In this article, we will answer two major questions:
Should a nonresident individual or business pay US taxes when using dropshipping service?
Should a nonresident individual or business owning a US LLC or corporation pay US taxes when using dropshipping service?
Dropshipping business model
In the dropshipping business model, a seller (true retailer) sells tangible personal property (inventory items, usually called goods) on its website or another international online selling platform to a customer in the US. Simultaneously, the seller buys this inventory item located in US warehouse and belonging to a US business (a dropshipper), such as Sellvia, LLC, and provides delivery instructions to the dropshipper.
What US tax obligations could arise in this dropshipping sales model? The most common ones are sales tax, use tax, income tax, and some other taxes.
Sales and use tax
If a nonresident seller has no authorization from a state to collect sales tax, it may not withhold this tax from a customer. In this case, sales tax becomes a use tax, and the tax obligation lies with the customer. Because states do not have sufficient staffing to collect use tax from every state resident, they transfer this tax-collection obligation to the company arranging the delivery — a dropshipper in our case. If the dropshipper has a sales tax permit in the state of the final customer’s residence, it must collect the use tax from the customer and pay it to the state.
For example, dropshipper Sellvia, LLC, is in California and is authorized by the state to collect the sales tax. If a true retailer gives Sellvia instructions to deliver goods to a California customer, Sellvia will accrue the use tax on the cost of the delivered goods, pay it to the state, and include it in the invoice to the nonresident seller. Assume that Sellvia is not duly registered in Arizona. If a final customer resides in Arizona, Sellvia will not accrue the use tax on the cost of the delivered goods and will not add an extra charge to the true retailer’s invoice.
If a nonresident seller owns a US-registered LLC or corporation, that business entity might have a seller’s authorization certificate from the state of the final customer’s residency. In that case, the true retailer provides a reseller’s certificate to the dropshipper and collects sales or use tax from the customer on its own.
Income tax for nonresident individual
The correct answers to most tax questions depend on multiple factors and should be provided by your tax advisor on a case-by-case basis.
Generally, according to Paragraph 1.861–7 of the US Code of Federal Regulations, “a sale of personal property is consummated at the time when, and the place where, the rights, title, and interest of the seller in the property are transferred to the buyer. Where bare legal title is retained by the seller, the sale shall be deemed to have occurred at the time and place of passage to the buyer of beneficial ownership and the risk of loss.”
We must define the time and place of passage. According to Section 2–401 of the Uniform Commercial Code, “Unless otherwise explicitly agreed title passes to the buyer at the time and place at which the seller completes his performance with reference to the physical delivery of the goods . . .
(b) if the contract requires delivery at destination, title passes on tender there.”
An online purchase of goods is usually not accompanied by an explicit (written) contract; nevertheless, such a purchase customarily implies the delivery of the goods to the buyer. In other words, by making an online purchase a buyer enters into an implicit destination contract with a seller. Under such a contract, the title to the goods passes to the buyer when the seller puts the goods at the buyer’s disposition at the named place. To the extent the title of an inventory item passes onto US territory, it is considered a US sale, and per 26 U.S.C. § 861(a)(6), gains, profits, and income derived from the sale of inventory property within the US create US-sourced income. This means that a nonresident merchant has US tax-reporting obligations and must file Form 1040-NR.
If this merchant resides in a country having a tax treaty with the United States, the amount of tax due could be reduced or even eliminated. Be aware that absence of tax due (per international tax treaty or otherwise) does not mean absence of the tax-reporting obligation. If a nonresident merchant does not file an income tax return (Form 1040-NR) and does not report its US business activity, the IRS will consider all gross sales as taxable income.
Income tax for business entities
A nonresident alien could own three types of US business entities: single-member LLC (SM LLC), multimember LLC (partnership), and C corporation.
US Treasury regulations treat SM LLCs as “disregarded entities” from their owners for tax purposes. Therefore, these businesses have the same tax treatment as nonresident individuals. Additionally, an SM LLC must file a special relative transactions information return (Form 5472) and keep highly accurate accounting books of transactions.
Foreign-owned partnerships and corporations are US tax persons and must report transactions from all over the world on their income tax returns. A partnership is a pass-through business entity. It does not pay federal income tax but rather passes tax liability to the partners; this tax treatment creates additional opportunities for foreign partners because they may be excluded from US income tax under certain circumstances.
C corporations are taxable business entities and pay taxes on net income from all over the world. Dividends paid to foreign shareholders are subject to 30 percent fixed, determinable, annual, and periodic income tax withholding if not reduced or eliminated by an international tax treaty.
If a foreign corporation is involved in dropshipping business, it has the same tax reporting obligations as a US corporation and must file a US income tax return on Form 1120F.
Some specific inventory items could be subject to other state or federal taxes. For example, a federal excise tax on fishing products. Collection of other taxes follows the same rules as collection of the sales and use tax. If a dropshipper is registered with the appropriate government agency for such tax collection, it must add this tax to the cost of delivered goods.
Following the above-described complicated tax rules and satisfying tax reporting obligations is not a simple task. According to some experts’ opinion, most professional tax return preparers do not properly complete it. This is understandable because most of these professionals prepare tax returns primarily for US residents. Therefore, be careful in choosing a tax return preparer, because, as the taxpayer, you are responsible for your tax return.
To ensure compliance with requirements imposed by the Internal Revenue Service, we inform you that any tax advice contained in this article was not intended or written to be used, and cannot be used, for the purpose of (i) avoiding tax-related penalties or (ii) promoting, marketing, or recommending to another party any tax-related matters addressed in this article.
The information contained in this article is of educational nature and is not intended as advice directed toward any specific party or any client-specific tax situation and should not be regarded as rendering tax advice to any person or entity. A nonresident seller must seek tax advice pertaining to its specific tax situation from a tax professional who is experienced in international taxation. We will be happy to help.
Sergei Suslov, PhD, CPA, CGMA
SVS Accounting LLC