Drop shipments are everywhere, from the baseball cap you ordered online to complex B2B supply chains. As more businesses move away from holding inventory, drop shipments offer convenience and scalability. But who owns the responsibility for sales tax in these multi-party, multi-state transactions?

The answer isn’t always simple. In fact, misunderstanding sales tax obligations in drop shipment scenarios is one of the most common and costly errors businesses make. In this guide, we’ll break down how drop shipments work, when sales tax applies, and how to avoid double taxation or non-compliance.

A drop shipment involves three parties:

• Manufacturer or distributor: ships the product directly to the customer
• Retailer: sells the product but never handles inventory
• Customer: receives the product

There are two taxable transactions involved:

1. Distributor → Retailer
2. Retailer → Customer

Sales tax is determined based on the destination state—the "ship-to" location.

Nexus is a connection between a business and a taxing jurisdiction. Under the Wayfair ruling, economic activity alone (not just physical presence) can establish nexus.

If either the distributor or retailer has nexus in the ship-to state, they may be required to collect sales tax on that transaction.

Retailers often try to exempt the distributor’s tax by using resale certificates. However, the rules vary:

• Georgia allows out-of-state certificates.
• California and Illinois require the retailer to register in-state.

If the retailer cannot issue a valid certificate, the distributor must collect tax—even if it’s ultimately a resale.

A retailer based in South Carolina sells a baseball cap through its website to a customer located 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 located in Illinois. For purposes of this example, assume the Arkansas distributor has “nexus” and is registered for sales and use tax purposes in Illinois and the South Carolina retailer does not have nexus in Illinois and nor is it registered for Illinois sales and use tax purposes. The South Carolina retailer is only registered in the state of South Carolina for sales and use tax purposes.

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 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 resale exemption certificate. 

In our example above, the Arkansas distributor is required to charge Illinois use tax to the South Carolina retailer; the laws in Illinois require that a valid Illinois resale certificate be issued by the retailer to the distributor in order for the transaction to be exempt from the Illinois use tax. Since the South Carolina retailer is not registered in Illinois for sales and use tax purposes, it is unable to issue a valid Illinois resale certificate. The South Carolina retailer is faced with a decision – either pay the Illinois use tax to the distributor, eating into their profit margin; or, register in Illinois for sales and use tax purposes and charge tax on all its sales to Illinois customers. Even if the South Carolina retailer opts to pay the Illinois use tax to the distributor, the Illinois customer will have an additional use tax liability directly to the state of Illinois on the purchase price of the baseball cap. 

But not all states require the same level of documentation to substantiate and exempt sale for resale as Illinois. Using the example above, if we removed Illinois and inserted the state of Georgia and all other facts remained constant, the South Carolina retailer could have issued to the distributer a Georgia resale certificate with their South Carolina sales and use tax registration number listed on it to exempt this transaction from Georgia use tax. The customer would be responsible for remitting the Georgia use tax directly to the state. 

With economic nexus laws active in all states with a state-wide sales tax, drop shipments now trigger obligations for more sellers than ever. Without a strategy to manage sales tax, drop shipments, exemption certificates and registration, businesses risk overpaying, under collecting, or getting audited.

 Our experts can help you understand where you’re exposed, what actions to take, and how to stay compliant. Get in touch to learn more!