One of the biggest game-changers in the ecommerce market has been the expansion of drop shipping. While modern tools exist to ensure seamless drop shipping for your business, the sales tax implications of drop shipments are often confusing to sellers.
Drop shipments are ordered by a buyer from a seller, but shipped by a third party. For instance, if you take orders for car parts from your offices in California, you might take an order from New York, and have a wholesaler ship the parts to the out-of-state buyer.
The biggest question about sales tax, whenever a drop shipment is involved, is who will be responsible for paying sales or use tax on the shipment. It often surprises businesses to find out that the answer varies, depending on which parties in the transaction have a taxable connection to the state where the goods are shipped — a connection known legally as "nexus":
Nexus rules have become increasingly complex over time. Initially, the idea of nexus simply referred to having a physical presence in a given state (having a location or employees there, for example). The rise of internet sales made this arrangement impractical for states. Many online sales were made by businesses that didn’t have nexus under this old definition, leaving consumers responsible for paying use tax. Because most consumers don’t bother to file, states were left high and dry, with their sales tax bases dwindling.
Since that time, most states have made significant efforts to expand the definition of nexus. Today, activities like being part of an affiliate marketing program or attending trade shows may be seen as creating nexus. Why does it matter? Because when it comes to who collects and remits taxes on drop shipments, it all depends on nexus.
If the retailer in a drop shipping transaction has nexus in the state where the buyer is, the answer is clear: the retailer must collect and remit the appropriate sales tax amount (unless the buyer presents a current sales tax exemption certificate). It’s equally clear when neither the retailer nor the drop shipper have nexus — the responsibility falls to the consumer to remit use tax.
In some states, simply engaging in drop shipping transactions, or selling a certain threshold amount of goods via drop shipping in a state, can be seen as constituting nexus. Small ecommerce retailers are often unaware they’ve created a nexus obligation in this scenario, which can lead to costly mistakes if a sales tax audit is conducted.
The place where these transactions get tricky is when the retailer doesn’t have nexus with the state where the purchase is made, but the drop shipper does. In several states, like Hawaii and California, this scenario obligates the drop shipper to pay sales tax.
In other states, this transaction does not require either the drop shipper or the retailer to collect tax. The retailer must present the drop shipper with a proper exemption certificate in this scenario to avoid being required to collect and remit tax. In some cases, the exemption certificate from the retailer’s home state can be used elsewhere, but other state governments will require the retailer to obtain a new certificate valid in their state.
It’s clear that drop shipping can complicate a business’s sales and use tax compliance strategies. Automated sales and use tax compliance software, like Avalara AvaTax, can simplify the process of calculating, collecting and remitting these taxes so that your business can focus on core growth activities.