What is Dropshipping and What Are the Tax Consequences?

A drop shipping transaction involves a situation where a seller is selling a product to a buyer but shipping that product to the buyers customer which may or may not be located in a different state.

Drop shipping is an incredibly complicated thing from a tax perspective because you may have one party or multiple parties in multiple jurisdictions. You could have a California seller, you could have a Florida buyer or you could have a customer in New York where the product is ultimately going to.

So the biggest challenge for tax professionals in this situation is where do you pay the tax to? With customers in different states  this is really important because there are a variety of issues around the situs of tax which state has jurisdiction to collect the tax revenue that make this incredibly complicated.

In a drop shipping transaction, you want to make sure you understand the different types of situations that your company faces and then create a plan around how to address those both from a tax filing perspective. Then also in your sales process so that you're collecting the appropriate documentation and you're doing what you can to mitigate your own risk in this situation.

The problem with a lot of drop shipping transactions is many companies assume that because product is going one place or because their customer is located outside their state that they're not obligated to collect tax, and unfortunately the way that most state sales tax laws are written particularly surrounding drop shipping transactions is it put the online business on the hook for liability unless they're collecting resale certificates from that particular state or they're taking other appropriate measures to mitigate their risk so there are a lot of tax consequences to drop shipping.

There's a lot of variables that go in to drop shipping transaction and so you want to make sure that when you're engaging in drop shipping or if you're in any part of the drop shipping spectrum so to speak that you understand the tax consequences and are taking appropriate action.

The tide has shifted. The laws are not in your favor. Is your business prepared?

In 2018, the Supreme Court held that state laws permitting taxes against business without physical presence in that state were constitutional. This groundbreaking decision overturned sixteen years of past precedent.

Unbeknownst to many, California passed Revenue and Taxation Code 6203 in 2012. Under the law, businesses with presence in California are obligated and liable for state sales/use tax and potentially state income tax. Many other states have had laws like this on their books for years.

The major issue with the Supreme Court's decision is that it did nothing to address retroactivity. Translation: California's law is valid and your business may have exposure in California since 2012.

The states, short on revenue, have responded to the Court's decision by aggressively targeting out of state businesses. California, in particular, famously went after 4.5m small businesses selling products through Amazon and other online marketplaces.

California faces a 35b budget shortfall this year. It is widely expected that enforcement efforts against out of state businesses will only increase in the current post-coronavirus economy. The laws are complex and ever-changing and small businesses are facing hundreds of thousands or even millions in past tax liability. Do not get caught in the crossfire.

 

Let us break this down:
If you have an online business outside of California…

 

If you have any inventory or store property in California, even through a 3rd party, you have likely created nexus and will owe tax to California.

This was the key issue involving that do business through Amazon and other marketplace facilitators. The California Department of Tax and Fee Administration held under Revenue and Taxation Code 6203 that the storage of property in California is a nexus creating activity, even if it involved a 3rd party and even if that business did not physically move its inventory into California. This has broad impacts for retailers, wholesalers, distributors and manufacturers.

 

If you have an employee, independent contractor, agent, vendor, or engage with a variety of parties in California, you have likely created nexus and will owe tax to California.

The mere presence of any of these individuals in the state of California can constitute doing business here and can avail you to California's tax laws. This is true even if their presence in the state is only temporary or transitory, if you do not consider them doing business here, or if their presence in the state is largely unrelated to their activities for your company. One of the biggest problems with nexus creating activities, particularly surrounding employees, is that the smallest activity can bind the entire conduct of a much larger organization. 

If you cross a certain threshold of sales to California residents, even without physical presence, engage in "drop shipping," pay compensation to those who sell or promote your products in California, you have likely created nexus and will owe tax to California.

This was the issue in the Supreme Court's decision in Wayfair v. South Dakota. In spite of a lack of contact with the state, the Court held that companies need not have a physical connection with a state to subject themselves to tax here. The broader issue is that the states, including California, have expanded this concept to include a variety of activities, which on their face may not seem like they subject your company to tax jurisdiction here. 

Chances are California is not your only problem. Chances are that this may be the tip of the iceberg when it comes to your multi-state tax exposure.

California may be one of the most aggressive, if not the most aggressive state against out-of-state businesses, but do not make the mistakes and think that similar states do not have laws on their books similar to California. The problem is that each state may do things differently or may have different interpretations when it comes to the activities and tax exposure of your business. Additionally, the laws are confusing, complex, and ever-changing. 

 

What Brotman Law Can Do For You

We are one of the few tax law firms that focuses on multi-state tax issues. These issues are technical and difficult to address and are a "speciality within a speciality" within the area of tax law. Very few firms have the experience being on the front lines of this issue and in dealing with the genesis in this area of law.

In order to deal with these issues effectively, you need a specialist who understands not just how the law is written, but how it is enforced.

 

We are a nationally recognized local law firm and what do you get with us? A team small enough to provide individualized and personal service for our clients with the ability to really get to know their business. But little hinges can swing some pretty big doors. Our firm is nationally recognized for excellence in tax law and are often quoted by major media publications. We have a wide range of experience guiding organizations across industries and those who range in size from start-up to hundreds of millions in annual revenue. That lead us in 2018 to be recognized as the 14th fastest growing law firm in the United States.

Tax Issues & Concerns Must Be Dealt With Immediately For A Peace of Mind Now and In The Future

If you want to identify, manage, and mitigate your risk so you can prevent any unwanted tax problems now or in the future, book your first free 60 min session with us today. Each session includes a complete road map to solving your problem or maximizing your profit from your business.

Our Strategy Sessions:
- Designed to deliver high value in a short amount of time.
- Build a complete strategy to defend your business against California and the IRS.
- No further obligation. We will be available to represent you or assist only if needed.
- 100% money back guarantee. You will receive value or the strategy session is free.

If you have any questions about drop shipping taxes or California sales taxes for your business, Click "Book A Strategy Session" to request a free 60 min strategy session with our senior legal team today to protect your online business profits.

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Sam Brotman, JD, LLM, MBA

Owner and Director of Legal
Brotman Law

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