A drop shipment is a delivery in which the seller a customer bought from never handles the goods, because a supplier ships them straight to that customer on the seller’s instructions. The arrangement compresses two sales into one shipment, which is why it creates a tax question that an ordinary sale does not.
California’s sales and use tax regulation defines it precisely, and the definition is the one the ranking authorities work from: “drop shipment” means and includes any delivery of tangible personal property by an owner or former owner thereof, or factor or agent of that owner or former owner, to a California consumer pursuant to the instructions of a true retailer (California Code of Regulations title 18, Regulation 1706(a)(1)).
Sales tax is a state tax, and treatment of drop shipments varies by state. The rules below are California’s, quoted because they are worked out in more detail than most and because they show the shape of the question every state has to answer. A file in another state is answered by that state’s own rules.
Two Sales, and the Roles Each Party Plays
The regulation sets out the structure before it sets out the tax. A drop shipment generally involves two separate sales: the true retailer contracts to sell tangible personal property to a consumer, the true retailer then contracts to purchase that property from a supplier and instructs that supplier to ship the property directly to the consumer, and the supplier is a drop shipper (California Code of Regulations title 18, Regulation 1706(b)).
Two of those roles are defined terms and they do not mean what the plain words suggest. “True retailer” means and includes any retailer who is not a retailer engaged in business in this state and who makes a sale of tangible personal property to a consumer in California (California Code of Regulations title 18, Regulation 1706(a)(7)). “Drop shipper” means and includes any owner or former owner of tangible personal property, or factor or agent of that owner or former owner, who makes a drop shipment (California Code of Regulations title 18, Regulation 1706(a)(2)).
So the true retailer is the one without a taxable presence in the state. That is the whole reason the regulation exists.
The Drop Shipper Is Reclassified as the Retailer
Here is the operative rule, and it is a conditional rather than a blanket one. A drop shipper that is a retailer engaged in business in this state is reclassified as the retailer and is liable for tax as provided in this regulation (California Code of Regulations title 18, Regulation 1706(b)).
The condition is the middle clause. A drop shipper with no presence in the state is not reclassified by that sentence.
Longer chains are handled by a separate sentence in the same subdivision, and it picks one party out of the series. When more than two separate sales are involved, the person liable for the applicable tax as the drop shipper is the first person who is a retailer engaged in business in this state in the series of transactions beginning with the purchase by the true retailer (California Code of Regulations title 18, Regulation 1706(b)).
“First” and “beginning with the purchase by the true retailer” both do work. The series is walked from the true retailer’s purchase forward, and the first in-state retailer found is the one that owes the tax, whatever the parties behind it look like.
What the Tax Is Measured On
The base is the price the consumer paid, not the price the drop shipper charged. Unless the sale to the California consumer and the use by the California consumer are exempt from sales and use tax as otherwise provided in the Sales and Use Tax Law, a drop shipper must report and pay tax measured by the retail selling price of the property paid by the California consumer to the true retailer (California Code of Regulations title 18, Regulation 1706(d)(1)).
That is a figure the drop shipper usually does not know, which is what the next rule is for.
The Mark-Up Rule, With Every Limb It Has
This is a four-part rule and summaries routinely give the first part only.
The first part is the safe harbour. Except as provided in subdivision (d)(3) of the regulation, for reporting periods commencing on or after January 1, 2001, the drop shipper may calculate the retail selling price of its drop shipments of property based on its selling price of the property to the true retailer plus a mark-up of 10 percent (California Code of Regulations title 18, Regulation 1706(d)(2)).
The second part allows a lower figure. A drop shipper may use a mark-up percentage lower than 10 percent if the drop shipper can document that the lower mark-up percentage accurately reflects the retail selling price charged by the true retailer to the California consumer (California Code of Regulations title 18, Regulation 1706(d)(2)).
The third part turns an audit finding into a usable rate, with a condition attached. If a mark-up percentage lower than 10 percent is developed in an audit of the drop shipper, the drop shipper may use that percentage for the subsequent reporting periods provided the drop shipper has not had a significant change in business operations (California Code of Regulations title 18, Regulation 1706(d)(2)).
The fourth part handles a later audit that finds a higher figure, and it has a protective half and a restrictive half. Provided there is no significant change in business operations, if a later audit develops a higher percentage, the Department would not assess additional tax based on that newly computed mark-up percentage; however, for subsequent reporting periods, the lower mark-up from the previous audit cannot be used, and the drop shipper must instead use the higher percentage developed in the most recent audit or 10 percent, whichever is lower (California Code of Regulations title 18, Regulation 1706(d)(2)).
That closing “whichever is lower” is the limb most easily lost, and it is the one that caps the exposure.
The regulation’s own worked example runs the rule. Where the Department developed and applied a mark-up of 8 and a half percent during a drop shipper’s last audit and develops a mark-up of 11 percent during the current audit, the Department will apply the 8 and a half percent figure in the current audit provided there was no significant change in business operations (California Code of Regulations title 18, Regulation 1706(e)(4)).
The Mark-Up Route Has a Carve-Out
The procedures set forth in subdivision (d)(2) of the regulation do not apply to drop shipments of vehicles, vessels, and aircraft, also known as “courtesy deliveries” (California Code of Regulations title 18, Regulation 1706(d)(3)). Those three terms are defined in Revenue and Taxation Code sections 6272, 6273, and 6274 respectively (California Code of Regulations title 18, Regulation 1706(d)(3)).
Marketplace Sales Change Who the True Retailer Is
The regulation adds a rule for platform sales and it works by removing a label. When a marketplace facilitator is the retailer for a retail sale of tangible personal property to a California consumer by a marketplace seller under Revenue and Taxation Code section 6043, the marketplace facilitator is not a true retailer (California Code of Regulations title 18, Regulation 1706(c)).
Because the whole drop shipper reclassification runs off the presence of a true retailer, removing that label changes the answer rather than adjusting it.
Why the Word Appears Outside Accounting
Search the term and a third of the results are enterprise software documentation, where “drop shipment” names a field or a flag on a purchase order rather than a tax concept. That is a different sense of the same words: the software sense describes how an order is routed, the tax sense describes who the law treats as the seller. A question about a drop shipment field in an ERP system is a configuration question, not the question this entry answers.
Common Questions
Under California’s rule it is the drop shipper, but only where that drop shipper is a retailer engaged in business in the state, in which case it is reclassified as the retailer and is liable for the tax (California Code of Regulations title 18, Regulation 1706(b)). Other states answer the question with their own rules, so the party who collects is a state-by-state question rather than a single national answer.
The measure is the retail selling price paid by the consumer to the true retailer (California Code of Regulations title 18, Regulation 1706(d)(1)), and where that is unknown the regulation allows the drop shipper to calculate it from its own selling price to the true retailer plus a mark-up of 10 percent, subject to the lower-percentage and audit rules in the same subdivision (California Code of Regulations title 18, Regulation 1706(d)(2)).
The regulation names one party rather than splitting the liability. The person liable as the drop shipper is the first person who is a retailer engaged in business in this state in the series of transactions beginning with the purchase by the true retailer (California Code of Regulations title 18, Regulation 1706(b)).
They overlap but they are not the same statement. The regulation defines a drop shipment as a delivery arrangement, any delivery of tangible personal property by an owner or former owner, or a factor or agent of that owner, to a California consumer pursuant to the instructions of a true retailer (California Code of Regulations title 18, Regulation 1706(a)(1)). A business model built entirely on that arrangement is one way of triggering the definition, and a single such delivery inside an otherwise conventional business triggers it just as well.
Accountably places trained offshore accountants inside US CPA and EA firms, working under the firm’s own review, and a firm can put a block of its own sales tax and reconciliation work through a trial task before a client file depends on it.
