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Issues in Sales Tax Audits & Appeals for Drop Shipping Companies

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Issues in Sales Tax Audits & Appeals for Drop Shipping Companies

As e-commerce and online retail continue to thrive, so too will the drop shipping business model. Drop shipping is an effective solution for retailers to minimize their burdens of cost and administration by relying on another business to store inventory and ship products directly to customers. However, the relationships and transactions at play in drop shipping create new challenges in sales tax compliance because of confusion over who is responsible for collecting and reporting.

You or your client’s business may be the target of a sales tax audit and notice of liability because of varying state rules and uncertainty over the proper reporting practices. Consider those challenges in the following discussion on sales tax for drop shipping businesses. We explain the different possibilities of taxation for drop shippers depending on the jurisdiction, including key information when navigating a sales tax audit or when looking to appeal a determination of liability.

How Drop Shipping Works and Why It Creates Sales Tax Problems

As you likely know, drop shipping is when a retailer or online business receives a purchase order from a customer and contracts with another business to help complete the order. The drop shipper will generally do one of the following as a part of the overall transaction:

  • Directly fulfill the order by taking a product from its inventory and delivering it to the customer.
  • Send the product to the retailer’s fulfillment service, which then delivers it to the customer.
  • Contract with another drop shipper to complete the order.

Retail sales that rely on drop shipping will have a minimum of two transactions to deliver a single consumer product. You could even have more transactions depending on the involvement of other third parties (e.g., a fulfillment service company or an additional drop shipper). This differs from the traditional business model, where a retailer first purchases from a wholesaler using a resale certificate and later makes a final sale to a customer, which is where the sales tax applies.

Drop shipping reverses and fragments that order of operations, which makes it difficult to track sales tax obligations. The location of the parties in a drop shipping arrangement increases the complexity because of the potential differences in the applicable state’s sales tax rules.

Are Drop Shippers Responsible for Paying Sales Tax?

Your responsibilities as a drop shipper when it comes to collecting and remitting sales tax to the state of delivery will depend on the applicable law of that state, in addition to other factors. Sometimes, you will have the burden to collect and pay sales tax, and other times you could have the luxury of accepting a resale certificate from the retailer. Knowing your compliance needs can be difficult without guidance from a sales tax professional. As you review some general information, consider a consultation with our team for state-specific information.

What Factors Contribute to a Drop Shipper’s Responsibility for Collecting Sales Tax?

The following circumstances and issues surrounding sales involving drop shipments could play a role in determining your sales tax obligations:

  • The delivery location.
  • The retailer’s location.
  • The retailer’s sales tax registration status in the state of delivery.
  • The drop shipper’s location.
  • The drop shipper’s registration status in the state of delivery.
  • Whether the state accepts resale certificates from the retailer’s home state.

Two common situations arise where drop shippers must be especially careful of sales tax compliance. The first is when the retailer’s location is outside of the taxing state, but the drop shipper’s location is in the taxing state. For example, an Arizona retailer sells to a customer in California through a drop shipper also located in California.

The second is when both the retailer’s and drop shipper’s locations are outside the taxing state. For example, an Arizona retailer sells to a California customer through a drop shipping company located in Texas. Both scenarios create a potential increase in the likelihood that the drop shipper will need to collect sales tax depending, of course, on other relevant information.

An Example of How Sales Tax on Drop Shipments Can Vary State-to-State

Let’s compare the sales tax rules and application of states that could create different outcomes for drop shippers. States like Maryland and California, for example, generally require the drop shipper to collect and remit sales tax when handling a transaction involving an unregistered vendor. This forces the drop shipper to either require the vendor to register for tax and submit a resale certificate or collect tax like any other transaction. Other states, like Minnesota, offer a more streamlined application for the drop shipper by allowing them to accept a resale certificate no matter the Minnesota sales tax registration status of the retailer.

In cases where the drop shipper collects the tax, another wrinkle can exist over the appropriate amount of tax to collect (i.e., the wholesale rate or the retail rate). California requires drop shippers to collect based on the retail sale amount or the wholesale amount plus a 10% markup.

Why Do Tax Departments Perform Sales Tax Audits on Drop Shipping Companies?

In a post-Wayfair sales tax environment, state audits from revenue departments can come for drop shippers located all over the United States. Some of the issues that can initiate an audit or expose tax liability for drop shippers after an audit include:

  • Incomplete or fraudulently used resale certificates.
  • Accepting resale certificates from other vendors in states that a Department of Revenue will not accept or recognize (e.g., a New York resale certificate related to a sale delivered in Maryland or California.
  • Applying the tax rate to the wrong sale amount (e.g., the retail vs. wholesale price).
  • Not adjusting the tax rate to account for local county or municipal surtaxes.
  • Not having documentation to show tax does not apply to your sales (e.g., customer information like delivery or billing address). [GS1]

When Should Drop Shipping Businesses Appeal a Sales Tax Liability?

The feasibility and overall benefit of protesting or appealing a sales tax assessment as a drop shipper is a business decision that depends on the preference of the taxpayer. Consider the following in consultation with one of our sales tax professionals:

  • The amount of overall liability compared to the costs of appeal.
  • Your ability to support your sales tax position. States have a low burden of proof, and the pressure is often on the taxpayer to produce sufficient evidence of a wrongful assessment.
  • Weaknesses in the audit report (e.g., incorrect assumptions or use of bad data).
  • Legal challenges that could limit your exposure (e.g., states that primarily obligate the primary retailer to collect tax and not the drop shipper).

Drop Shippers Facing an Audit or Appeal Can Get a Free Consultation

Drop shippers who recently received notice of audit or assessment or have concerns about liability should schedule a review with our sales tax professionals. We help online retailers, manufacturers, delivery companies, and others in the supply chain that face sales tax issues across multiple jurisdictions. Involving a professional early can minimize some of the administrative burdens of a sales tax audit in an unfamiliar jurisdiction and could help to prevent or challenge an unfair assessment of tax.

Schedule your free consultation today.