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How Dropshipping Affects Sales Tax

Gail Cole

Drop shipping enables retailers to offer a wide range of products without laying out a lot of money for inventory. It’s an efficient process that gives retailers a tremendous amount of flexibility. However, drop shipping can also complicate sales tax compliance, especially now that states have the authority to tax remote sales.

Remote sales tax recap

The Supreme Court of the United States issued a seminal sales tax ruling in South Dakota v. Wayfair, Inc. (June 21, 2018). Prior to the decision, states could only require businesses with a physical presence in the state to collect and remit sales tax. By overruling the physical presence rule, the court authorized states to impose a sales tax collection duty on out-of-state sellers with no physical connection to the state.

Although having a physical presence in a state still establishes nexus — the connection between a seller and state that enables the state to require the seller to collect and remit sales tax — the Wayfair ruling authorizes states to base a sales tax collection obligation solely on a remote seller’s economic activity in the state, or economic nexus.

More than 43 states have adopted economic nexus since the Wayfair ruling (well, 43 states and Washington, D.C.). In fact, Florida and Missouri are the only two states that have a general sales tax but don’t have an economic nexus law or rule; there’s no statewide sales tax in Alaska, Delaware, Montana, New Hampshire, and Oregon. Consequently, businesses that sell across state lines are now more likely than ever to have nexus in more than one state.

Dropshipping Sales tax

The many faces of economic nexus

At its most basic, an economic nexus law requires a remote seller doing a certain amount of business in a state to register with the state tax authority and comply with sales and use tax laws. Unfortunately, nothing is ever that simple with sales tax.

Every state economic nexus law is unique, and nowhere is that more obvious than with each state’s economic nexus threshold — the amount of sales and/or transactions in a state that triggers a remote sales tax collection obligation.

For example, a remote seller must have more than $500,000 in retail sales of tangible personal property (TPP) delivered into California in the current or previous calendar year to establish an economic nexus with California. In New York, the economic nexus threshold is more than $500,000 in gross sales of TPP delivered into the state and more than 100 separate transactions in the previous four sales tax quarters. However, in South Dakota, the threshold is more than $100,000 in sales or at least 200 transactions of TPP, electronically delivered products, or services (including all exempt sales) in the state in the current or previous calendar year.

In some states, a remote seller that makes only exempt sales can establish economic nexus. Understanding how drop shipping impacts sales tax compliance is therefore now more challenging — and essential — than ever.

Dropshipping Sales tax

Drop shipping and sales tax

Drop shipping typically involves three steps:

1.       The retailer takes a customer order

2.       The retailer places the order with a wholesaler or manufacturer (the supplier)

3.       The supplier delivers the product to the customer (or contracts with a third party to deliver it)

Sales or use tax must be collected and remitted somewhere along that line. A resale or exemption certificate must also be collected, since the sales tax isn’t collected at each step.

Who’s responsible for collecting and remitting sales tax depends on nexus.

Dropshipping Sales tax

Seller has nexus

A seller that has nexus in the state where the goods are delivered must collect sales tax from the customer. This is true even if the retailer uses drop shipping and doesn’t ship the product to the customer itself.

As noted above, sellers are more likely to have nexus in multiple states in the post-Wayfair world. In fact, making just 200 transactions into the state in one year will give a remote seller economic nexus in Arkansas, Georgia, Illinois, Indiana, Iowa, Kentucky, Maine, Maryland, Michigan, Nebraska, Nevada, New Jersey, North Carolina, Ohio, Rhode Island, South Dakota, Utah, Virginia, West Virginia, Wisconsin, Wyoming, and Washington, D.C.

Supplier has nexus

If the seller doesn’t have nexus in the state where the goods are delivered, but the supplier does, the supplier may be required to collect sales tax from the customer. A handful of states, including California and Texas, typically hold a third-party drop shipper with nexus liable for sales tax if the retailer doesn’t have nexus with the state.

However, most states don’t consider the transaction between a retailer and a supplier to be taxable. Thus, instead of collecting sales tax from the customer, the supplier must collect an exemption or resale certificate from the retailer.

Now that nexus can be established by economic activity alone, suppliers are increasingly likely to have nexus with states where they don’t have a physical presence. It’s essential that suppliers know where they have nexus and register with those states; the states will follow the supply chain during an audit and seek proof that each exempt sale is valid. 

Dropshipping Sales tax

Neither the seller nor supplier has nexus

In the event neither the seller nor supplier has nexus in the state where the sale occurs, the customer is responsible for remitting consumer use tax directly to the state tax authority.

However, not having nexus in a state doesn’t ensure you’re entirely off the hook for sales and use tax in that state. Several states require certain non-collecting sellers or marketplace facilitators (e.g., Amazon, eBay, Etsy) to comply with the following use tax notice and reporting requirements:

  • Notify customer of their obligation to report and pay use tax if sales tax wasn’t collected
  • Provide an annual purchase summary to customers
  • Send an annual customer information report to the state tax authority

In this situation, customers are reminded that they owe use tax and are given information to help them remit the proper amount, and states are given information to facilitate use tax compliance. States with non-collecting seller use tax reporting requirements include Colorado, Oklahoma, and Vermont.

The most effective way for any business, seller or supplier, to manage sales and use tax compliance is to automate it.

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Gail Cole
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