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How to Set Up Shopify Taxes for Dropshipping

Written and researched by experts at AvadaLearn more about our methodology

By Sam Nguyen

CEO Avada Commerce

Drive 20-40% of your revenue with Avada
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Even when you’re dropshipping, there are still taxes that you’re obligated to fulfill. Do you know what they are? If you don’t know yet, this article will break down what are the taxes that you need to pay when you dropship, how much you need to pay for each, and how you can pay. I know, I know, you hate taxes. All of us do, so it would be surprising if you don’t.

Fortunately, it’s not hard to meet your tax obligations as a dropshipping entrepreneur. I will show you what your tax obligations are when you do dropship with Aliexpress and how you can setup Shopify Taxes for Dropshipping so that taxes will be automatically collected for you when you make sales.

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Before we jump into the details, please keep in my that this article is pure advice from the Internet, not from well-trained accountants or lawyers, so that means you should always seek further advice from an expert, and not just rely on the advice that I’m going to be giving in this article. Now, let’s dive into the first question.

What taxes do you need to pay when it comes to dropshipping?

Did you know there are certain types of taxes that you need to consider when calculating the Shopify taxes for dropshipping? Let’s break down some of the most common ones below:

1. Income Tax

What is income tax?

Set up Shopify taxes for dropshipping: income tax

Income tax is the money that you need to pay based on the profit that you store generates in a year. When you’re operating a store, you have revenue and net profit.

Net profit (Before taxes) = Revenue - Marketing costs - Inventory costs - Overhead costs.

Your income tax is calculated based on your net profit when do dropshipping before taxes. This is similar to when you have a job; you will have to pay income taxes based on your salaries. Your store’s net profit before taxes is basically the “salaries” based upon which you’ll have to pay tax.

How to calculate income tax?

Let’s break down the process step by step in straightforward terms, starting with the costs or fees involved in determining your taxable income:

  1. Dropshipping Revenue: This is the total income you earn from selling products through your Shopify store before any deductions.
  2. Business Expenses: These costs are directly related to running your dropshipping business. They include Shopify fees, transaction fees, advertising expenses, website maintenance costs, office supplies, and shipping costs not passed on to customers.
  3. Cost of Goods Sold (COGS): COGS encompasses the expenses associated with purchasing products from suppliers, shipping costs, and other directly related expenses.
  4. Gross Profit: After subtracting the COGS from your dropshipping revenue, your gross profit remains. It reflects the income earned from your sales before accounting for other expenses.
  5. Net Income: After subtracting all allowable business expenses from your gross profit, you arrive at your net income—the total income earned from your dropshipping business.
  6. Self-Employment Tax: Self-employed individuals are subject to self-employment tax, covering Social Security and Medicare taxes. The rate is 15.3% on the first $142,800 net income and 2.9% on any amount above that threshold.
  7. Income Tax: Your income tax is determined by your net income and the applicable tax bracket. The USA uses a progressive tax system, meaning different portions of your income are taxed at different rates.
  8. Deductible Taxes: After calculating your income tax, consider any tax credits or deductions you may qualify for, such as the qualified business income deduction or retirement plan contributions.
  9. Total Tax Liability: Add your self-employment and income tax (after deductions) to determine your total tax liability.
  10. Estimated Quarterly Taxes: If required, divide your total tax liability by four and make estimated tax payments throughout the year.
  11. Final Tax Return: Report your dropshipping income, deductions, and tax payments on your annual tax return using Form 1040 and Schedule C.

Example of Final Tax Return: If your dropshipping business earned $50,000 in income and you have $20,000 in deductions for expenses like software subscriptions and advertising, along with $5,000 in estimated tax payments throughout the year, you would report these on your Form 1040 and detail the income and expenses on Schedule C. This results in a net profit of $30,000, which you would be taxed on after factoring in the estimated tax payments already made.

Overall, understanding the costs of calculating your dropshipping income tax is essential for maintaining your business’s financial health. Consulting with a tax professional can provide valuable guidance tailored to your specific circumstances and help ensure compliance with tax regulations.

2. Sales tax

What is sales tax?

Set up Shopify taxes for dropshipping: sales tax

First off, while income tax is imposed on your net profit when do dropshipping, sales tax is imposed on the goods/services that you sell. Income tax is imposed by the federal government, so it’s applied nationwide. On the other hand, sales tax varies based on the state you live in.

How to calculate sales tax?

Here are the key considerations about dropshipping sales tax on Shopify:

  • Identify Nexus: Determine the states where you have sales tax nexus based on your business activities.
  • Collect Sales Tax: Use the appropriate sales tax rate for each transaction, and collect the tax from your customers at the time of purchase.
  • Record Sales Tax: Keep detailed records of the sales tax you collect for each state and each transaction.
  • Calculate Tax Owed: Calculate the total sales tax owed for each state by summing up the sales tax collected from all your transactions in that state.

For instance, suppose you have three transactions in California with sales taxes collected: $5.00, $3.50, and $6.25. To calculate the total sales tax owed to California, you would add these: $5.00 + $3.50 + $6.25 = $14.75. This means you owe California $14.75 in sales tax for these transactions.

  • File Sales Tax Returns: File sales tax returns with the tax authorities in each state where you have nexus, reporting the sales tax collected and remitting the funds to the appropriate state agencies.
  • Stay Compliant: Keep track of changes in sales tax laws or rates to ensure ongoing compliance.

It’s important to note that sales tax rates can vary depending on the specific location within a state. Even within the same state, tax rates can differ based on city, county, or special taxing districts. For the most accurate sales tax information, consult a tax professional or refer to your state’s Department of Revenue website.

3. Value-Added Tax

Shopify Dropshipping Value-Added Tax (VAT) refers to the tax you might need to charge your customers if you’re dropshipping to countries that use a VAT system. This tax is similar to a sales tax and is applied to the value of the goods you sell. Common in Europe and other regions, VAT rates can be substantial (e.g., 20% in the UK).

VAT rates and how you manage them vary between countries. It’s crucial to familiarize yourself with the specific VAT rules for every country where you sell products to ensure you’re correctly charging, collecting, and paying (remitting) the VAT. Please do so to avoid penalties and complications with tax authorities.

4. Import Taxes and Customs Duties

When dropshipping products from suppliers in other countries, your customers might have to pay additional fees called import taxes and customs duties. These are charged by their local customs authorities when the shipment arrives in their country. 

As the retailer, you’re not responsible for paying these fees directly. Still, it’s crucial to inform your customers about them upfront. This will inform them about potential extra costs associated with their order and avoid unpleasant surprises.

Being charged on products shipped internationally, these fees can vary depending on the product and country of origin.

5. Self-Employment Tax (if based in the US)

You’ll be responsible for paying Social Security and Medicare taxes if you’re self-employed. In 2023, this is 15.3% of your net business income.

6. Business Registration

Depending on where you operate and the size of your venture, registering your Shopify dropshipping business with the relevant tax authorities might be necessary. This registration process typically involves obtaining a tax identification number and ensuring compliance with local tax laws and regulations. 

By completing this step, you ensure that your business is legally recognized and can fulfill its tax obligations, helping you avoid potential penalties or legal issues.

7. Tax Deductions

Dropshipping comes with business expenses; luckily, many of those costs can be tax deductions! This means they can lower the amount of income you’re taxed on. You can deduct advertising, website costs, office supplies, and other expenses for running your shop. 

Tax laws can be tricky, so getting help from a tax professional is always a good idea. They’ll make sure you get all the deductions you deserve and avoid any potential fines for mistakes.

How to set up dropshipping sales tax in Shopify?

1. Register for Sales Tax

Before setting up taxes on Shopify, determine if your business has a sales tax nexus in any state. A sales tax nexus connects your business to a state that mandates you collect and remit sales tax. Register for a sales tax permit with the state’s tax authority if you have a nexus in a state.

2. Enable Automatic Taxes

Shopify offers an automatic tax calculation feature that simplifies tax management. To enable this feature, access your Shopify admin dashboard, navigate to Settings and select Taxes and Duties

set up dropshipping sales tax in Shopify

3. Set Up Origin-Based or Destination-Based Tax

Decide whether you need to set up origin-based or destination-based tax. Origin-based tax applies the tax rate based on your business location, while destination-based tax applies the tax rate based on the customer’s location. Most states in the USA utilize destination-based tax.

set up dropshipping sales tax in Shopify

4. Enter Tax Rates for Your Nexus States

For states with a sales tax nexus, enter the applicable tax rates. You can typically find this information on the state’s tax authority website. If your business operates in multiple local jurisdictions within a state, you may need to set different tax rates for each.

set up dropshipping sales tax in Shopify

5. Enable Taxes for Other States

Even if your business has no physical presence in certain states, you might still be required to collect sales tax due to economic nexus laws. You can enable taxes for these states in Shopify by choosing to Charge taxes on all products

6. Exemptions and Product Taxability

Certain products may be exempt from sales tax or subject to reduced tax rates in specific states. In the Taxes settings, you can set up exemptions or custom tax rates for these products.

7. Test Tax Settings

After configuring your tax settings, conduct test orders from different states to ensure that the correct tax rates are applied based on the shipping address.

8. Stay Compliant

Sales tax laws can change, so staying informed about any updates or revisions in tax regulations is vital. If there are any changes, promptly update your tax settings to remain compliant.

9. File and Remit Taxes

As you collect sales tax from customers, maintain accurate records of the taxes collected. Depending on your location and sales volume, you may need to file and remit sales tax to the appropriate tax authorities regularly. Shopify facilitates the generation of reports to streamline this process.

set up dropshipping sales tax in Shopify

Final Words

So, here are the key takeaways from this article for you.

  1. You’re obligated to pay income tax on the net profit that your store generates. This is paid to your government where you’re based, and you will need to pay this tax annually.
  2. Online merchants are required to collect and pay sales tax in any state where they have a physical presence.

I hope this article has relieved the headaches that taxes have caused you and help you to set up your Shopify Taxes for Dropshipping easier.

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Yes! As your business grows, handling taxes for many states gets trickier. Third-party apps specifically designed for e-commerce tax management can be a lifesaver. Popular ones include Avalara, TaxJar, and Quaderno. These often integrate directly with Shopify for a smoother experience. Research which app has features that best fit your business size and sales volume.

Selling internationally means dealing with a whole new set of tax rules! Countries often use VAT (Value-Added Tax) rather than sales tax. You might also face import duties/fees. Each country has different regulations, so you must do extensive research or hire a tax professional with international expertise to avoid trouble with foreign tax authorities.

Tax laws change frequently, and states increasingly adopt "economic nexus" thresholds (meaning you collect tax if you sell a lot, even with no physical presence). At a minimum, review and update your Shopify tax settings before each tax season. Ideally, check for quarterly or monthly changes if your business has a high sales volume.

Sam Nguyen is the CEO and founder of Avada Commerce, an e-commerce solution provider headquartered in Singapore. He is an expert on the Shopify e-commerce platform for online stores and retail point-of-sale systems. Sam loves talking about e-commerce and he aims to help over a million online businesses grow and thrive.