Guidelines for Suppliers and Retailers Engaging in Drop Shipping
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).
Inventory Considerations with Drop Shipping
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
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.