Most small and medium sized businesses are always on the lookout for ways to cut costs and improve efficiency through outsourcing tasks to specialized providers. You may already be outsourcing functions like payroll and IT. Another area where companies are finding ways to shift responsibility to third party providers is order fulfillment and shipping.

Commonly referred to as “drop shippers”, these businesses (often a manufacturer or wholesaler) receive an order from a retail vendor, bill the vendor, and then ship the product directly to the retail customer. The retail customer pays the vendor, and the vendor pays the drop shipper. This model seems to be a win-win. The vendor gets to expand their geographic and time boundaries, and the drop shipper can increase sales without dealing directly with customers.

Whatever your role in the equation, you need to be aware of the sales tax implications of the relationship.

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In the Dropship Model diagram, when is there a sales and use tax obligation? Here are three possible scenarios with different answers to the question of who is responsible for collecting/remitting the sales or use tax:

1.       The retailer has nexus in the state where the transaction takes place.

2.       Neither the retailer nor the shipper has nexus in the state where the transaction takes place.

3.       The retailer doesn’t have nexus, but the drop shipper does.

But it gets even more complicated. In some states, drop shipping activity can actually create nexus for an out-of-state retailer. And in these states, there can be variations on how the taxable amount is calculated. For example, in one state, the full retail price of a piece of large equipment could be taxable, while in another state, only the wholesale price is taxable.

Typically the transaction between retailer and drop shipper isn’t taxable as long as proper documentation of exemption is provided. But not all states will accept other states’ exemption certificates/resale certificates, so the retailer may need to provide proof of exemption in a format designated by the shipper’s state.

There are often risks associated with outsourcing in general, yet often businesses find that the rewards outweigh the risk. If being a part of the drop shipments model is a key component to your business, you can mitigate the sales tax risk by outsourcing something else: sales tax management.

To learn more about the complexities of the drop shipping equation, download our free whitepaper: Sales Tax Implications of Drop Shipping. Or contact your Clients First representative to learn how we can help you implement a cloud-based sales tax automation solution that integrates with your current ERP software.