Drop Shipping and Sales Tax Risks

Drop shipping is a great way for remote businesses with limited inventory to expand their product lines. By selling products that are stored by a third party distributor, such as a manufacturer, wholesaler, or fulfillment house, retailers are able to reach a larger audience. However, this practice complicates how a business must handle their sales tax obligations. If handled incorrectly drop shipping can have a negative effect on investment returns and overall profits. Are the sales tax risks of drop shipping worth it?

How Drop Shipping Complicates Sales Tax

Drop shipping is an order fulfillment strategy where products ship directly from a wholesaler or manufacturer to the customer without going through the usual distribution channels. Due to a third party now being involved in the transaction, sales tax naturally becomes more complicated. Even products that are normally tax-exempt can now be liable for sales tax. While drop shipping purchases are meant to be tax exempt in any other circumstance, nexus comes into play with out-of-state consumers, suppliers, or retailers. Nexus will often impact how sales tax rules apply to a sale and can create sales tax liabilities for drop shipping.

Sales tax relies heavily on nexus. Without nexus, there isn’t an obligation to collect sales tax. However when drop shipping, is the sales tax the responsibility of the retailer, the distributor, both, or neither? The answer may surprise you. These sales tax scenarios are helpful to understanding sales tax and drop shipping but always check with jurisdictions for sales tax laws.

  • Scenario 1: If the retailer and the shipping destination are in the same state, sales and use tax must be collected by the retailer, regardless of where the distributor is located.
  • Scenario 2: If neither the retailer nor the distributor are in the destination state, then the customer is generally responsible for any tax or exemption.
  • Scenario 3: If the distributor and shipping destination are in the same state, but the retailer is elsewhere, the distributor would be responsible for sales and use tax, but because this is technically an item for resale, the distributor must provide acceptable proof of exemption in order to avoid the tax. However, there are some conditions and exceptions to this rule because each state handles exemptions differently.

Where complications normally arise is in Scenario 3. Proof of exemption is handled in most states with a formal out-of-state exemption certificate from the distributor that is kept on file with the retailer. In many cases, states will even accept forms of alternative documentation proving that the distributor qualifies for a sales tax exemption. While other states will only accept an in-state exemption that an out of state retailer is incapable of obtaining making them liable for sales tax they otherwise would not be collecting. Every state has a different policy and it is the responsibility of the retailer to understand what they and their distributors should be doing in regard to sales tax compliance.

Benefits of Drop Shipping

Drop shipping can be a huge source of revenue for your company. When weighing out the risks to benefits of sales tax liabilities with drop shipping, it’s important to take stock of all the benefits your company receives by using drop shipping.

  • Offering More Products: Depending on the type of business, drop shipping can allow retailers to offer more products to their consumers such as products that they might otherwise be unable to provide because of inventory limitations.
  • Quicker Sales: Drop shipping eliminates wait times when products are shipped from the distributor or manufacturer to the merchant. With drop shipping, a seller can start selling the moment the product is available on their online site or catalog.
  • New Product Testing: Drop shipping gives merchants a way to test new products without having to buy and store inventory.
  • Reduced Investment: Drop shipping agreements generally do not require any upfront investment so a retailer can reduce its initial investment.
  • More Time: The retailer does not receive, stack, store, pull, pack, or ship products. All of these tasks are time-consuming, which means drop shipping saves time.

Drawbacks Of Drop Shipping

Six reasons you might not want to use drop shipping.

  • Thinner Profit Margins: If you are buying at wholesale prices, you are not receiving additional savings from buying in bulk.
  • Quality Issues: You have less control over your shipping details. This means that if your drop shipper has a delay or inadequate
    packaging, it reflects poorly on you.
  • Increase of Goods Sold Costs: Stocking retailers typically get better pricing, additional bonuses, marketing incentives, insider knowledge about the product line, and access to deals than drop shipping retailers.
  • Limited Product Selection: Depending on what type of products you are selling, distributors may not be willing or able to drop ship.
  • Higher Fulfillment Costs: In addition to the cost of stocking, picking, packing, and shipping, some distributors charge a hefty markup can make the cost of drop shipping increase as your business grows.
  • Increased Customer Service Problems: On average, drop shipping entails at least twice as much customer service work on every order and because of a third-party, fixing errors can be difficult and time consuming.

Is drop shipping worth the added sales tax complications? That question can only be answered by you and your business. We can help you look into sales tax liabilities for your company to help you weigh the risks and benefits but also help you reduce your risk with our sales tax products that reduce errors and time spent doing sales tax accounting. Sales Tax DataLink offers a wide variety of sales tax software to help your business’s compliance even allowing you to test drive our products with your own data.

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