Dropshipping is an online retail model in which a retailer doesn't stock or ship products. Instead, when a customer orders an item, the retailer purchases it from a third-party supplier, who then ships it directly to the customer.
Dropshipping is becoming increasingly popular, with businesses generating more than $276 billion with this model in 2023.
For ecommerce businesses that dropship, determining where the responsibility for tax collection lies can be complicated, and it depends on multiple questions, such as:
- What is your nexus — your physical or economic connection — to the states involved in the transaction?
- How do those individual states define nexus within their jurisdiction?
- Do you have a resale certificate?
In this guide, we’ll be answering these questions, walking you through common issues and how to deal with them, sharing valuable resources and best practices, and more.
Understanding sales tax basics in dropshipping
Dropshipping gives retailers a way to sell products without the hassle of maintaining a physical inventory. A typical dropshipping transaction involves the following steps:
1. A customer orders something from a retailer or ecommerce business.
2. The retailer sends that order to the supplier, often a warehouse or manufacturer, along with the customer’s shipping information.
3. The supplier retrieves the order from their inventory, packages it, and ships it to the customer.
4. The supplier sends delivery tracking information to the retailer, who forwards it to the customer.
5. The customer receives their item, and the supplier charges the retailer the wholesale product price and any shipping fees they incurred.
Simple, right? But there’s a complex question embedded in that process. Who’s responsible for collecting and remitting state sales tax? In a typical retail setting, like a shopping mall, it’s always the retailer’s responsibility. But when a third party enters the transaction and ships customers’ orders, the question gets more complicated.
In a dropshipping sale, whether the retailer or supplier collects sales tax depends on whether they have nexus in their customer’s state. If the retailer has nexus in a particular state, they’ll usually need to collect sales tax when they sell products to customers living there. And in certain situations, the sales tax may become the supplier’s responsibility. But that’s not always the case.
The role of the retailer, supplier, and customer
Let’s look at the issue of nexus in more detail, and how the retailer, supplier, and customer each factor into the sales tax equation.
Sales tax responsibility for the retailer
For most dropshipping transactions, the retailer handles the collection and remittance of sales tax from the end customer if they have nexus in that customer’s jurisdiction.
There are two primary types of nexus to be mindful of.
- Physical nexus: If you have a physical presence (such as an office or a warehouse) or employees in a particular state, you have physical nexus there.
- Economic nexus: If you exceed a certain annual transaction volume in a given state, you’re considered to have economic nexus in that state. It’s important to remember that you can have economic nexus in a state — and be required to collect and remit sales tax on orders sent to customers there — even without physical nexus.
Economic nexus depends on how much business a company does in a particular location each year. States set their own thresholds for economic nexus. For instance, Alabama’s annual threshold is $250,000, while California’s is $500,000.
But the most common is 200 individual sales or $100,000 in annual transactions. If you have physical or economic nexus in a particular state, you’ll need to collect and remit state sales tax on transactions with customers living there.
Sales tax responsibility for the supplier
As we mentioned earlier, the retailer handles the collection and remittance of sales tax from the end customer. However, doing so becomes the supplier's obligation in the following scenario:
- They’re selling directly to the end customer, without the retailer as an intermediary.
In the event that the supplier has nexus in the same state as the retailer — the supplier’s customer — they’ll need to collect sales tax from the retailer. The supplier won’t have to collect sales tax from the retailer if the retailer has an exemption certificate, for example, a resale certificate, or another type of certificate that exempts nonprofits and some other companies from collecting sales tax.
A resale certificate typically states that the supplier doesn’t need to collect state sales tax from the retailer because the item is being resold, and the retailer will collect sales tax on the final sale.
The customer’s role in sales tax
Usually, customers are not obligated to remit sales taxes directly to tax authorities. Vendors must collect sales taxes and then remit them. But the end customer is still part of the equation.
If sales tax wasn’t collected when the customer made the purchase, they’ll need to pay what’s known as a use tax on that item when they file their state taxes.
Most consumers aren’t aware of this, and sometimes it’s not enforced very aggressively. However, this is changing, and enforcement around online purchases has been growing in recent years.
Common sales tax issues in dropshipping
These are some of the main factors that can complicate the question of when to collect sales tax on dropshipping sales:
- Challenges with resale certificates: States set different standards governing the use of resale certificates, allowing them to be used in some types of transactions but not others. Getting this right is extremely important for both retailers and suppliers because mistakes can result in significant exposure if you’re ever subjected to a sales tax audit.
- Navigating nexus complexities: As we mentioned previously, the issue of nexus — especially economic nexus — can quickly become a headache. Since each state has different rules, sellers can easily end up spending a lot of time navigating regulatory complexities.
- Sales tax exemption certificates: As with resale certificates, carelessly handled exemption certificates can spell trouble for sellers. These certificates are required to be furnished at the point of sale for each applicable transaction if sales tax is to be avoided. If that process is handled manually, errors are practically guaranteed at some point, and retailers could face fines if audited.
- Avoiding double taxation: One of the reasons it’s so important for retailers and suppliers to understand their sales tax responsibilities is to avoid double taxation. If both parties believe they need to collect tax on a given transaction, and both do, and this happens a lot, it can create a financial burden all around — not to mention the financial inconvenience to end customers.
- International rules and regulations: If products are being dropshipped internationally, completely different sales tax regulations come into play. For instance, countries in the European Union require the collection of VAT (value added tax), and New Zealand and Canada require what’s known as GST (goods and services tax). This adds an entirely separate layer of complex laws and regulations that suppliers and retailers need to follow.
Clearly, that’s a lot to manage, and businesses can be hit with substantial sales tax compliance penalties if something goes wrong, either at home or abroad. If you’re starting to feel overwhelmed, don’t worry. Ecommerce sellers and suppliers can leverage sales tax compliance tools to streamline this vital part of their business. Here are a few of the most popular sales tax tools for ecommerce sellers.
Tools and solutions for managing dropshipping sales tax
With so many moving pieces, businesses need to manage dropshipping sales tax with care and precision. Retailers can benefit from using software to automate the collection and remittance of sales tax at appropriate times, furnish resale certificates or exemption certificates as needed, and handle other essential tax-related workflows during transactions.
For retailers and suppliers using Shopify, the platform offers a useful jumping-off point for sales tax management. For instance, you can automatically calculate and collect the correct amount of sales tax you should charge based on your customer’s address. However, users are still required to manually handle resale certificates, exemption certificates, and other non-basic tax issues. Many sellers opt to use a Shopify sales tax app alongside Shopify’s tax engine.
For businesses looking to automate sales tax management entirely, a software tool like Numeral could do the trick. Numeral uses AI to simplify ecommerce sales tax for retailers and suppliers. Simply connect your Shopify, Amazon, or other stores, and Numeral can help you with:
- Registration: Numeral can get you registered for sales tax in all 47 states that currently charge it.
- Monitoring: Numeral proactively monitors for tax rate changes, both domestic and international, and automatically applies them to your sales.
- Filing: Numeral can remit taxes and submit tax returns on your behalf, saving you time and hassle.
- Forecasting: Numeral provides sales tax forecasting, which calculates how much you’ll owe at a future point based on your current sales volume. This can be super helpful when budgeting and conducting financial planning and analysis.
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The bottom line
In most dropshipping scenarios, the responsibility for sales tax lies with the retailer. However, exceptions to that rule are common, and both sellers and dropshippers can face stiff compliance penalties — and run the risk of double taxation — if they fail to understand their respective obligations.
Numeral can help you transform sales tax collection from a stressful and confusing issue into an automated process you barely need to think about.
