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Tax Issues in Drop Shipment

Working in drop shipment in the US can be very lucrative. Even more so if you learn how to maximize the e-commerce side of your entrepreneurial ventures. Part of the appeal is the fact that you have a very large market to cater to.

But there is a downside that's common to all businesses in the US: taxes. After all, Benjamin Franklin once said, "in this world nothing can be said to be certain, except death and taxes." Anyone who lives in the US is aware (and if they're not, they'll surely wish they were) that tax compliance is strictly enforced, and an audit is something to be feared.

Audits can break an otherwise successful business and reduce individuals to tears. Sounds melodramatic, but underestimating the impact of tax violations is a sure way to end your entrepreneurial dreams indefinitely.

E-commerce, due to its novelty, has largely escaped a ton of taxation, which has enabled this blossoming section of the economy to become a significant player in the retail revenue stream. In fact, it's projected to reach $370 billion by 2017.

Of course Uncle Sam wants his fair share of this large chunk of change. Typically, he gets his cut by way of sales tax. However, since online stores and their buyers can be located in different parts of the country, and never the twain shall meet (physically, at least), states have to be vigorous in collecting taxes from online merchants (or suppliers/consumers, whichever applies). And woe unto anyone who neglects their tax liabilities!

It's so easy to make a mistake in filing the correct tax, even in the most straightforward business, because there are about 11,000 tax jurisdictions in the US, and a multitude of laws in each jurisdiction. This is the reason why most businesses engage the services of an accounting professional (and you should consider it too!).

In most cases, the tax requirements are pretty clear for a given industry. However, dropshipping can be a lot more complicated because of the number of parties involved. The biggest tax issue in drop shipping is this question: “who pays?” Today we're giving you an overview of what to expect and and how to prepare to handle taxes if you're dropshipping in the U.S.

Definition of Dropshipping Terms

But before we go into that, we should clarify what we mean by the terms we will be using in this article:

  • Dropshipper: The retailer who sells directly to the consumer or end user (you).
  • Supplier: The entity that actually has the product (usually the manufacturer, but it can also mean a distributor or even another retailer). At any rate, the supplier provides the goods and executes fulfillment.
  • Fulfillment: The delivery of goods to the end user or consumer.
  • Buyer: The end user or consumer.

The reason we are OCD-ing on these terms is because some of the common resources available to learn about drop shipment and taxation will refer to either dropshippers or dropshipping companies, but they actually mean suppliers in our parlance. That can be a bit confusing, if you're the type to check out the sources we cite. Now that we're all on the same page on the terms, let's move on to the meat of the matter.

Nexus

As we pointed out earlier, the drop shipment process involves several parties, typically three in all: buyer, dropshipper, and supplier. A supplier will often involve a third-party delivery service as well, so that's another consideration to take into account.

To keep things simple we'll confine our discussion to the three major players. The dropshipper sells the items but does not hold inventory or fulfill a buyer's order; that's what the supplier does. The buyer receives an item from the supplier sent on behalf of the dropshipper.

All right. So far, so good. Now comes the complicated part.

All parties involved in a transaction have a physical location. For example, a buyer may be located in Florida, the dropshipper in Kansas, and the supplier in Pennsylvania. These parties are subject to the laws of their respective states, and that includes tax laws. As we mentioned earlier, there are a lot of laws that can affect your business, especially if several states are involved in the mix because of something called a nexus.

A nexus basically means having a presence in a state which makes an individual or business subject to that state's tax laws. In our case, this pertains to the collection of sales taxes. Depending on the state, a mere physical presence does not necessarily constitute a nexus, unless that individual or business has registered to collect sales tax. Some states confer nexus status to a seller that makes a single sale, regardless of amount; while others provide a threshold in total sales before a nexus is established.

Below is a sample of sales taxes per state. For the complete list and more details, go here.

sample_sales_tax_rates.png

According to Shopify, tax collection for small business is stated quite simply: if the dropshipper and the buyer are physically located in one state that imposes a sales tax, then the dropshipper collects it from the buyer. If the buyer is from another state, the dropshipper does not collect a sales tax. However, that isn't always true.

Dropshippers may be required by some “ship-to” states to pay a sales tax to the supplier, if that supplier has a nexus in that state. If neither the dropshipper nor the supplier has a nexus in the ship-to state, then the tax obligation is imposed on the buyer. Of course, it's not always that simple.

Dropshipping and Tax Exemptions

Items for resale generally qualify for an exemption to the sales tax. That's good news for dropshippers as they are essentially resellers. In cases where the item sold is certified to be exempt, no sales tax will be collected from either the dropshipper or the supplier.

However, that opens up another can of worms. To qualify for a certificate of exemption, a dropshipper must apply and provide documentation acceptable to the state where the certificate will be applied. The Multistate Tax Commission has attempted to streamline this process.

A registered applicant may apply for a resale certificate that is accepted in more than one state. But some states still require a reseller (dropshipper) to have a nexus in that state and obtain a state registration number to be eligible for an exemption. In such cases, the dropshipper must collect sales taxes from buyers in that state.

The drop shipment certificate (if valid) has to be sent to the supplier to demonstrate that no sales tax needs to be collected from the dropshipper. Even so, the supplier may choose to reject it based on the applicable tax laws of the state where the supplier has a nexus. In such cases, the supplier may still impose a sales tax on the dropshipper.

You also need to be careful when registering for a resale certificate because it may trigger tax liabilities in some states. In some instances, it's better to cover your bases by imposing a sales tax on your buyers in every instance, and file those sales in your tax returns. Unfortunately, this may result in lost sales, double paying taxes, and/or paying the wrong state. It's advisable to carefully consider the applicable tax laws in all the states you ship to. It's also a good idea to have a well-documented arrangement with your supplier on tax issues, to make sure that you are on the same page on all transactions.

Takeaway

If all this has given you a headache, don't worry; you're not alone. Considering how complicated tax issues can become for you as a dropshipper, the best advice we can give you is to consult a tax professional about initially establishing a workable system, one that applies to most of your possible transactions. There are also quite a few accounting software solutions available that will help you do this.

You should engage the services of a tax accountant whenever filing your tax returns. If you have just a few transactions, you may be able to muddle through in DIY fashion, but this should not be your endgame. You should want to grow your business as far as it will go. We just want you to be prepared for the tax consequences well ahead of the eventuality.

Have you had any run-ins with the IRS? How did your tax troubles get resolved? Share your experiences in the comments.

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