Drop shipping businesses in USA & Indian Tax Residents Tax implications

Discover the tax implications for dropshipping businesses in the USA and India. Learn about entity types, income tax, international tax forms, Indian laws, and tax treaties to navigate the complexities and ensure compliance while maximizing profits.

Dropshipping has emerged as a popular e-commerce business model that offers numerous benefits, such as low overhead costs, easy scalability, and the ability to offer a wide variety of products without investing in inventory. However, dropshipping also has unique tax implications that every entrepreneur in this field should be aware of. From sales tax to income tax, understanding the tax perspective of dropshipping is critical for avoiding potential legal issues and maximizing profits. In this article, we’ll explore the tax implications of dropshipping, including income tax reporting, and international tax considerations, so you can confidently run your business without worrying about the tax implications. Sales tax on dropshipping business is really complicated stuff and hence we shall discuss the same separately.

• What is Dropshipping?

Dropshipping is a retail fulfillment method where a store doesn’t keep the products it sells in stock. Instead, when a store sells a product, it purchases the item from a third-party supplier and has it shipped directly to the customer. The seller never handles or sees the product, and the supplier handles inventory storage, packaging, and shipping.

The dropshipping business model has become popular in recent years due to its low startup costs and the ease with which an entrepreneur can launch an online store. Rather than investing in inventory upfront, a dropshipper can start selling products immediately, avoiding the risk of sitting on unsold merchandise.

Dropshipping also provides flexibility in terms of the products that can be sold, as there is no need to invest in inventory or commit to specific products. A dropshipper can sell products from multiple suppliers, offering a wide variety of products to their customers.

However, there are some downsides to dropshipping. Since the supplier handles inventory and shipping, the retailer has little control over the customer experience. Delays in shipping or low-quality products can lead to dissatisfied customers, which can harm the retailer’s reputation. Additionally, finding reliable suppliers can be a challenge, and the profit margins on individual products tend to be lower than if the retailer were to purchase and store inventory themselves.

• Possible Dropshipping Business Models in the USA for Indian/ any nationality Owners
• Direct doing business from Indian Sole Proprietorship or Indian Entity
• Opening an Entity in the USA for carrying the dropshipping business

Selling goods directly from the Indian sole proprietor or Indian entity creates many challenges which we will discuss at some other time, currently, in this article, we will discuss conducting the dropshipping business by opening an entity in the US.

• Feasible Entity Types for Dropshipping Business in the USA

• • Limited Liability Company
  • Corporation
• Detailed Analysis of Feasible Entity Types
• Limited Liability Company

• • Protection – LLC provides personal liability protection for the business owner. This means that if the business is sued, the owner’s personal assets are protected from seizure to pay business debts or legal settlements.
  • Easy to setup – The LLC are easy to setup and need less formalities as compared to opening a Corporation.
  • Less compliance requirements – Compared to other business structures, such as corporations, LLCs typically have fewer compliance requirements. This can result in lower administrative costs and less paperwork for the business owner.
  • Flexible management structure – LLCs allow for a flexible management structure, where the business can be managed by the owner(s) or by a group of managers. This can be particularly useful for businesses with multiple owners or for businesses that plan to bring in outside investors.
• Corporation
  • Protection – Like an LLC, a corporation provides personal liability protection for the business owner. This means that if the business is sued or incurs debt, the owner’s personal assets are generally protected.
  • Access to capital – Corporations can raise capital through the sale of stock, which can be attractive to investors looking for an ownership stake in the business. This can provide a source of funding that may not be available to other types of businesses.
  • Tax advantages – Corporations can take advantage of certain tax deductions and credits, such as employee benefits, that may not be available to other types of businesses. 
  • Credibility – Forming a corporation can add credibility to a business and make it more attractive to potential investors, partners, and customers. It also signals a commitment to professionalism and responsibility, which can help the business establish a positive reputation.
  • Perpetual existence: Unlike an LLC, a corporation has a perpetual existence, meaning that the business can continue to exist even if the ownership changes. This can make it easier to transfer ownership or to pass the business down to future generations.

Both the business structures works well for a dropshipping business. In real life, LLCs are more preferred options as they provide limited liability as a Corporation does, however, at the same time are easy to setup and have less compliance requirements. Further, LLCs are hybrid entities and IRS allows them to file an election to choose their tax classification (discussed below in detail). Due to these advantages, LLCs are preferred in the US by the Indian dropshippers.

• Income Tax Implications in the USA

As mentioned above, LLCs are hybrid entities and can choose how they want to be taxed. They have a choice by way of filing an election to be taxed as a Sole Proprietorship (if a single owner), or a Partnership (if more than one owner), or a Corporation (available to both whether single or multiple owners).

On the other hand, a Corporation can only be taxed as a Corporation and can not choose to be taxed as a Sole Proprietorship or a Partnership, unlike the LLCs. Tax treatment for a Corporation and an LLC elected to tax as a Corporation is same under the US tax laws.

This tax election flexibility also make the LLCs a preferred choice over Corporations for doing a dropshipping business. 

Tip – Form 8832 is required to be filed by the LLC to make a tax election.

Tax treatments in various case scenarios

• In case LLC is elected to be taxed like a Sole Proprietorship (Technically, a Sole/Single Member LLC treated as a Disregarded Entity for Tax Purposes)
• As the LLC is treated similar like Sole Proprietorship, LLC will not file a Tax Return in the US. Instead, its Indian Owner, who are Non-Residents of the US, will file a Tax Return in Form 1040-NR and file Schedule C for reporting dropshipping business income.
• The Indian owner will need an Individual Tax Identification Number (ITIN) to file the tax return in the US.
• The Indian owner shall pay tax on the profits of the dropshipping business to the IRS (the tax authority in the US) as per the slab rates defined by the IRS for Individual taxpayers which can be as high as 37% depending upon the amount of taxable income of the Indian owner in the US. 
• Here, it is notable that IRS already knows how much sales your dropshipping business has done, as you will receive a Form 1099-K from the payment gateways like Stripe, PayPal, etc. and e-commerce platforms like Amazon, Shopify, etc. in the US. These payment gateways and e-commerce platforms file this Form to IRS as well, thus, showing less income or non-filing of the tax return will lead to tax notices from the IRS.
• The cash surplus available in the business after paying the taxes to the IRS is freely available to be taken into India subject to FEMA and RBI compliances in India. (FEMA and RBI are the hidden guys sitting in the dark but when they come into light they can wipe out your entire hard earned money to penalties. Be super cautious about this!)
• Technically, the Indian owner cannot take the Foreign Tax Credit of the tax paid in the US on dropshipping business income in her/his personal India Income Tax Return. (We will discuss this below in detail)
• In case LLC is elected to be taxed like a Corporation or the Indian Owner(s) has formed a Corporation to do dropshipping business in the US
  • As a Corporation is separate taxable entity, the Corporation or LLC elected as a Corporation will file their own Income Tax Return in Form 1120 with the IRS.
  • The Corporation or LLC elected as a Corporation shall pay tax on the profits of the dropshipping business to the IRS as per the tax rate defined by the IRS for Corporations. Currently, the Corporate tax rate in the US is flat 21% on taxable income.
  • The cash surplus available in the business after paying the taxes to the IRS can be distributed as Dividend to the Indian Owner(s). However, the dividend income is also taxable in the US at 20%. Thus, a careful consideration is required for Dividend distribution as the profits are taxed twice, first @21% and then the remaining portion distributed as dividend @20%. (There are ways to bring money back to India legally without distributing dividend and save this 20% dividend tax.)
  • Any money brought into India is under the purview of FEMA and RBI. Be super cautious about how you bring back money to India from your US dropshipping business. Believe me, you don’t want to give yourself a tough time with this!
  • Here, the Indian owner(s) can take the Foreign Tax Credit of the dividend tax paid in the US on dividend income in her/his personal India Income Tax Return. (We will discuss this below in detail).
• International Tax Forms
• Form 5472
  • LLC elected to be taxed like Sole Proprietorship – needs to compulsorily file this form to tell the IRS about transaction between the Indian Owner and the LLC. Here, the transaction includes Capital introduction, and Distributions made. Apart from that, any payments between the related parties of Indian owner is also reported here.
  • A Corporation or LLC elected to be taxed as a Corporation – needs to file Form 5472 only if there are transactions between Indian owner(s) and this entity or this entity and related party of the Indian owners(s). But it is notable here that Capital introduction, and Distributions made are not reported here.

Please ensure filing this form as there is a $25,000 penalty attached to it. We are sure that you don’t want that.

• Indian Laws in the Movie
• FEMA in Action
• Overseas Investment Outside India (popularly known as ODI or OI)
• Whether you open an LLC or a Corporation in the US, being a tax resident of India, you have to report this to RBI and file relevant forms with them. This is simply a reporting to the RBI that you have opened a business outside India. The RBI keeps a watch on the dollars you send outside India and the dollars you bring into India.
• Income Tax Act in the Playground
• If the LLC is taxed as Sole Proprietor in the USA

• • Income earned in the US is taxable in India in the personal tax return of the Indian owner. No FTC is, technically, allowed in India.
• If the Indian owner floated a Corporation or elected the LLC to be taxed as a Corporation

• • The business profits are taxed @21% in the US. As the dropshipping business entity is a Corporation or is treated as a Corporation, it need not to file India income tax return and thus business profits are not taxed in India. However, the dividend distributed to the Indian owner(s) is taxed in the US as well as India. 
  • FTC will be allowed in India on tax paid on dividend by the Indian owners(s) in the US.
•  Reporting in Schedule FA and FSI in India Tax Return
  • Schedule FA – Details of Foreign Financial Interests, is required to be completed as the India owners hold interest in either LLC or Corporation. That is reported to the India Income Tax Department.
  • Schedule FSI – Details of Income accruing or arising outside India, is to be completed to disclose the US source income earned by the Indian owner(s). Whether the Indian owner earn Business Profits in LLC taxed as Sole Proprietorship or Dividend in a Corporation or LLC taxed as a Corporation, both is reported on Schedule FSI.
• Tax Treaty in the Game!
• Permanent Establishment (PE) Issues

• • The US-India Double Taxation Avoidance Agreement (DTAA) covers that the US business entity whether LLC or Corporation, PE shall be the place where the decision making about the business is happening. Technically, as the Indian owner(s) are sitting in India and taking the decisions, thus, as per the DTAA, the PE of the US dropshipping business entity should be in India.
  • Taxation of Business Profits
  • As per the US-India DTAA, the Business Profits of the US dropshipping business is taxable in the country where PE is located. Technically, as explained above, if the PE is in India due to decision making is in India, the profits should be taxable in India and not in the US. A treaty based position must be claimed in the US tax return (Form 1040-NR or 1120) to say that PE is in India and India will take the tax.
  • But, this raises an issue that the US tax authorities must be satisfied of this reasoning otherwise they can tax the entire income in the US and on the downside, Indian Tax authorities may not allow the FTC of this as well.

• Taxation of Dividends

• • As per the US-India DTAA, the dividend income is taxable both in the US and India and thus, FTC is also allowed. As dividend income is received by the Individual Indian owner(s), the same will be taxable in their personal hands.

Conclusion

Dropshippers planning to start business in India should go by incorporating a separate entity in the US, preferably an LLC. It is easy to setup, have less compliance requirements, and have tax election flexibility attached to it. As discussed above in detail, there are potential tax issues in case the LLC is taxed as a disregarded entity (similar to a Sole Proprietorship). The US-India tax treaty sources entire income to India due to PE issues (as Sole Proprietor business can only be controlled where the owner is situated) and thus no FTC shall be allowed by the India income tax department. A possible solution (not a full proof – in fact, no full proof solution exist till date) for this can be electing the US LLC as a Corporation or floating a Corporation to do the dropshipping business. This gives the US business entity a separate tax structure which is separate from its owner(s) unlike a disregarded entity which do not have its own identity and owner is considered as the business itself. Controlling issues in the Corporation can be managed by appointing a manager on records in the US and saying that the decision was taken in the US by such person. Further, there are ways funds can be brought back into India by way of current account transactions from the US entity legally under FEMA and Income Tax Act and dividend tax can be planned smartly within the purview of law. 

Dropshipping business is very rewarding and cost efficient as compared to other business models, a proper business structure and tax planning can save you a lot of time and efforts at a later stage as well as your hard earned money. It is not difficult at all, many dropshippers are already doing it legally, following both the countries laws and regulations. It just takes your conscious decision to abide by the law and earn money with complying with the requirements laid by the law.

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If you need any assistance in filing this form or any other service related to us tax, accounting, and compliance please contact us @ services@ustaxconsultant.com.