Drop shipment: simple yet complex for sales tax

Sales tax comes with a lot of important terms. One is “drop shipment.”

Drop shipments are common in ecommerce and often occur when a seller uses a distributor for order fulfillment to a buyer. In such a transaction, a distributor must charge sales tax to the seller.

Sounds simple – and in many ways it is, except that a drop shipment can often involve not two but three locations (usually states) where sales tax must be considered.

More than one

Many purchases we all make online today are commonly drop-shipped: Many companies now have marketplaces on websites and yet have no inventory. They simply take orders and facilitate a retail sale and then buy from other suppliers.

Though they might seem to be one transaction, drop shipments are really two: one transaction between the distributor and the retailer and another between the retailer and the end-user customer.

Understanding the parties’ sales tax obligations starts with knowing the nexus of the business/retailer that’s making the sale to the end user and the nexus of the drop shipper/distributor. “Nexus” refers to a connection between a company or a person and a taxing authority or a jurisdiction.

To bring up another sales tax term important to drop shipments, generally sales and use tax situs is based on the ship-to location: When anyone has nexus in a jurisdiction and ships tangible personal property into that jurisdiction, they are required to comply with sales and use tax laws of that state.

A typical drop shipment

A retailer receives an order and leverages the inventory of a larger distributor, places the order with the distributor and the distributor drop ships that product directly to the customer.

Let’s say a retailer based in South Carolina sells a baseball hat through its website to a customer in Illinois. The South Carolina retailer purchases the baseball cap from a distributor located in Arkansas and instructs the distributor to ship the baseball cap directly to the customer in Illinois.

Let’s also say that the Arkansas distributor has nexus in and is registered for sales and use tax purposes in Illinois and the South Carolina retailer does not have nexus in Illinois and is not registered for Illinois sales and use tax purposes (the retailer is only registered in South Carolina for sales and use tax purposes).

So from the distributor’s perspective, the above transaction is a single sale to the South Carolina retailer where the situs of the transaction for sales and use tax purposes is in Illinois (the ship-to location). The Arkansas distributor will be required to charge Illinois use tax on the sale to the retailer unless the retailer can present the distributor with a valid exemption certificate.

Possible wrinkles

Nothing’s ever simple in sales tax, of course: Some states require different documentation to substantiate an exempt sale. For instance, if the sale above involved Georgia instead of Illinois, the South Carolina retailer could have just issued to the distributer a Georgia resale certificate with their South Carolina sales and use tax registration number on it to exempt this transaction from Georgia use tax.

Also, Utah is one state with a special drop-shipment rule that allows for a non-nexus creating retailer to issue their home-state resale exempting certificate to a distributor in a drop shipment.

(Check out the drop-shipment surveys from the Institute for Professionals in Taxation for more and check this TaxConnex webinar on top questions about drop shipments.)

If you think your business may be impacted by sales tax complexities and decisions, contact TaxConnex. TaxConnex provides services to become your outsourced sales tax department.