Tax Analysts Blog

Drop Shipping Is Popular With Retailers, but Can Create Tax Challenges

Posted on Oct 22, 2014

Drop shipping is a commonly used retail method in which the retailer doesn’t hold the inventory it sells to the end customer. After a retailer accepts an order for a product, it places an order for that product with a third party, typically the manufacturer or wholesaler (shipper) who ships the product directly to the customer. The shipment is typically done via common carrier, but that is not a hard and fast rule. The shipper bills the retailer, and the retailer in turn bills the customer. The retailer makes money on the difference between what it charges the customer and what it pays the shipper.

Drop shipping is used by all types of retail businesses that don't have space to hold a significant amount of inventory. Although these are often small and online businesses, larger companies may choose to use drop shipments for some types of products. For example, companies that offer custom products may choose to drop ship because it isn’t feasible to keep custom products in inventory.

I’ve noticed the term “drop shipping” dropped (pun intended) casually in the news. When announcing that it had secured capital from investors, Loop & Tie Inc., a digital gifting platform developer, noted that it employed only three workers but that it has drop shipping agreements with 60 suppliers. JR Global Resources LLC announced a new online pet supply store that makes shipping affordable through drop shipping. And Wholesale Blank Clothes, which provides blank clothing for customization, touted the fact that drop shipping doesn’t void the cost of wholesale savings.

While drop shipping may ease the retailer’s burden of having to stock large quantities of inventory, drop shipments can create tax consequences for all parties involved. From a sales and use tax perspective, if the retailer has nexus with a particular state or is voluntarily registered in the state where the sale took place, the retailer is required to collect sales tax on the transaction with the customer. Conversely, if neither the retailer nor the shipper has nexus with the state in which the sale took place, neither can be required to collect sales tax. In that situation, the customer is required to pay use tax unless the purchase was otherwise exempt. Although establishing nexus in those two situations is relatively simple, things get a bit more interesting when the retailer does not have nexus with the taxing state but the shipper does.

Let’s assume the following: A retailer takes an order for a product from a customer in State A. The retailer does not have nexus with State A. If that were a single transaction, the retailer would not be required to collect sales tax because it lacks nexus with the taxing state. But with a drop shipment, there is a third party. So assume also that the shipper, which is fulfilling the order, has nexus with State A. In that scenario, the retailer is not required to be registered to collect sales and use tax in the taxing state, but that may not remove all collection and remittance responsibilities from the shipper.

States are split on whether the shipper is required to collect sales tax if the retailer does not have nexus with the taxing state. California, Massachusetts, Nebraska, Nevada, Rhode Island, Tennessee, and Wisconsin are among the states that have laws on the books imposing some level of sales and use tax collection obligation on the shipper.

Retailers and shippers must be aware of the sales tax implications inherent in drop shipping. In the end, it all comes down to nexus, and even if a retailer is not doing anything that in and of itself would establish nexus with a state, the existence of a third-party shipper complicates the matter. It is imperative that both retailers and shippers review state laws to ensure they are properly in compliance with them.

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