A Quick Guide to Complex Dropshipping Taxes for Distributors

As distributors increasingly adopt online marketplace and dropshipping business models, tax implications change and, often, get more complex. When it comes to sales orders and dropshipping, in particular, there’s a lot to consider.

A solid understanding of these regulations and a tax compliance strategy can save you time and headaches in the long run. This article aims to provide key insights into ensuring tax compliance for dropshipping, and will cover:

• Why dropshipping differs from standard ecommerce
• How to determine nexus in a dropshipping model
• How to manage exemption certificates

Before we dive into the details of sales tax compliance, let’s first take a look at the dropshipping fulfillment model at the point of transaction.  

Dr‎opshipping: The Three-way Exchange

Dropshipping differs from standard shipping because there are two sales in one, making it an ecommerce party of three: the customer (who can be a retailer), the distributor, and the manufacturer. 

A B2B dropshipping scenario typically works like this: 

1. The customer places an order with the distributor
2. The distributor then places an order with a third-party manufacturer and has them dropship the products directly to the customer  
3. The manufacturer bills the distributor 
4. The distributor bills the customer

In many ways, dropshipping is a win-win for everyone involved. For the distributor, it allows the ability to sell products without having to keep inventory in stock, which improves overall scalability. It also offers low startup costs, reduced inventory risk, fewer supply chain issues, and the ability to provide a range of products to customers. These benefits often make dropshipping worth it.

Because dropshipping entails this three-way exchange with two sales transactions embedded within it, there can also be the added complexity of involving two or more states. Adding states can create specific sales tax obligations for both B2B businesses, ultimately raising an important question: Who has to collect and remit sales tax in dropshipping transactions? 

It’s important to point out that in most dropshipping sales tax scenarios, the distributor is commonly referred to as the supplier. And while there is no easy answer, it is the end customer who should always pay the sales tax. But since both the supplier and wholesaler have the ability to dropship, the answer ultimately boils down to if and where you have nexus (i.e.: a sales tax obligation with a state).

De‎termining Nexus in a Dropshipping Model

As you expand sales into new states and territories, it’s crucial to determine where your business may have nexus. Two common ways a business creates nexus are through physical presence in a state and economic activity in a state.

Physical nexus is established when you have real property in a state, such as having an office or brick-and-mortar store. Even having temporary or remote employees in the state can establish physical nexus. Housing inventory in the state, whether in your own warehouse or controlled by a marketplace facilitator like Amazon, eBay, Etsy, or Walmart, can also trigger physical nexus. Another trigger that distributors may not be aware of is trade show attendance.

Economic nexus is established when a business with no physical presence in a state meets or surpasses the state’s economic nexus threshold, typically set at a specific dollar amount (e.g., $100,000) or a number of sales transactions (e.g., 200 transactions). It’s worth noting that these economic nexus thresholds vary across states, and in many states, they include exempt transactions. 

Physical and economic nexus can impact a distributor's sales tax compliance obligations. If you (the distributor) have nexus with the state where your customer is located (the ship-to state), you’ll need to do one of two things: collect a valid resale or exemption certificate from the dropshipper, or charge your customer sales tax.

Why?

Because in every state, every sale is taxable unless the seller can prove otherwise. And every sale is a sale at retail unless the distributor collects an exemption certificate. 

Economic nexus has given states greater authority to tax remote businesses. Due to high sales volumes, a distributor often reaches economic nexus thresholds and should assume they must have a sales tax license in every state — along with collecting and remitting sales tax. 

Dr‎opshipping’s Silent Hero: Exemption Certificates

Managing exemption certificates is a key factor in ensuring sales tax compliance with dropshipping. Since multiple parties are involved in a dropshipping transaction, at least one party is likely reselling. If you’re a distributor with nexus, you must collect sales tax, a valid resale exemption, or a resale certificate from your customers to comply with tax regulations. You'll need to keep track of your exemption certificates for each exempt sale to present regulators in the event of an audit.

Managing Exemption Certificates

In a B2B transaction, the distributor’s sale is usually an exempt wholesale transaction because the buyer purchases the goods to resell them.

Nevertheless, suppose the goods sold are normally subject to sales tax in the state. In that case, the distributor must validate the exempt transaction by collecting a resale or exemption certificate from the licensed dropshipper. Without a valid resale exemption certificate on file, the transaction can be considered a retail sale rather than a wholesale sale, and the state could legally obligate the distributor to collect sales tax from its customer.

Dropshipping Tax Relief with Automation

Tax compliance can be tedious for distributors with multiple resale customers because they must maintain and properly update exemption certificate documentation for every reseller and their associated ship-to locations. 

An automated solution that integrates with your existing systems can help reduce costs and improve efficiency when managing exemption certificates. In addition to providing instantaneous and accurate sales tax calculations, an automated sales tax solution can help distributors track nexus obligations and stay up to date with the latest changes in sales and use tax information. 

When selecting an automated sales tax solution, distributors should prioritize consistency, repeatability, and accuracy. By choosing the right tax solution and dropshipping platform, you can reduce the burden of tax compliance and focus on what matters most — satisfying your customers.

Sales tax rates, rules, and regulations change frequently. Although we hope you'll find this information helpful, this article is for informational purposes only and does not provide legal or tax advice.

Author Bio: Nikki Gerren is the Web Content Writer at Avalara, the cloud-based compliance solution for transactional taxes, globally and locally.

🔵 Subscribe to Nautical emails for marketplace insights directly to your inbox🔵