When you sell online and use a third party for fulfillment, understanding your dropshipping tax requirements is essential. While they may seem confusing initially, dropshipping taxes are fairly easy to handle once you get the hang of the basics.
Here’s a guide to dropshipping taxes for beginners with everything you need to know to ensure you stay on the right side of the law with accurate taxes for your dropshipping business.
Dropshipping is a type of business where a third-party vendor fulfills customer orders. For example, suppose you own a business selling computer parts. Instead of storing and fulfilling every order yourself, a dropshipping vendor can store your ecommerce products in their warehouse and ship them to customers on your behalf after each sale. This business model can be much easier to manage, particularly for entrepreneurs working alone.
You may be familiar with the Fulfillment by Amazon (FBA) service, which is a form of dropshipping. But countless other drop shippers are working with businesses of all sizes to fulfill orders ranging from t-shirts to car parts to kitchen appliances and much more.
While dropshipping companies charge fees for storage and order fulfillment, they give e-commerce business owners the luxury of maintaining little, if any, inventory in their regular workplace and don’t have to deal with the hassles of packing orders or taking them to the post office.
Dropshipping potentially opens up the online retailer to different tax compliance requirements than self-fulfillment, so it’s critical to understand dropshipping taxes to stay on the right side of the federal, state, and local tax authorities.
Dropshipping taxes you may need to pay
As a drop shipper, you may owe taxes in multiple locations. For example, in addition to federal income taxes, you may owe taxes to your state and the state where your drop shipper is located. If your drop shipper uses multiple locations for fulfillment, you could owe taxes in multiple jurisdictions where your inventory is physically located.
- Federal income taxes: No matter your business type, if you profit, the IRS wants a piece of the action. In addition to federal income taxes, you’ll likely owe Self-Employment Tax, a combination of Medicare and Social Security taxes.
- State income taxes: Most states require you to pay income taxes if you run a profitable business within the state.
- Sales taxes: You’re probably familiar with sales taxes from visits to a local store, but you may owe them when selling online. Your primary headquarters location, the locations of your customers, and the locations of your dropshipping fulfillment centers may require you to remit sales taxes for sales fulfilled to or from that state. If you sell enough in a state or to a state to meet minimum tax requirements, it’s called a sales tax nexus.
- Local taxes: While less common, certain localities may require taxes. For example, your hometown may require local businesses to register and pay an annual tax or fee to operate in the city, even if you’re working from home.
- Use tax: If you buy items tax-free that would have been subject to sales tax if bought in your home state, you may owe use tax. Use taxes vary by U.S. state.
If you don’t pay taxes as required, you may be subject to those taxes plus additional penalties and interest. It’s much better to stay on top of your business taxes than remedy the situation later. Tax rules vary by state, so the taxes required in California or New York may differ from Texas and Florida.
S Corps and dropshipping taxes
While your sales taxes are likely set in stone, some savvy solo entrepreneurs can mitigate their self-employment taxes by electing to have their LLC taxed as an S Corp.
When you operate as a sole proprietorship, which is also the default taxation of an LLC, you pay income taxes and self-employment taxes on your business income. Self-employment tax pays into your Social Security and Medicare taxes.
When you opt for S Corp taxation and pay yourself a regular salary, you only pay Social Security and Medicare taxes on your payroll. The remainder of your business income is only subject to federal income tax, lowering your total tax liability.
Dropshipping tax exemptions
Sales taxes are only required once for items sold in the United States. Businesses may qualify for a tax exemption if they only sell wholesale to other resellers. When customers have a resale certificate, the vendor doesn’t have to collect sales taxes. If you’re buying products for other businesses to resell, it likely makes sense to have a tax exemption certificate for your online store.
As a drop shipper, you may also be exempt from paying sales taxes to your supplier, as you act as the reseller in this scenario. This type of sales tax exemption applies in 36 states. To qualify for this exemption, you may need an exemption certificate in each state. Or you can use the 36-state uniform exemption certificate to simplify your tax-exempt status applications.
Record keeping for dropshipping taxes
Active businesses with customers nationwide may owe different types of taxes with different state tax rates in dozens of jurisdictions. That can make tracking your sales somewhat complex but, nonetheless, extremely important. Several helpful tools and services are available to help you manage drop shipping taxes.
Marketplace tax collection
If you sell through marketplaces like Amazon and Walmart, which fulfill your sales, your shipper (Amazon or Walmart in this scenario) may automatically collect and remit sales taxes on your behalf. Check with your drop shipper to determine if they collect tax for you. Platforms like Shopify also have built-in tax tracking, but if you have a Shopify store and sell on other platforms, you may need to charge sales tax on the other platforms
Accounting and sales tax software
If your drop shipper doesn’t handle sales taxes, you must track and remit them yourself. You can subscribe to dedicated sales tax software to automatically track your sales taxes and update tax rates. Some accounting software has sales tax tracking features as well. Software may help you prepare sales tax forms for your online business with an accurate sales tax rate for each state, as they are not part of your regular income tax returns.
Dropshipping taxes: The bottom line
While taxes can be complicated for drop shippers, there’s no reason dropshipping taxes should stop you from running a thriving business. With the right software or team standing behind you, tax laws are much easier to manage, so you can focus more on growing your business.
Eric Rosenberg is a finance, travel, and technology writer in Ventura, California. He is a former bank manager and corporate finance and accounting professional who left his day job in 2016 to take his online side hustle full-time. You can connect with him at Personal Profitability or EricRosenberg.com.