Generally, sales for resale are not subject to state and local sales taxes - provided that a purchaser supplies proper exemption documentation.
As a result, wholesalers who deliver taxable products directly to their customer’s customer do not typically worry about collecting sales or use taxes. This is because they assume their customer can give a valid resale certificate. But, as explained below, that is not always the case.
Figuring out when a purchaser can give a resale certificate can be challenging. No more so than in the case of a drop shipment. States’ sales tax rules on drop shipments can be complex, depending on the locations and circumstances of the parties involved. Failure to comply with these rules can lead to an expensive surprise on audit.
A typical drop shipment transaction involves at least two sales. First, a consumer purchases a product from a retailer who does not have the product on hand. In order to fulfil the sale to the consumer, the retailer places an order for the product with a supplier, along with instructions to ship the product directly to the consumer.
Drop shipment transactions may involve multiple intermediate sales, where someone in the supply chain ships the product directly to someone other than their customer.
If the supplier has a taxable presence, or “nexus,” in the destination state and the product is taxable there, the supplier will want to collect a resale certificate (or similar exemption documentation) from its customer.
The question then arises as to whether the customer can give a valid resale certificate to the supplier. If the supplier’s customer is registered in the destination state, the supplier should have no difficulty obtaining a valid certificate.
However, what happens if the customer is not registered in the destination state? Can the customer give valid resale documentation? This is where the rules can get tricky.
States have lost significant revenue from being unable to require that out-of-state retailers collect and remit sales tax. Consequently, some states have reacted by shifting collection obligations to suppliers that make drop shipments when they are registered, or do business, in those states.
The complexities involved in determining the taxability of drop shipments are due to state nexus considerations. Generally, nexus with a state exists when a business has a physical presence in the state. The state may then legally impose sales tax reporting and/or collection obligations on the business.
Typically, an out-of-state supplier will have sales tax nexus in a state if they have a business location or an employee in the state. However, merely sending independent salespersons into the state, or engaging in other types of promotional activities, is enough.
The following is a common example of how the rules apply to multi-state suppliers. Suppose a consumer in Connecticut purchases a product from a retailer located in Georgia.
Suppose that retailer purchases the product at wholesale from a supplier located in Washington, who drop ships the product directly to Connecticut. The Washington supplier is registered for sales tax purposes in both Connecticut and Georgia.
Under all states’ sales tax laws, an interstate sale of goods is deemed to occur at the shipment destination. Therefore, both the retail and wholesale sales in our example are considered Connecticut sales.
Here are the questions to consider:
- Since the product never ships to the Georgia retailer, should the supplier obtain resale documentation from the retailer pursuant to Connecticut’s rules, or Georgia’s rules?
Resale documentation usually includes a resale certificate, or permit number, issued by a state. During an audit, the supplier takes on the burden of showing that they collected “proper” resale documentation. What is considered “proper” varies by state.
Often, a retailer will do business in a number of states. This mean that the supplier should obtain the appropriate documentation for the state in which the sale occurs. In our example, that state would be Connecticut. While some states allow suppliers to accept retailers’ home-state resale certificates (Georgia in our example), some do not.
Further, more than twenty states that are members of the Streamlined Sales and Use Tax Agreement accept a “SST Exemption Certificate” to document resales. Washington allows suppliers to accept a valid reseller permit issued by the state, an SST Exemption Certificate, and certain other documents under appropriate circumstances.
- Suppose the retailer does not have nexus in Connecticut and does not collect sales tax from the consumer. Since the supplier is registered in Connecticut, do they have an obligation to collect sales tax and remit it to Connecticut?
The answer is yes; the supplier must collect sales tax from the retailer. This is because, under Connecticut law, the supplier may only take a valid resale certificate from a retailer registered in Connecticut. In this way, Connecticut insures the sales tax will be collected and remitted to the state. This is the case in a number of other states as well.
- If the supplier has an obligation to collect sales tax, is it collected from the retailer or the purchaser? Further, should sales tax be calculated based on the price of the wholesale sale, or the retail sale?
The majority of states, including Connecticut, require suppliers to collect sales tax from retailers based on retail prices, if known, or based on wholesale prices if retail prices are unavailable.
In the case of California drop shipments, the drop shipper is liable for sales tax based on the retail selling price. If the drop shipper does not know the retail price, California tax regulations provide a safe harbor that allows suppliers to calculate the amount of the tax due, based on a 10% markup of the wholesale price.
In summary, while the structure of a multi-state drop shipment may be simple, the sales tax consequences are complex.
In addition to dealing with resale documentation issues, suppliers making drop shipments must also be aware of, and comply with, the various tax collection requirements in each state.
Given the complexities involved, we encourage suppliers to contact their tax advisor or Clark Nuber for assistance in complying with each state’s drop shipment rules.
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