Avalara : What’s the difference between drop shipping and selling through a marketplace?

There are important differences when it comes to how drop shipments and marketplace transactions work on the back end - and especially when it comes to sales tax.

How do drop shipments work?

The drop shipment model works like this: A retailer offers X for sale but doesn't keep X in stock. When a consumer purchases X from the retailer, the retailer tells the supplier (aka, the drop shipper) to send X directly to the consumer. This is easy to scale; it works whether the retailer sells 10 or 10,000 X in a year.

Yet drop shipping can complicate sales tax compliance because it involves two businesses, two sales transactions, one consumer, and often multiple states with unique sales tax rules and regulations. Which state's rules govern the transaction? Which business is liable for collecting and remitting the tax due?

There's no one answer: It depends on the location, role, and responsibilities of each business and the location of the consumer. A key consideration is nexus, the connection between a state and a business that allows the state to impose a tax collection obligation on the business.

There are at least three common drop shipping scenarios, each of which impacts tax differently.

Scenario 1: The retailer has nexus.

Generally, when a retailer has nexus in the consumer's state, the retailer is required to collect sales tax from the customer and remit it to the tax authorities. This is true even if the supplier ships the product to the consumer.

In this case, the supplier's sale to the retailer is generally exempt as a sale for resale. To validate the exempt transaction, the retailer would give the supplier an exemption or resale certificate.

Scenario 2: Neither the retailer nor the supplier has nexus.

If neither the retailer nor the supplier has nexus in the consumer's state, neither can be required to collect and remit sales tax. The obligation to report and remit tax falls on the consumer.

Instead of sales tax, consumers are responsible for remitting the equivalent consumer use tax to the tax authorities. In some states, consumer use tax can be reported annually on a state income tax return. In other states, it's necessary to file a separate consumer use tax return.

Scenario 3: The supplier (drop shipper) has nexus, but the retailer doesn't.

When the retailer does not have nexus in the state where the sale occurs, but the supplier does, the supplier may be obligated to collect tax on its sale to the retailer - unless the retailer can supply a valid exemption or resale certificate. This tends to be the most challenging scenario.

Approximately 30 states allow suppliers to accept exemption certificates from out-of-state retailers. In this case, since tax isn't collected on the supplier's sale to the retailer or the retailer's sale to the consumer, the customer is generally required to remit consumer use tax.

Approximately 16 states do not allow suppliers to accept out-of-state exemption certificates. Sales tax compliance is trickiest in these states. Some states require the supplier to collect tax on the wholesale price paid by the vendor. In Maryland, the supplier must either "require the vendor to obtain a Maryland sales and use tax license and provide a valid resale certificate," or "charge the vendor the tax based on the amount of the sale."

Other states require the supplier to collect tax on the retail price charged to the final customer. Since many retailers don't typically share the retail price with their suppliers, there's usually a Plan B.

In Connecticut, for example, the supplier should charge the retailer tax on the wholesale price if the supplier doesn't know the retail selling price. The customer is then "liable for payment of the remainder of the tax directly to the State of Connecticut as a use tax."

In California, a supplier can add 10% to the wholesale price and charge the retailer tax on that amount (wholesale plus 10%) if it doesn't know the final retail price.

What are marketplace transactions?

Marketplaces are businesses that bring together multiple vendors under one roof - or website. After the rise of online marketplaces like Amazon, eBay, and Etsy, states developed marketplace facilitator laws to clarify who was responsible for collecting and remitting sales tax on a marketplace transaction: the individual marketplace seller or the marketplace facilitator (aka, marketplace provider).

Every state with a sales tax now has a marketplace facilitator law on the books, though Missouri won't enforce its law until January 1, 2023. And all marketplace facilitator laws generally require the marketplace facilitator (Amazon, eBay, Etsy, etc.) to collect and remit sales tax on third-party transactions.

How do marketplace facilitator laws impact drop shipping?

Since drop shipping laws generally predate marketplace facilitator laws, they typically don't stipulate how a marketplace transaction would impact drop shipping, or vice versa. Similarly, marketplace facilitator laws usually don't refer to drop shipping.

California is one state striving to make the difference between marketplace sales and drop shipping clear. According to the California Department of Tax and Fee Administration (CDTFA), marketplace sales are not drop shipments. It's supporting that stance with a proposed amendment to its drop shipment regulation (Regulation 1706).

The CDTFA wants to add definitions for "marketplace," "marketplace facilitator," and "marketplace seller" to Regulation 1706, as well as definitions for the following:

Retailer engaged in business in this state: Any person who would be so defined by Revenue and Taxation Code section 6203 if the person were a retailer

True retailer: Any retailer who is not a retailer engaged in business in this state and who makes a sale of tangible personal property to a consumer in California

The proposed amendments state that in California, the true retailer is the business that sells property to a consumer. The true retailer may purchase property from the supplier (drop shipper) and instruct the supplier to ship the property to the consumer. If the drop shipper is a retailer engaged in business in California (i.e., registered to collect and remit California sales and use tax), the drop shipper becomes the retailer liable for the tax. The amended regulation explains: "When more than two separate sales are involved, the person liable for the applicable tax as the drop shipper is the first person who is a retailer engaged in business in this state in the series of transactions beginning with the purchase by the true retailer."

California does not consider the marketplace facilitator to be the true retailer of a marketplace transaction. Furthermore, "if the marketplace seller contracts to purchase the property from a supplier and instructs the supplier to deliver the property directly to the consumer, the supplier is not a drop shipper."

The CDTFA offers this example: "ABC Co. is a marketplace seller and not a retailer engaged in business in this state. On December 1, 2019, a marketplace facilitator that is registered with the Department … facilitates a retail sale of tangible personal property to a California consumer by ABC Co. through its online marketplace. ABC Co. then contracts with XYZ Inc. to purchase the tangible personal property and instructs XYZ Inc. to ship the property directly to the California consumer. XYZ Inc. is not a drop shipper liable for the applicable tax as the retailer. The marketplace facilitator is the retailer and is liable for the applicable tax."

As of this writing, the proposed changes to California Regulation 1706 are still in the works.

Learn more about the impact of drop shipping on sales tax compliance.