By: Ned A. Lenhart, MBA CPA

Third-party drop shipments are a common way for remote sellers to fulfill their customer’s orders. As a refresher, a “drop-shipment” occurs when your vendor ships your customer’s order directly to the customer and bills your company for the purchase. In a traditional drop-shipment transaction, two separate sales occur simultaneously at the point the goods are delivered to your customer.

The first sale is between your vendor and your company. This first sale is, most likely, a “sale for resale” from your vendor’s perspective. Your vendor is billing you for the wholesale price of the property your company purchased and had delivered directly to your customer. In this first sale, there is a transfer of title from your vendor and your company at the point the property is delivered to your customer. At the point of product delivery, the second sale occurs. That sale is between your company and your customer. This sale is documented by the sales proceeds you receive from your customer for the goods they purchase. Assuming that your customer is the end-user of the products sold, this second sale is a retail sale and is taxable as dictated by the laws of the state where your customer is located.

This all sounds very convenient and as an easy way to manage inventory and meet your customer needs in a timely fashion. It also presents a myriad of sales tax challenges that the states are willing to capitalize on whenever possible to make sure that taxes are paid by someone on these transactions. With two separate sales occurring in a drop shipment transaction, there are two separate sales tax decisions that need to be made. Each sale requires that three questions be answered to properly determine the sales tax rules:

(1) Does your vendor (shipper) have nexus in the destination state?,

(2) Does your company have nexus in the destination state?,

(3) Is the sale to end customer a taxable sale?

Why Nexus Matters

Determining the answer to questions 1 and 2 above is vital to determining the responsibility each party has for collecting sales tax in the destination state on the drop-shipment transaction. As noted above, the shipment of property from the vendor to your customer is actually a sale of property from your vendor to your company. If your vendor has nexus in the destination state, then your vendor is required to charge your company sales tax on the wholesale price unless your company provides them with a resale certificates that is valid in the destination state.

If your company has nexus in the destination state, then your company will need to obtain an exemption certificate from your customer or your company will need to charge your customer sales tax on the retail cost of the property and any delivery charges that may be taxable.

There are several scenarios to evaluate. For simplicity, these scenarios assume that each party to the drop shipment is located in a different state and that the goods are shipped from outside of the destination state.

Scenario 1: Neither your vendor nor your company has nexus in the destination state. In this case, your vendor does not have a legal obligation to obtain an exemption certificate from your company and your company does not have the legal obligation to charge sales tax to your customer (assuming they are the end user). In this situation, the customer will be obligated to pay use tax to the destination state.

Scenario 2: Your vendor has nexus in the destination state but your company does not. In this scenario your vendor should be asking your company for a resale certificate that is valid in the destination state. What is valid in the destination state will vary. Many states will accept your company’s “home” state certificate or will accept your “home state” registration number on the certificate issued by the destination state. As long as your business is registered in one state, the registration number issued by that state (‘home state’) can be used on the Multijurisdictional Exemption Certificate, the Streamlined Sales Tax Exemption certificates, or the exemption certificates issued by the destination state.

Some states, however, are very rigid and will only accept a resale certificate from the destination state with a registration number issued by the registration state. These states include California, Washington, Illinois, Maryland, and Massachusetts. That is, if your vendor has nexus in California and California is the destination state, your vendor will be required to charge your company California sale tax on their sale unless your company can provide them with a California resale certificate with a California registration number. California will not accept your ‘home state’ registration number. Once your company obtains a California registration number, it will be required to collect California sales tax on the sales made to California customers.

Scenario 3: Your vendor does not have nexus in the destination state but your company does have nexus in the destination state. In this scenario, your obligation is to collect the appropriate sales tax from your customer based on the tax rate at the destination location.

Scenario 4: Both your company and your vendor have nexus in the destination state. In this case your vendor will be expecting to receive a resale certificate from your company that is valid in the destination state and your company will be obligated to collect tax from your customer if the sale is taxable. If the sale is not taxable, your obligation is to obtain a valid resale certificate from your customer.

 

 

What Are Your Options?

Your company’s failure to provide your vendor with a valid resale certificate will cause your vendor to charge your company sales tax on their sales to your company. This will turn this “resale” transaction into a taxable “retail” transaction. This can pose a real dilemma for companies that don’t have nexus in the ship to state (such as California) but have drop-shipments made to these customers. If your customer is a wholesaler and your company does not have nexus in California, then your customer can provide your vendor with a resale certificate directly.

To avoid being charged tax in situations like this, your company has limited choices. First, your company can register with the destination state so that it can provide the requisite resale certificate. By virtue of registering for tax, your company is now accepting responsibility for collecting tax on these ‘drop shipments’ even though it may not have nexus in the state. Another option is to break the drop-shipment structure. In some situations, the tax charged by your vendor is substantially greater than the additional shipping costs that would be incurred if the property were shipped to your company in the “home state” and then your company re-shipped the product to the customer in the destination state. The final option is to pay the tax charged by the vendor and just consider it an additional 8.5 percent to your cost-of-sales.

Conclusion

As a retailer using drop-shipments to fulfill orders your company may face some additional and unexpected sales tax obligations based on the nexus footprint of your vendors. Thankfully, most states will accept the “home state” certificate or the “home state” registration number on destination state’s exemption certificate. In those few state which don’t accept ‘home state’ certificates, your company may be confronted with some unexpected tax costs or some unexpected administrative costs related to registering and collecting tax from customers in state where your company does not have nexus.

As states become more aggressive on audits, your vendors will likely be the first ones to feel the sting when they determine under audit that they don’t have a valid resale certificate from your company in a state where they have nexus and have ‘drop shipped’ products to your company’s customers. Sophisticated multistate sellers and shippers are keenly aware of the documentation they must obtain from their customers to avoid charging these customers sales tax on these drop-shipments. These sellers will not hesitate to add sales tax to drop-shipments if their customers do not provide resale certificates that are valid in the destination state.