While each state has their own sales tax rules on drop shipping, there are two critical rules that are broadly applicable for manufacturers, distributors, and retailers. First, sales tax is a consumer-based tax. This means sales taxes are imposed on the final consumer of a taxable product or service. Sellers merely collect tax from their customers and remit the funds to the states. Next, sellers are only required to collect tax when selling to final consumers that are located in states where the seller has sales tax nexus. For these two reasons, it’s very important to know your customers and know where your company has sales tax nexus.

It’s also important to understand how consumers use tax works. In general, use tax is the same as sales tax but applies when sellers do not collect sales tax. Purchasers are often required to self-assess use tax when purchasing taxable items from out of state sellers that are not required to collect sales tax in their state.

What is the Problem with regards to Drop Shipments?

The problem is properly pushing the tax liability to the consumer. Absent a resale certificate or other specific exemption, all 45 states with a sales tax and the District of Columbia will tax drop shipments of retail sales of tangible personal property. The key question for the manufacturer or wholesaler is which resale certificate, if any, is acceptable.

To understand how to solve the problem we need to break down a transaction and define each party’s role within a drop ship scenario.

True Retailer – This company makes the sale to a Customer and will bill that customer directly.

Drop Shipper – This company will ship products to the customer and bills the True Retailer.

Customer – This could be the end consumer. Alternatively, this could be another reseller.

Here’s how the drop ship scenario unfolds. True Retailers initiate sales to Customers where the True Retailer does not have sales tax nexus. This generally means the True Retailer cannot collect sales tax because they are not registered in the Customer’s state. The True Retailer then orders a Drop Shipper to directly ship products to the Customer. In this situation, Drop Shippers are often required to remit tax to the Customer’s location state because the Drop Shipper has nexus and the True Retailer does not.

Outside of a drop ship scenario, a seller would simply collect the tax from their customer by adding a sales tax line item to their bill. This properly pushes the tax liability to the end consumer. From a mechanical standpoint, the problem stems from the disconnect between Drop Shippers and Customers. Because Drop Shippers do not bill Customers, they cannot collect the taxes they are required to remit to the states. At this point, Drop Shippers either absorb the tax costs or attempt to pass the costs on to the True Retailers. Because neither the True Retailers nor Drop Shippers are the end consumers, it does not make sense for either party to pay the tax, but the reality is that they often do. The problem is further compounded because the Customer is still liable for self-assessing use tax as their bill does not show that tax has been paid.

Common Drop Ship Solutions

States handle this problem in several different ways. The first thing companies should look for is Streamlined Sales and Use Tax Agreement (SSUTA) member states. This is because many of these member states allow Drop Shippers to accept a specific multistate sales tax exemption certificate. Other states accept the Multi-state Tax Commission’s (MTC) multijurisdictional uniform sales and use tax exemption certificate.

Another common solution is for states to allow Drop Shippers to accept out of state exemption certificates from True Retailers. This works well for True Retailers, but Drop Shippers can be reluctant to accept them because of increased audit risks. This increased risk could be mere perception, but the risks can be real because these complex transactions come with higher risks of record keeping errors and misinterpretation. Mistakes on the part of the Drop Shippers’ employees or auditors could lead to unnecessary tax assessments.

In other cases when the True Retailer’s Customer is another reseller, some states would allow them to collect resale exemption certificates from their Customers’ home states. The True Retailer would then pass on the state certificate to their Drop Shipper. When states allow resale certificates to pass in this manner, Drop Shippers are relieved from their obligations to remit tax on the sale.

In other cases, where the Customer is a taxable final consumer, some states would allow a True Retailer to collect the tax from their Customers and remit the tax to their Drop Shippers, who will ultimately remit the tax to the state. When states allow this kind of pass-through treatment, True Retailers may collect sales tax in states where it does not register to do so. This is not common practice, and states have rules about how the collection of tax must be stated on the Customer’s bill.

Of course, having the True Retailer register in the states allows for the collection of sales tax from the consumer and takes any tax collection responsibilities away from the Drop Shippers. This could have other repercussions for True Retailers, including additional compliance costs, monitoring exemption certificates, collecting tax, identifying the correct rate of tax for each transaction (local rates cause problems), filing multistate returns monthly, quarterly or annually and possibly creating income tax nexus.

While not perfect, in the end, these solutions allow sellers to properly push sales tax obligations to consumers.