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The 5 W’s of Drop Shipping Tax Rules: Why?


Most retailers have a handle on tax rules where they maintain stores, offices, or distribution operations. They register with state tax authorities, receive a resale certificate, and charge sales tax according to state and local rules. If the retailer sells into a state where it does not have nexus, the retailer doesn’t have to charge sales tax — instead, the customer is expected to pay a use tax.

But it gets more complicated when a drop shipper gets involved. In drop shipping, there are really two transactions:

  • Retailer to customer
  • Retailer and the drop shipper (usually a manufacturer or distributor)

Case in point: A customer places an order in a state where the retailer has nexus but the drop shipper does not. The order is for a drop ship item, so it’s really going right from the drop shipper to the end customer. Usually the retailer can share its resale certificate with the drop shipper, then charge the correct sales tax to the customer.

“But if the drop shipper has nexus or is registered in the state where the retailer does not have nexus, it gets complicated,” said Pete Bunio, Tax Research and Support Lead at Vertex. Many states will accept the retailer’s resale certificate from another state — those that are members of the Streamlined Sales and Use Tax Agreement, for example, use an SST-certified exemption certificate for that purpose. However, “there are handful of states that don’t accept an out-of-state certificate,” Bunio said. “They’re very rigid and will only accept their own.” That forces the drop shipper to charge sales tax to the end customer.

Calculating that tax is tricky. Sales tax is a percentage of the sale, but which sale — the sale between the retailer and end customer, or the retailer and the drop shipper (the wholesale price)? Drop shippers usually don’t know the retail price. States deal with that situation differently. In California, if the retail price is unknown, the drop shipper is expected to base the tax on the wholesale price plus 10%.

In addition, many drop shippers aren’t equipped to bill the customer separately for tax, and retailers find going back to the customer to recoup a tax balance unwieldy or unwise. “It’s a rabbit hole that you don’t want to go down,” Bunio said.

Jurisdictions might even disagree with how the basis — wholesale or retail price — is determined.

Calculating the correct sales tax also means the retailer must know which drop ship facility the inventory will ship from, instantly. Ideally, “you calculate tax immediately in the cart and you charge the appropriate tax immediately,” said Michael Sonier, Senior Director, Product Management, Magento Commerce. “That requires a pretty complex orchestration of your order management system, one that knows where you’re going to source that order from immediately at the time you take that order, and a tax solution that knows exactly where that’s going to come from and tells you the right tax. That’s the best-case scenario.” Without that, retailers are forced to guess, and make up any difference from margin to avoid compliance penalties. “You want to have the most accurate information up front so you limit your liability and deliver the best consumer experience,” Sonier said.  Customers are unaware of all this, of course. They simply want the retailer to calculate and display the correct sales tax so they can hit the “submit order” button.

To learn more how Vertex Cloud can help navigate your company through the complexities of taxes through drop shipping process, schedule a demo now.

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