by Andrew Johnson

In today’s economy, people are looking for ways to make more money. Maybe working from home is the way to go? One opportunity is to sell products online as a drop shipper. The way it is pitched goes like this: It’s easy; no upfront investment in inventory; it’s convenient and efficient; you can do it anywhere (like Hawaii?); etc. Building a drop shipping empire sure sounds great, but what are the downsides?

When it comes to evaluating the drop shipping opportunity, there are some significant downsides to consider. The first three are downsides that others have mentioned, but the fourth one never seems to come up, and it could be the most costly of all. First downside: competition is fierce, so margins are low; second, you could be selling something that the manufacturer no longer has in stock, which can cause you headaches; and third, because you never see the product, how well are you going to be able to describe and sell it? The fourth downside is a potential deal-killer — sales tax. Is sales tax due on what you sell, and if so, who is supposed to collect it? If you, the seller, are required to collect the sales tax and you don’t, you could be facing the biggest tragedy in sales tax. At the very least, your business could be wiped out by assessed taxes, penalties, and interest. At the worst, the business owner could face personal penalties.

Why Worry About Sales Tax? Online Sales Are Not Taxed (Right?)

A common misconception is that goods sold over the internet are not taxable. This is simply not true. The fact is that most tangible items sold online are taxable in most states. The question is whether you the seller are required to collect that tax. The answer to that question is not so easy to determine, unfortunately. It comes down to how connected the seller is to the state they are shipping to. We call this “nexus.” If you are sufficiently connected to your customer’s ship-to state, then you have nexus with that state and they can force you to collect their taxes, even though you are selling online.

It All Comes Down To Nexus

So what activities create nexus for sellers? See this list of 10 Common Nexus-Creating Activities for Sales Tax. If you conduct any of these activities in any other state, you could be forced to start collecting tax there. Also, see this other list of 10 Other Nexus-Creating Activities that vary by state.

Those are activities that create nexus for any type of business. But it’s not that easy for online sellers who do drop-shipping exclusively because they are unique. They don’t typically have any real property (such as warehouses, offices, etc.), nor do they own inventory, nor do they have employees, nor even sales reps in other states. So maybe there’s nothing to worry about. But one thing that might trip up an online seller could be the services your supplier might be performing for you. Consider these situations and whether they could give you nexus:

•  The manufacturer acts as a fulfillment agent packing and shipping the products in the final customer’s state. That doesn’t seem fair. It’s one of the main upsides of selling online and using drop-shipping in the first place. The idea is that you would outsource all of that hassle of packing and shipping to someone else. The problem is that several states say those activities create nexus for you the seller. Get the chart here.

•  The manufacturer accepts and processes returns? That’s another of the main benefits of doing business this way — you don’t have to handle returns. Many states say this also creates nexus for you in their state. Get the chart here.

Maybe after reviewing the lists above and consulting your advisor, you determine that you do not have nexus in any other state (of course you realize you would have a tax collection responsibility at least on shipments to customers in your home state). Good for you, that’s a load off your shoulders! But, as a drop shipping mogul, you know not to let your guard down! State governments are always looking to expand the rules so that more and more online sellers will be drawn into their net, so keep an eye out for those changes. But there’s another potentially more costly sales tax problem to watch out for.

Other Sales Tax Issues That Could Kill Your Profit Margin

Imagine the following scenario. You find your niche products. Your marketing prowess has customers flocking to your online listings, and products fly off the virtual shelves. Shipments go out. The money rolls in. The customers are happy; you’re ecstatic. According to your calculations, based on the suppliers’ prices to you, you’re going to make a handsome 8 percent profit margin. Beautiful! Except for one small detail…

When the charge from your supplier hits your credit card you see that they have charged you sales tax of 10 percent. Not only is your profit wiped out, but you’re in the hole and the hole is getting deeper with every new sale. Is this possible? Is it correct? How can this be?

It All Comes Down To Nexus For The Supplier, Too

It sounds like a nightmare come true, but this scenario is not uncommon. The reason is the same as we discussed earlier. It has to do with the manufacturers and distributors of the products you are selling and where they have nexus. If they have nexus in the state where your customer resides, then they may be forced to charge you, the seller, sales tax on those shipments. And this is where it gets really complicated — and potentially costly to you. Because, depending on the states involved, the manufacturer/distributor may have no choice but to charge you sales tax on a product you are shipping to a customer in another state. Even though you are simply reselling those items to another person. Sales tax can range from 5 to 10 percent.

And to add insult to injury: Depending on the states involved, the manufacturer may be required to charge you the sales tax not on their price to you, the seller, but on the estimated final sales price to your customer.

Now that is a tragedy!

This is a complicated area of sales tax. We have some charts that may be of interest to you as the seller in a drop-ship situation. Also, the situation is further complicated if there are additional middlemen involved between the manufacturer and the seller and the final customer.

•  If the manufacturer is registered in the final customer’s state, but the seller is not, is the manufacturer required to collect tax on its sale to the seller? Get the chart here.

•  If the manufacturer is required to collect the tax, what is the basis of the tax? The sales price to the seller or the sales price to the final customer or some other value? Get the chart here.

•  Can the seller avoid the tax by giving the manufacturer/distributor a resale certificate from the seller’s home state? There’s no simple chart for this because there are lots of complicating factors in the resale certificate area. For example, what if you as a seller operate out of Oregon or other non-sales tax state? Also, what other documentation could the manufacturer accept in order not to charge the seller tax?

•  What if the final customer is a school, church, hospital, etc. that is a non-taxable entity in their state? They don’t pay sales tax by virtue of the exemption they are given, but the manufacturer could still be required to charge you sales tax. Get the chart here.

Nobody likes to be the wet blanket on another’s enthusiasm fire as they begin new business ventures. So please don’t kill the messenger. It’s better to be aware of the potential pitfalls in advance so you can take steps to minimize the damage and your new business can thrive. In the final analysis, there’s probably no way to make money easily and legally with no risk from home. Selling products online using drop-shipping suppliers sure seems like it could be easy, and there’s no doubt it’s legal, but beware of the sales tax consequences and avoid the trap of paying the tax yourself years later. Know the pitfalls to avoid, and you can build your own empire with confidence.