Drop Shipment: The Sales Tax Monster Hiding in the Closet

Why supply chain management is so critical for distribution companies

Although the economy and the markets seem to have recovered from the financial crisis, the financial picture has not significantly improved – if it has improved at all – for states. Many are again facing significant budget deficits created by a decrease in federal funding and underfunded pension plans. Pennsylvania alone is facing an approximate $1.5 billion deficit for the 2016-2017 fiscal year.

As many states face significant shortfalls in revenue, along with added pressure to maintain the line on taxes, they are left with the burden of enforcing current laws to raise much-needed revenue to fund budgets. One area where there is believed to be significant revenue left on the table is sales tax.

Sales tax can account for up to 45 percent of a state’s revenue for a fiscal year. Aggressively auditing taxpayers and the exemptions they claim from sales tax can potentially lead to additional revenue without raising taxes. One of the most commonly used exemptions is the “sale for resale exemption.” Many taxpayers take this exemption for granted and are lax in their compliance with the exemption requirements. Obtaining a valid exemption certificate at the time of the sale is required to treat the sale as an exempt sale for resale. When the reseller and vendor are both located within the same state, obtaining a valid exemption certificate is fairly straightforward. However, when a reseller engages in a drop shipment, the process of obtaining a valid exemption certificate becomes significantly more complex.

A drop shipment involves the use of a third party to fulfill an order between the reseller and its customer. For example, Company A uses Company B to fulfill an order with its customer, Company C. If all three companies are located within the same state, the issue of a valid exemption certificate is generally uncomplicated. If Company B, the drop shipper, is located in another state and ships the product to a state where it has nexus then most states would require that it receive a resale certificate from the state where the delivery occurs. The complication arises when Company A, the reseller, is not registered in the state where delivery occurs. If Company A cannot provide the drop shipper with a valid exemption certificate, then that sale is taxable.

Based on my experience, sales tax auditors have not historically focused on drop shipment transactions. However, the auditing of drop shipments is on the rise. Any company that files in multiple states and engages in drop shipping should review its policies surrounding exemption certificates to ensure that they are, at a minimum, obtaining an exemption certificate and then reviewing the certificate to ensure that it is valid.

It is no longer safe to presume that a sale for resale will automatically be treated as an exempt transaction. Sales tax for multistate companies is clearly becoming more complicated and requires constant monitoring to minimize exposures due to non-compliance.

Thomas M. Frascella can be reached at tfrascella@kmco.com or 215.441.4600.

 

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