How the Nexus Issue Plays Out With Amazon and Drop Shipping
In the middle to late 1990s, Amazon came onto the retail scene with its revolutionary online marketplace. They began in Silicon Valley and would take orders shipping directly from their fulfillment center in California.
Amazon rattled many brick-and-mortar businesses because the rules of a nexus dictated that unless you had a substantial presence in a particular state, then you did not need to charge sales tax. The only state where Amazon had a substantial presence was California. The brick-and-mortar companies were upset because, in their view, Amazon had an unfair advantage for not having to charge sales tax.
Fast forward to 2017, and Amazon has a substantial presence in most states. In order to get their products out quicker, they established fulfillment centers all over the United States. Now, the days of Amazon eluding sales tax are over.
I had a client that was incorporated in Florida and shipped their products across the U.S. They sold auto parts for souped-up Nissans. What they did to get their product out faster in the U.S. was implement drop shipping, a retail fulfillment method in which a store doesn't keep the products it sells in stock.
When a store sells a product, it purchases the item from a third party and has it shipped directly to the customer. As a result, the merchant never sees or handles the product.
The state of South Carolina sent my client an inquiry on their sales practices to see if a nexus for sales tax had been created. To make this more confusing, the company produced its own product line of auto parts and sold them to others in different states. Yet with all this going on, my client only had employees in Florida.
The question of whether drop shipping in and of itself created a nexus is entirely left up to the state. If you sell a product that you don’t have in stock, the question is who pays the sales tax?
To illustrate my point, my client has a nexus in Florida. He sells the product to the drop shipper in South Carolina, who then marks up the product and sells to the ultimate consumer in South Carolina.
So again, we have to answer the question as to who pays the sales tax. Quite simply, my client is acting as a wholesaler. How? Because he is selling to someone that is going to then mark up the price and resell to someone else. In this case, the drop shipper creates the nexus for sales tax.
However, what had to be proven to the state of South Carolina was that this was always the case. There were some sales where my client sold the product to the drop shipper, paying a fee as usual but in this case, the drop shipper did not mark up the product and simply handed off the product for what he bought it for.
According to South Carolina, my client, under their state’s rules, had created a nexus. The fact that the drop shipper didn’t mark up the product showed that my client had a substantial presence in the state that forced him to pay sales tax.
As you can see, these rules are complex, and it is simply a matter in which you need to check with each state where drop shipping takes place to determine whether a nexus has been created. You could, and should, charge a substantial fee for your investigation.
There is a movement that gains momentum from time to time, in which Congress decides that they are going to make a federal law that will handle these rules of nexuses. The problem they always run into is the Constitution.
Each state has their own right to tax or not to tax. However, we all know from tax law that typically, federal law supersedes state law on most occasions.
The last time a bill that discussed sales tax was discussed before Congress was 2015. The reason that nothing was done was that implementing these changes would be next to impossible, not to mention enforcing them.
What happened to my client was that he had to register in South Carolina as a foreign corporation, and then had to file a tax return with the South Carolina sales and expenses.
If you have a client like this, first of all, there is software that can help you work through your nexus issues.
But you do have to investigate on a case-by-case basis to determine if a nexus has been created given the circumstances. Make sure that you charge a good fee for your time in investigating this matter for your clients.
Craig W. Smalley, MST, EA, has been in practice since 1994. He has been admitted to practice before the IRS as an enrolled agent and has a master's in taxation. He is well-versed in US tax law and US Tax Court cases. He specializes in taxation, entity structuring and restructuring, corporations, partnerships, and individual taxation, as well as...