A Primer on Drop Shipping and Sales Tax Exemption Certificates (Part 3)

If you read posts one and two in this series, by now you should have a decent understanding of what role your company plays in the drop shipment relationship and how to handle exemption certificates. While this knowledge will help you lay a strong foundation for achieving compliance, there’s still one more critical component to address:

Audit of exempt sales in a sales and use tax audit.

As with anything impacted by sales and use tax, audits have a tendency to take unprepared companies by surprise. Even a seemingly small oversight can potentially turn into a big problem under audit.

In this post, we’ll look at three common compliance pitfalls and how to avoid them when documenting drop shipment transactions.

Pitfall #1: Overlooking a drop shipment transaction

The Solution: Thorough, accurate documentation at each stage

Remember that, from your auditor’s perspective, every drop shipment can be viewed as two or three separate transactions. First, the customer buys an item from the seller. (Transaction one.) Then the seller makes that same purchase from a supplier. (Transaction two.) And lastly, the supplier drop ships the packaged goods to the customer. (Transaction three.)

To remain compliant, you will need to scrutinize jurisdictional sales and use tax requirements as well as corresponding exemption certificates at each step. Your best defense against audit risk will be documentation that’s both deeply thorough and highly accurate.

Here’s why:

In many drop shipping relationships, it’s the supplier who bears responsibility for collecting and storing exemption certificates in states where the company has nexus. As state audits become more frequent and auditors are less lenient, these drop shippers will likely be first to feel the pain when it’s determined they don’t have a valid resale certificate to vouch for products that have been delivered on behalf of a retail partner. If it’s determined under audit that those certificates were not correctly collected for tax-exempt transactions, the supplier may be asked to go through the painstaking process of providing additional shipment documentation to prove the items were sent out of state.

However, this does not mean that sellers are off the hook. Providing accurate, valid exemption certificates will not only foster positive business relationships with drop shippers, but also will help keep your company (the seller) in the auditor’s good graces. Although a seller is not likely to be audited when no nexus has been established, an auditor might look at incomplete or invalid resale exemption certificates as an indication that the seller needs to be registered in the state.

Even in instances where nexus has been established and taxes are passed on to the customer, there’s the possibility that this end user will be sales tax exempt. Under these circumstances, a valid exemption certificate will need to be collected from the customer. 

Quick Tip: Most states will consider drop shipment exemption certificates acceptable if “resale” is listed as the reason for exemption. Auditors will also look for the names of both buyer and seller, and check to make sure the entire form is filled out correctly and signed.  

Pitfall #2: Mis-documenting drop ship resale exemptions

The Solution: State-by-state certificate selection

When documenting tax-exempt drop shipment transactions, make sure the exemption certificates you collect (or provide, if you’re the one filling them out) meet state-specific requirements. The rules can vary dramatically from one jurisdiction to another, so it’s extremely important to identify the correct certificate in each state where you will be documenting resale exemptions in drop shipment transactions.

Sometimes confusion can arise when a seller decides to use a multijurisdictional form to document exemptions in several states at once. Two common certificates are the Streamline Sales Tax form with Multi-state Supplemental form (SST) and the Multi jurisdiction form (MTC).

While these certificates are very convenient for the company filling them out, they might raise questions during an audit if they are not properly completed. Companies that accept them should review each one meticulously to ensure the proof of a drop ship resale exemption is crystal clear for each and every state represented on the certificate. If you are the one filling out the form, understand that you may be asked to make adjustments or fill out a different, state-specific certificate—especially if your drop ship supplier has prior experience with sales and use tax audits. These are valid requests and should be responded to promptly.

Quick Tip: If you are not sure which exemption certificates to use for drop shipment transactions, a good place to start is the free CertCapture certificate library. You can identify and download blank, fillable certificates by state.

Pitfall #3: Expired or invalid certificates

The Solution: Monitoring state requirements as they change

Again, each state has its own unique approach to drop shipping and exemption certificates. This means that the length of time for which each resale exemption certificate is valid will vary from jurisdiction to jurisdiction. In some states, they may be valid for decades. In others, they will expire after five years. To remain compliant, your company will need to be aware of these varying expiration dates.

Many states are handling sales and use tax audits much more aggressively than they have in years past. Some are also redefining how they determine nexus—the very factor that dictates if and when a drop shipment transaction creates tax responsibilities to a state.

If your staff is not trained and staying up to date on drop shipment requirements as they change, audit risks can increase drastically. That’s the bad news.

The good news is that education can really pay off. In fact, you may be surprised to hear that there are times when prepared companies actually know more than their auditors. For example, states that recently became members of the Streamlined Sales and Use Tax Use Agreement may still be re-training their auditors. If an auditor is still relying on non-SST information, the well-informed company will be in a good position to confidently provide the correct documentation.

In Conclusion

Managing the sales tax exemption side of drop shipment relationships is complicated, particularly if you drop ship to numerous states. Each jurisdiction has its own rules around what qualifies as an exemption and what certificate must be used to document it. Failure to correctly collect, validate and store exemption certificates in drop shipment transactions has the potential to harm business relationships or, even worse, put your own company’s compliance status in jeopardy.

What other questions do you have on drop shipping and exemption certificates? What other issues would you like to see addressed in the CertCapture Resource Center? Let us know in the comments!

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