because states are becoming increasingly more aggressive about enforcement on these fronts.
Keep informed on the issue of drop shipping and ensure that you are in compliance with the laws of every jurisdiction to which you are availing yourself.
That is where Brotman Law comes in. We have worked with companies that have become burdened with millions of dollars in liability as a result of drop shipping omissions when they believe that they were in compliance. By being proactive and working with us to develop an airtight sales tax compliance plan, you can save yourself a lot of headaches.