Most would agree the administration of a drop-shipment or "third party sale" ranks very high on the list of troubling tax issues. This issue can affect many different businesses, including manufactures, wholesalers, distributors, retailers, and eventually, the end user. To understand the taxation of a drop-shipment, we must first look at the logistics of the transaction as shown in the illustration below. Generally, the following illustration occurs:

• The retailer accepts an order for tangible personal property from its customer, the final end user of the tangible personal property;
• The retailer (who does not have the desired property) places a similar order with a third party, usually a manufacturer or distributor;
• The third party then ships the tangible personal property directly to the retailer's customer (ultimate user), but sends the invoice for the property to the retailer;
• The customer then receives an invoice from the retailer.

So how does sales and use tax apply to this transaction? The answer depends, in part, on the states involved in the transaction. If the third party shipper is not registered to collect tax in the state where they are shipping the property (destination state) on behalf of the retailer, then the shipper charges no tax on their bill. If the retailer is not registered in the destination state, the liability then falls into the hands of the ultimate end user to self-assess the applicable use tax on the transaction. See our discussion of registration requirements on the nexus page of this web site. But let's muddy the water. If the shipper IS registered to collect tax in the destination state on behalf of their customer (the retailer), then by law they are required to collect a tax on the transaction from the retailer. You may be thinking, "Isn't this a resale transaction?" You are correct, but more than one state is involved. Most states will allow the shipper to exempt the transaction with the retailer from tax as long as they have a valid resale certificate on file from the retailer. You see, most (destination) states will accept as proof of resale, a certificate issued from a state other than theirs. However, some (destination) states do not. These states require the shipper to have a valid resale certificate from the destination state issued by the retailer. If the retailer can't issue a certificate from the destination state, the shipper must charge tax on their invoice. Basically the destination state is saying that they don't care what other certificate you have, they will only accept a certificate issued from their state. The impact on the retailer is to pay the tax to the shipper. They usually bury this cost in the price of the tangible property when invoicing the end user. Alternatively, the retailer can volunteer to register in the destination state as a reseller. Then they could issue an acceptable resale exemption certificate to the shipper. But watch out. As a consequence of registering in the destination state, the retailer must now collect tax on all sales they make to customers in that state. Since each state makes their own rules, it is important to analyze each state's laws to correctly administer their sales tax provisions when dealing with third party drop-shipments into their states.

Give us a call to discuss your drop-ship transactions and to determine the states where you will likely run into tax snares.

Feel free to call or e-mail us to discuss any tax issues you may have.

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