Drop shipments are increasingly common in ecommerce and modern supply chains. In a typical drop shipment transaction, a wholesaler sells a product to a retailer but instructs the supplier/distributor to ship the product directly to the end customer of the retailer.
Although the customer receives the product from the distributor, two separate transactions occur for sales tax purposes:
- A wholesale sale between the distributor and the retailer
- A retail sale between the retailer and the end customer.
Because multiple parties and locations are involved, drop shipments can create complex sales tax compliance obligations for both retailers and distributors.
Why Drop Shipments Can Complicate Sales Tax Compliance
Unlike a traditional retail sale that involves only a seller and a buyer, drop shipments often involve three parties and potentially three different states:
- The retailer selling the product to the end customer
- The distributor or supplier fulfilling the order
- The customer receiving the product
Each party’s sales tax obligations depend on whether they have nexus in the ship-to-state.
How Drop Shipment Sales Tax Works
Example:
A retailer based in South Carolina sells a baseball cap through its website to a customer in Illinois. The retailer does not carry inventory and instead purchases the cap from a distributor located in Arkansas, instructing the distributor to ship the product directly to the customer in Illinois.
If the South Carolina retailer is registered and has nexus in Illinois, the retailer should provide a resale exemption certificate to the distributor, and charge tax to the end customer, remitting it to Illinois.
Without proper exemption documentation, the distributor may be required to charge Illinois sales tax on the transaction, even though the retailer, not the distributor, made the sale to the customer.
Exemptions, Certificates, and Common Drop Shipment Challenges
Documentation is the most common failure point in drop shipment audits. Sellers and drop shippers generally need to retain a properly completed resale/exemption certificate to support a non-taxable sale for resale.
Common failure points:
- Whether the ship-to state will accept an out-of-state resale number when the retailer is not registered locally
- Whether state-level certificates work for local taxes
State-Specific Drop Shipment Rules
Some states have adopted special rules that allow out-of-state retailers to provide alternative documentation when they are not registered in the ship-to state.
For example:
- Georgia allows a retailer to provide a resale certificate that includes a valid sales tax registration number from another state.
- Utah allows an out-of-state retailer to provide a home-state resale certificate or other documentation confirming the purchase is for resale.
States That Reject Out-of-State Resale Certificates
While some states allow retailers to use resale certificates issued by another state, others require the retailer to be registered in the ship-to state before providing a valid resale certificate.
What This Means for Your Business
Companies that rely on drop shipment models should carefully review their sales tax procedures. Key considerations include:
- Confirming whether distributors require resale certificates from the ship-to state
- Determining where the retailer or supplier has nexus
- Ensuring proper exemption documentation is provided to suppliers
- Monitoring economic thresholds that may require sales tax registration
Leyton’s Perspective
As ecommerce continues to grow, drop shipment transactions are becoming more common.
Curious whether your company’s drop shipment transactions are creating unnecessary sales tax costs? Leyton’s SALT specialists can help review your processes and identify opportunities to improve compliance and recover tax paid in error.
