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Sales tax is full of complexities, but there are certain topics that seem to cause more of a headache than others. Drop shipments are one of those topics.

As e-commerce continues to explode – it almost doubled during the pandemic and was already rising sharply nationwide in early 2019 – drop shipment transactions have become even more prevalent. Many companies have added marketplaces on websites and don’t maintain their own inventory for online purchases. Instead, they are leveraging other suppliers/distributors who “drop-ship” the product directly to the customer. 

One challenge to understanding this topic is remembering that three parties are involved in a drop shipment.

Who’s responsible for the tax?

Understanding who owns the sales tax obligations when it comes to drop shipments hinges on knowing the nexus of the business/retailer that’s making the sale to the end-user and the nexus of the drop shipper/distributor. It’s also important to understand that drop shipments, while they appear to be a singular transaction, are really two different transactions. One transaction between the distributor and the retailer, and a second transaction between the retailer and the end-user customer.

In a typical drop ship situation, 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.

Who is ultimately responsible for the sales tax in this three-party transaction? Looking at each of the two transactions individually helps to make the answer clear:

Let’s look at a distributor in Arkansas who sells to a retailer in South Carolina (at that retailer’s request) and drop ships the product to the retailer’s customer in Illinois. For interstate commerce, the tax situs (the point where tax applies) is based on the destination (Illinois in this example) which is different than the bill-to location (South Carolina in this example). Knowing that tax is due in Illinois, we must consider whether the distributor has nexus or not in Illinois. If the distributor has nexus in Illinois, then they are required to charge Illinois sales tax.

From the distributor’s perspective, this 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 reselling retailer must issue an exemption certificate for resale to the distributor that is valid in Illinois.

Carrying this forward, the retailer has entered into a transaction with a customer based in Illinois. If the retailer has nexus in Illinois, they are required to collect the Illinois sales tax. In an ideal situation, the retailer issues their Illinois resale exemption certificate to the distributor, the distributor does not charge any sales tax, and the retailer charges and collects sales tax from their customer in Illinois.

The challenge with Illinois is that the only way to present a valid resale exemption certificate is to be registered for sales tax purposes in the state of Illinois. This is not always in the best interest of the retailer – especially if they don’t already have sales tax nexus in Illinois.

Not all states are alike

Let’s look at a different example. Let’s say the distributor is in Arkansas and the retailer is still in South Carolina, but the customer is in Utah instead of Illinois. The distributor has nexus and is registered for sales and use tax purposes in Utah but the retailer is not registered in Utah. Again, the distributor shipping to Utah will need to charge Utah sales tax unless the retailer can provide a resale exemption certificate that Utah will accept.

The difference, in this case, is that Utah has some latitude that allows the retailer to use their home state resale exemption certificate. Utah – like many other states – effectively allows the retailer to enter a transaction using their South Carolina sales tax registration number.

In this example, it is much easier for the retailer to exempt their purchase with the distributor. The retailer will then need to consider the separate transaction directly with the customer in Utah, and based on whether they have nexus or not, they may be required to collect Utah sales tax.

In our experience neither retailers nor distributors have a grasp of this complicated concept in all situations, resulting in a lot of lost tax savings.

Learn more about drop shipments on our most recent “Hot Topic” webinar.

If you need help understanding your sales tax obligations and whether you should be collecting sales tax, get in touch. TaxConnex has experts to help answer these questions and to help you establish an ongoing process to ensure you remain compliant – even with the frequently changing rules of sales and use tax.    

Robert Dumas

Written by Robert Dumas

Accountant, consultant and entrepreneur, Robert Dumas began his public accounting career on the tax staff at Arthur Young & Co., followed by a brief stint at Grant Thornton. In 1998, Robert founded Tax Partners, which became the largest sales tax compliance service bureau in the country, and later sold it to Thomson Corporation. Robert founded TaxConnex in 2011 on the principle that the sales tax industry needed more than automation to truly help clients, thus building within TaxConnex a proprietary platform and network of sales tax experts to truly take sales tax off client’s plates.