Drop Shipment Challenges to Sales Tax Compliance

In sales transactions between two parties, a consumer and a seller, it is generally easy to determine whether to collect sales tax and from whom.  If the seller has nexus and is registered in the consumer’s state, then the seller must collect and remit sales tax in that state (unless the consumer provides an exemption certificate which meets the requirements for that state).
When you introduce a third party into the transaction, things can get tricky.  A drop shipment scenario is where you have two sellers and one consumer.  The first seller sells property to the second seller, who sells to the consumer, but the first seller ships the property directly to the consumer. 

Since the first seller does not have a contract with the consumer, in the event the first seller is registered in the ship to state, who gets billed sales tax or is responsible for providing a resale certificate (since this is a resale situation)?  Generally, the answer would be the second seller, but to muddy the waters further, what if the second seller is not registered in the ship to state?

Alternative Documentation
Most states acknowledge this scenario and provide that alternative documentation can be provided to allow the sale to qualify as an exempt sale for resale.  In many cases, this alternative documentation is the second seller’s home-state resale certificate.

No Alternative Documentation Accepted
Some states do not accept alternative documentation.  It is important to review the drop shipment requirements of each state to determine what the specific state will allow, if anything.  For example, in California, if the consumer cannot provide a resale or other type of exemption certificate, the first seller should calculate and bill the second seller sales tax based on the retail selling price of the drop shipment plus a ten percent markup.  This markup can be lower if documentation can be shown supporting it.  While the first seller must include this on its invoice to the second seller, the second seller cannot invoice this tax on a separate line item to its consumer.  Instead, it can be built in to the cost of goods sold in order to recover the taxes billed.  Unfortunately, this can result in the consumer double-paying the tax since they may self-accrue use tax due to lack of visibility of the tax on the invoice.

How Can We Help? 
Allyn’s tax team is staffed with seasoned tax professionals experienced in all aspects of multi-state and local tax compliance and consulting for large US and global corporations.  We use that experience to your advantage.  Contact us and we can provide a customized cost-effective solution to meet your company’s needs.  For further information on Allyn Tax services, please contact: tax@allynintl.com.