Sales Tax Obligations
Article written by Ned Lenhart at Interstate Tax Strategies.
Most of the business community is now aware that the U. S. Supreme Court, in South Dakota vs. Wayfair, Inc. 138 S. Ct. 2080, (2018) (“Wayfair”), greatly expanded the authority states have to require out-of-state businesses to collect and remit sales tax on taxable sales made into their state. This opinion was issued on June 21, 2018. As I outline below, the Wayfairopinion also allows states to impose other sales tax compliance obligations on companies that don’t generally make taxable sales. The full impact of the Wayfairdecision is still being evaluated by states and taxpayers, but some aspects of the Wayfair decision are clear and all companies need to analyze the impact of this decision in light of their current business practices.
As of January 1, 2019, 31 states will have implemented some form of ‘economic nexus’ rule. By mid-2019 each of the 46 jurisdictions (45 states and D.C.) that have a sales tax will have some type of economic nexus rule. Under these rules, companies with sales into the taxing state exceeding some state specific threshold (i.e. $100,000, $250,000, or $500,000) are deemed to have nexus in the state even though the company does not have any type of physical presence in the taxing state.
Much of the attention to date on analyzing Wayfairhas been directed to companies selling at retail to end-users. In these cases, remote retailers with economic nexus in the taxing state are obligated to collect tax on sales shipped into the taxing state. My focus of concern in this posting is on the impact Wayfairhas on wholesalers in general and drop-shippers in particular.
Basic Drop Shipment Sales Tax Rules (Pre-Wayfair)
Drop shipments or third-party shipments are a mainstay in the supply chain fulfillment mechanism for both wholesale and retail sales. A drop shipment transaction involves at least three separate participants and at least two separate sales. For example, “Retailer”, located only in Georgia, accepts an electronic order from a customer (“Customer”) where customer requests the product be delivered to its Indiana location. Retailer does not currently have Customer’s item in stock, so Retailer contacts its supplier (“Supplier”) and instructs Supplier to ship the product directly to Retailer’s customer in Indiana. Supplier is only located in Florida. Supplier ships via common carrier the product to Indiana from its Florida inventory. Supplier invoices Retailer $500 for the product it sold to Retailer but shipped to Indiana. Retailer invoices Customer $675 for the product it sold to them. For purposes of this example, we will assume that Customer is the end-user of the product being purchased.
In this example there are two separate sales. The first sale occurs when Supplier sells the product to Retailer. Retailer cannot sell the product to Customer until it has first purchased the property from Supplier. The second sale happens when Retailer sells the product to Customer. Both sales occur when the property is delivered to Customer’s door step in Indiana. The sale from Supplier to Retailer is a nontaxable “sale for resale” and the sale from Retailer to Customer is a taxable retail sale. Because Retailer does not have physical presence in Indiana, Retailer believes it does not need to collect sales tax from the Indiana customer. Further, because Supplier does not have a physical presence in Indiana it also believes it does not need to charge tax on this sale or collect an Indiana resale certificates. The only hope the state of Indiana has for collecting the sales tax on this transaction falls to Customer to pay the use tax directly to the Indiana Department of Revenue.
Basic Drop Shipment Sales Tax Compliance–Post-Wayfair
Under the physical presence nexus standards in place for the past 26 years, the tax collection assumptions expressed above by Retailer and Supplier are likely accurate. However, under the economic nexus rules embraced under the Wayfair doctrine, the sales tax dynamics of this drop shipment transaction have changed. The state of Indiana is one of the 31 states that has adopted (as of January 1, 2019) rules concerning when companies have created sales tax economic nexus in the state only having sales which exceed a certain minimum dollar threshold in the taxing state. Indiana’s nexus threshold is $100,000 of sales or 200 separate transactions per year.
If we change our example a bit by assuming that “Supplier” and “Retailer” each have Indiana sales in excess of the $100,000 economic nexus threshold, the drop shipment transaction profiled above would change in the following respect.
- Supplier would require Retailer to provide a resale certificate that is valid in Indiana. Fortunately, Indiana will accept the Georgia resale certificate (Retailer’s home state) from Retailer. This will allow the initial sale of property to be exempt from Indiana sales tax as a ‘sale for resale’. If Supplier does not have a valid resale certificate from Retailer, then Supplier will be obligated to charge sales tax to Retailer on this initial sale.
- Because Retailer is selling to an end-user in Indiana and because Retailer has Indiana economic nexus with the state of Indiana, Retailer is be required to register with the Indiana Department of Revenue and collect the 7% sales tax on the sale it makes to Customer.
If the drop shipment described above were the only one that Retailer and Supplier had, then this scenario is easy to administer. In reality, this drop shipment scenario happens dozens or hundreds of times a day for both Supplier and Retailer and involves shipments to customers in many different states. Supplier likely drop ships property for multiple Retailers to multiple states in any given day. Retailer likely has multiple suppliers shipping products to customers in multiple states in any given day. As a seller with possible economic nexus in multiples states, Retailer’s sales tax obligations have changed significantly under the Wayfair rule.
Advanced Drop Shipment and Sales Tax Compliance-Post Wayfair
For companies like Supplier the impact of Wayfairis subtle but may create significant issues for companies that provide drop shipment services. Most states consider all sales of tangible personal property to be taxable until the seller obtains an exemption certificate from its customer documenting the sale as not taxable. This resale certificate must be valid in the state to which the property is shipped since that is the state where the sale from the Supplier to the Retailer occurs. In most cases, the certificate provided is a resale exemption certificate. Failure to have a resale exemption certificate from Retailer that is valid in the destination state causes the seller (Supplier in our example) to be liable for collecting sales tax on the sale. If tax is not charged and it is determined under audit that Supplier did not have a valid resale certificate, the Supplier will likely be assessed back sales tax and interest on the price charged on the drop shipment sale made to the Retailer.
In many cases, the destination state will accept the ‘home state resale certificate’ or the ‘home state registration number’. Indiana, as used in our example is one of these states. So long as the Supplier has the home state resale certificate from Retailer, Supplier is protected and has no obligation to collect tax. There are 36 jurisdictions that accept this ‘home state’ registration number or some other alternative documentation to support the resale claim.
The issues become more serious and a bit more complicated for Supplier and Retailer in the 10 jurisdictions that do not accept the home state registration number or resale certificate. Suppliers making drop shipments to these states must insist on receiving resale certificates valid in the ‘ship to state”. In most cases, this requires Retailer to register with the ship-to state and obtain a registration number which is used on the state specific resale exemption certificate. (Note: some states permit the use of the Multijurisdictional Resale Certificate, but it must include the registration number issued by the ship-to-state). Jurisdictions that do not generally accept the home-state resale certificate include: California, D.C. Florida, Hawaii, Illinois, Louisiana, Maryland, Massachusetts, Tennessee, and Washington.
There may be situations where Supplier exceeds the economic nexus threshold in the ship-to-state, but Retailer has not created economic nexus in the ship-to-state. Assume that Retailer (from the above example) instructs Supplier to drop ship products to a customer in Washington. Washington has a $100,000 sales threshold economic nexus and Supplier is registered in Washington because its total sales exceed that amount. Retailer, however, only has $30,000 of sales per-year in Washington and does not meet that economic nexus threshold and therefore is not registered. Because Washington will not accept the Georgia home-state resale certificate from Retailer, Supplier must charge Retailer sales tax on the wholesale price of the products it drop-ships to Washington. To avoid being charged this tax, Retailer must register with the Washington Department of Revenue and provide Supplier with a valid resale certificate once the registration is processed (which may take 30 days or more to complete). Once registered with the Washington Department of Revenue, Retailer will be obligated to collect tax on allsales shipped to customers in Washington even though Retailer does not meet the economic nexus threshold of the state.
This presents a significant dilemma for small retailers. Under the rules in states that do not accept the home state resale certificate but have economic nexus rules in place, retailers that fall below the thresholds will be required to obtain a sales tax registration in that state to provide a valid resale certificate and avoid being charged sales tax by their supplier. In some cases, it may be more economical for retailers to simply pay the tax to the supplier rather than to incur the compliance costs related to collecting and remitting the sales tax. Requiring retailers under the economic nexus threshold to secure a Washington registration number so that a valid resale certificate can be issued also appears to violate the benefit of imposing the $100,000 sales level which is supposed to provide a ‘safe harbor’ for small businesses.
If Supplier has economic nexus with a state that does not accept a home state resale certificate and it does not charge sales tax to their customer, the Supplier will be liable for sales tax due to that state. Once Supplier obtains economic nexus in Washington, or any other state that does not accept home state resale certificates, it is obligated to collect tax on all sales shipped to that state unless the Retailer provides a resale certificates that is valid in the delivery state. As noted earlier, if the ship-to state does not accept the ‘home state’ resale certificate, retailers must register with the taxing state to obtain a registration number that can legally be used on a resale certificate. Once registered, tax must be collected on all future sales shipped to customers located in that state; not just those sales that are drop shipped into the state.
As countless direct and drop shipments are made daily into states that do not accept home state resale certificates by companies having economic nexus, the sales tax risk is significant and real if these shippers do not immediately implement policies to require the correct resale certificate at the time the sale is made. States like California are vigilant in enforcing this rule on audit and are constantly looking for companies that should be registered for sales tax but are not.
Conclusion
Retailers and suppliers making drop shipments into states with the economic nexus rules are now required to comply with a wide variety of rules that, heretofore, they have not been required to follow. Failure to understand the economic nexus rules and to evaluate the obligations your company has for collecting resale certificates or for charging sales tax will create a real and potentially material financial liability for your company. All wholesalers and retailers MUSTcarefully evaluate the drop shipment relationships they have and adjust their sales tax policies as needed to meet the rules in states that do not accept home state resale certificates.
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