Sales Tax, Nexus, and Drop Shipments

Drop shipment transactions can be challenging for both a retailer and a supplier. In a typical drop shipment transaction, the retailer is making a retail sale to a customer. The retailer does not hold inventory and places an order with a supplier and asks the supplier to drop ship the merchandise to the customer. The retailer is buying and reselling the merchandise and thus the transaction between the retailer and supplier should be exempt from sales tax – provided the proper exemption documentation is in place.

To understand this best, let’s take a look at the two separate transactions that occur. One is between the retailer and the customer, and the second is between the retailer and the supplier. Let’s look at each transaction through two examples:

Example 1: (Retailer has sales tax nexus in the destination state)

• When the customer places an order with a retailer, the retailer charges sales tax because they have sales tax nexus in the destination state where the merchandise is being shipped. The retailer will invoice the customer for the merchandise including the sales tax.

• The retailer then places an order with the supplier. When the supplier ships merchandise to the customer, the supplier will apply sales tax based on where the merchandise is being shipped (provided the supplier has sales tax nexus in the destination state). The supplier will then invoice the retailer the applicable sales tax based on the destination.

• In this example, because the retailer has sales tax nexus in the destination state, it’s simple for the retailer to provider a valid resale exemption certificate to the supplier.

Example 2: (Retailer does not have sales tax nexus in the destination state)

• When the customer places an order with a retailer, the retailer does not charge sales tax because they do not have sales tax nexus in the destination state where the merchandise is being shipped. The retailer will invoice the customer for the merchandise and NO tax.

• The retailer then places an order with the supplier. When the supplier ships merchandise to the customer, the supplier will apply sales tax based on where the merchandise is being shipped (provided the supplier has sales tax nexus in the destination state). The supplier will then invoice the retailer the applicable sales tax based on the destination.

• In this example, the retailer has not charged their client sales tax but the supplier has charged sales tax to the retailer. Exempting this transaction from sales tax is a bit more complicated than the first scenario.

There are several options for potentially exempting the second transaction from sales tax. What we need to consider is how to exempt the transaction in the destination state. Let’s look at California and Georgia as two examples:

1. If the destination state is Georgia, then the retailer can issue (and the supplier can accept) the retailer’s home state exemption certificate, the Multi-jurisdictional Certificate with the retailer’s home-state sales tax id number, the SSTP form with the retailer’s home-state sales tax id number, or Georgia’s exemption certificate with the retailer’s home-state sales tax id number. Lots of options in Georgia.

2. If the destination state is California, none of the documentation that Georgia finds acceptable will work. The only way for the retailer to provide a proper exemption certificate is for the retailer to be registered for sales tax purposes in California and thus have a California sales tax id number. The retailer can then issue a California exemption certificate with their California sales tax id number.

If you’ve operated in the drop shipment world for long, you know that some states are like Georgia and others are like California. In total, there are 12 states that are similar to California.

This is a critical process for both the retailer and supplier to execute properly. For the retailer, if they are unprepared and are charged tax by their supplier, they could eat a large portion of their profit margin as a result of paying the unanticipated sales tax. If the supplier does not have the applicable exemption documentation they could be penalized under audit.

For more guidance on specific drop shipment transactions and the applicable exemption documentation, please contact me.