Drop shipment transactions involve a retailer facilitating the sale of goods to a customer without physically handling the merchandise.
In the first scenario, the customer places an order with the retailer, who then orders the product from a supplier and instructs the supplier to ship directly to the customer. The supplier invoices the retailer, and the retailer invoices the customer. In an alternative model, the supplier ships the goods to a distribution center, which then delivers the order to the customer upon the retailer’s instruction. The supplier still invoices the retailer, and the retailer bills the customer.
Both scenarios involve two core transactions:
- A wholesale sale from the supplier to the retailer (generally exempt from sales tax)
- A retail sale from the retailer to the customer (typically taxable)
If a third-party fulfillment center is involved, a third transaction may occur, potentially subject to tax depending on state laws.
Sales tax implications in drop shipments become complex when transactions cross state lines.
Key issues include determining nexus (whether a business has a sufficient presence in a state to be taxed), applicable exemptions, and the location of the sale. Nexus can be influenced by factors such as inventory storage, advertising, order processing, and agency relationships between the supplier and retailer. The role of distribution centers also matters—ownership, control, and location can affect tax obligations.
Additionally, both retailers and suppliers must analyze their collection responsibilities, considering economic nexus thresholds, transaction definitions, and local tax rules. States like Alabama, Louisiana, Colorado, and Illinois present unique challenges due to their local tax structures and administrative burdens.