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How Shopify Shop Owners Can Reduce Their Taxes

6 minute read

Owning your own business can be very rewarding, but usually comes with unique challenges. In the age of digital online marketplaces, the taxation of an online dropshipping business – an order fulfillment method where a business doesn’t keep the products it sells in stock and uses a third party to fulfill orders instead of shipping the products themselves[1] – can quickly become complex. Whether you are selling t-shirts, mugs, furniture, or anything in between, planning to minimize your business’s taxes is crucial to saving money. In the end, proper tax strategy can have a huge impact on your bottom line. This blog discusses some important tax aspects that Shopify business owners should consider to reduce their tax exposure.

What is a dropshipping business?

In general, a dropshipping business does not have any inventory readily available. Instead, a dropship business completes orders as they come in from buyers, and the business’s goods are purchased from another seller or manufacturer on an as-needed basis. In other words, dropshipping businesses act as the intermediary between the consumer and one or more suppliers or manufacturers.

One of the main benefits of operating a dropshipping business is that it removes the need for the seller to have a large amount of inventory ready to sell on-hand. There is no need for a warehouse or other storage facility. Thus, there are no costs associated with leasing, owning, or maintaining those facilities.

How are dropshipping businesses taxed?

Dropshipping businesses are subject to income tax and sales tax, among others: they are the two most significant types of tax a business should plan for. 

Income Tax: a business is taxed on a percentage of its profits generated for the year (i.e., your business’ net income), which are calculated based on their specific jurisdiction’s income tax rate. If your business does not profit, it will not be required to pay income taxes. Instead, the business will either break even or, most likely, report a loss for the tax year. Notably, nine states—Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington and Wyoming—have no income tax. Thus, if your business is located in one of those states, they will not be subject to income tax in that state. However, some states have income tax nexus laws that will subject your business to the state’s income tax, even if your business is not registered with the state or physically present in the state.

Sales Tax: sales tax is charged on the retail sale of a good or service to a consumer. A dropshipping business’s transactions are subject to the sales tax of the jurisdiction where the goods are sold if the business established a sales tax nexus within the jurisdiction. The sales tax is not imposed on the business itself. Instead, the consumer is the one who is being taxed. However, the business will be expected to collect and remit the sales tax on sales made within the specific jurisdiction.

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What constitutes “nexus”?

First and foremost, “sales tax nexus defines the level of connection between a taxing jurisdiction such as a state and an entity such as your business[2].” However, there is not a shared definition across all 50 states, so be careful to review your applicable states’ laws.

Generally, if your business has a physical presence in the state, it has a nexus with that state. However, even without physical presence, you can still have a nexus with a state if you meet certain sales thresholds. For example, if you make more than $100,000 of sales in South Dakota, or more than 200 sales transactions within South Dakota in the span of one year, according to the state law you have nexus in South Dakota.

Many states have similar income tax and sales tax nexus laws with varying thresholds. Once determining you have nexus within the state, you will be required to register with the state or jurisdiction. You then must proceed to collect and remit sales tax to the government based on your sales for the year. On the other hand, if your business does not meet any of the tax nexus laws of the jurisdiction, it will not be subject to tax in the state. Instead, the consumer themselves will most likely be subject to the jurisdiction’s consumer use tax or other applicable taxes.

What are the most common ways that a business can have a nexus with a state?

Here are some of the most common ways a business establishes nexus within a state:

  • Physical presence, such as a retail store front, office, warehouse, or other business structure;
  • Meeting a state’s specific sales threshold, typically measured either by a dollar amount or by the number of sales within the state;
  • Hiring employees in a specific jurisdiction, such as a salesperson, administrative professional, etc.

These are not the only ways nexus can be established. Determining nexus, and what sales are taxable, requires a thorough review of the jurisdiction’s rules and regulations.

What are the best ways dropshipping businesses can reduce their taxes?

Below are some key considerations dropshipping businesses should consider  to review, and potentially reduce, tax exposure:

  • Review the Jurisdiction’s Specific Tax Nexus Regulations. Jurisdictions have different rules that may or may not subject your business nexus with the state. Review the jurisdiction’s physical presence requirements, sales threshold amount, and other applicable laws. Laws and regulations are often updated, and you may find that a threshold has changed since you last reviewed it.
  • Obtain Sales Tax Exemption Certificates. Some jurisdictions provide an exemption to sales of goods between the dropshipping business and the supplier or manufacturer where the goods are obtained from. However, businesses are often required to obtain a sales tax exemption certificate and provide it to the supplier or manufacturer upon purchase. Every state has their own rules for how to obtain these certificates, and a thorough review of the regulations surrounding the certificates is required to confirm your business qualifications.

Tax Planning

While there may be no straight-forward, simple way to calculate a dropshipping business’s taxes, with proper planning and review, a dropship business can plan accordingly to meet all state requirements and potentially save on taxes—and avoid penalties for failing to remit sales tax—in the process. Ensure your ecommerce strategy is tax-advantaged. 

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Sources:

[1] https://www.shopify.com/blog/what-is-dropshipping 

[2] https://www.salestaxinstitute.com/sales_tax_faqs/what_is_nexus

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