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Drop ship blues Featured

9:41am EDT July 22, 2002

In the mad rush to get on the Web, some Internet start-ups have learned that what you don’t know can hurt you — especially when it concerns taxes.

“These companies are getting burned on the drop shipment rules,” says Patrick Carney, a tax partner with the Pittsburgh office of Ernst & Young. “They’re rather complex. But the bottom line is that they end up having to pay sales tax on drop ship transactions, which basically wipes out their profit margin.

“And, they don’t even know it until after it’s happened, because they don’t understand the rules.”

Drop ship? Hidden taxes? That’s right. Here’s how the law works, and how it may affect your e-commerce initiative:

Let’s says that someone forms a Web company in Ohio. A Pennsylvania customer visits the site and places an order. The Ohio business doesn’t keep those specific goods — or perhaps any goods — in inventory, so it contracts with a third party, perhaps in Pennsylvania, to supply them.

The Ohio-based Web business buys the goods and, instead of having them delivered to its offices in Ohio, has them shipped directly to the customer in Pennsylvania. That’s potentially a taxable transaction.

Why?

“There’s actually two sales going on here,” Carney explains. “The company in Ohio is billing the customer in Pennsylvania. They’re not registered in Pennsylvania, so they can’t really charge that customer sales tax.”

But, while that’s happening, the Pennsylvania supplier asks the Ohio company for a resale certificate. And therein lies the problem.

“Typically, these Internet companies, these start-ups, they’re registered in their home state, so they cannot supply that supplier with a resale certificate. The (supplier) has no recourse but to charge (sales) tax to the dot-com company in Ohio.”

In layman’s terms, the dot-com company is paying sales tax, but is unable to charge its customer sales tax. So the tax wipes out the profit.

Worse, “they’re not even aware of it,” Carney says. “We’ve seen a lot of these start-up companies that totally get blindsided by the drop shipment rules. Sales tax has been our biggest issue with companies that are growing, expanding or forming dot-com companies, because they hardly can keep up with the compliance. It’s just very cumbersome.”

Of the 50 states, 45 charge sales tax. Of those, there are 31 with drop ship rules or guidelines. A handful of those have procedures that help companies around the issue.

But that still leaves about half the states that could cause problems for start-ups.

To alleviate the problem, companies can register in each of the states, but that can become an administrative burden, Carney says.

“We’ve seen that already here in Pittsburgh with start-up dot-com companies. They think they have this whole thing figured out and they don’t realize the sales tax ramifications of what they’ve just done. I’ve been preaching that message here for awhile.

“These companies that want to get into Internet business are totally missing that issue.”

How to reach: Ernst & Young Pittsburgh office, (412) 644-7829

Daniel G. Jacobs (djacobs@sbnnet.com) is senior editor of SBN.