Supply Chain Chaos: Navigating 3PLs and State Income Tax

Key Takeaways for Ecommerce Brands:

1. ‍Supply chain disruptions are increasingly complex and frequent, with recent events like Houthi attacks, hurricanes, and labor strikes creating significant logistical challenges for businesses.

2. Third-party logistics providers (3PLs) offer critical support during supply chain instabilities, providing flexible resources and proactive risk management, but can unexpectedly trigger tax obligations across multiple states.

3. Using 3PLs or Amazon FBA can create "nexus" for state income tax purposes, potentially requiring businesses to pay taxes in states where they have inventory, even if they have no direct physical presence in those states.

Steve Lamar had reached his limits. “Enough already!” the CEO of the American Apparel and Footwear Association wrote in an email statement, after key ports on Canada’s West Coast shut down because of a labor strike in early November, leaving  U.S. trade in limbo once again. “Logistics networks are over-stressed, with Houthi attacks still diverting global trade and the threat of an East Coast strike pushed to mid-January.”

What pushed the threat to January was a tentative agreement that suspended the first large-scale work stoppage by East and Gulf Coast dockworkers since 1977. That stoppage had a $12 billion impact on the U.S. economy. It also confirmed what every brand operator has known since the COVID-19 pandemic: in the aftermath of every supply chain disruption, there's another supply chain disruption.

Here’s a partial list of events from the last few months (not including strikes) that disrupted supply chains: the CrowdStrike-Microsoft IT outage, back-to-back hurricanes – Helene and Milton – hitting the Gulf of Mexico and southeast U.S., and Houthi attacks targeting shipping routes in the Red Sea.   

The ongoing instability in the Middle East, in particular, has had notable ramifications for supply chains, including:

• Rising insurance costs, which in turn raises the overall cost of shipping goods and hurts business profitability.

• Rerouting of vessels as a security measure, leading to longer transit times.

• Disruption of key trade flows

Strategic Resilience: Leveraging 3PLs in Uncertain Times

Supply chain disruptions pose significant risks for DTC brands, affecting various aspects such as inventory management and customer satisfaction. Struggling to navigate these turbulent waters, many brands use third-party logistics providers (3PLs) to oversee and manage their supply chain management.

3PLs provide various services such as shipping, warehousing, packing, and order fulfillment. According to a recent market research report conducted by Inbound Logistics Magazine, the most popular services 3PLs offer are:

• Motor freight – purchased by 82% of brands.

• Expedited shipping and small package deliveries (74%)

• Logistics technologies like transportation management systems or warehouse management systems (72%)

Using 3PLs in times of disruptions can be especially beneficial, as you can take advantage of their flexible resources and vast network of carriers and partners. In addition, 3PLs typically take proactive measures to prepare for unexpected events, including regularly conducting risk assessments and establishing contingency plans to deal with supply chain shocks. 

Nexus Nightmares: Tax Risks for Online Retailers

While utilizing 3PLs can provide huge benefits on the operational side, it's important to be aware that they could also complicate things when it comes to a crucial financial aspect – ecommerce taxes. The reason is simple: 3PLs may create sufficient nexus to trigger income tax obligations in states brands don't even know they have a connection to.

Nexus, in tax parlance, is a connection between a business and a tax-collecting jurisdiction. The most straightforward nexus is any sort of physical presence in the state, whether it's property, an office, or employees. However, it could also be something less obvious, like having inventory in an Amazon facility. And this is where 3PLs come into play.

Let's use a hypothetical example to explain this: a DTC brand ships inventory to the closest warehouse operated by its 3PL. The third-party provider, trying to expedite order fulfillment, distributes that inventory to other warehouses it owns across the country. Now, the brand – without realizing it – has inventory in multiple states, including ones where warehousing stock constitutes physical presence.

Some states employ a factor presence nexus standard to determine if a business has to pay income tax. Typically, factor-based nexus is met if any of the following thresholds are exceeded in the state (the amounts might be adjusted annually to take inflation into account):

• $50,000 of property
• $50,000 of payroll
• $500,000 of sales
• 25% of total property, total payroll, or total sales.

It's important to note that a factor-based nexus standard does not necessarily replace the physical nexus test. For instance, a state may decide that warehousing inventory creates a nexus even if the stock is worth less than $50,000, providing that the brand is actively engaged in transactions for business profitability.

Fulfillment and Taxation: Amazon FBA's Minefield

Businesses selling with Amazon FBA (Fulfillment by Amazon) are generally subject to the same tax regulations that apply to 3PLs, though there are exceptions. In 2022, for example, the Pennsylvania Commonwealth Court ruled that the state could not collect taxes from retailers who housed inventory in a local Amazon facility, determining that the arrangement was insufficient to create a nexus.

California, on the other hand, has been particularly aggressive in collecting income tax from brands selling with Amazon FBA – even if the business is not located in the state. The Golden State considers having inventory above a certain threshold as “doing business” in California, triggering the state’s minimum $800 annual franchise tax fee.

So, what's the bottom line? It's complicated. With supply chain disruptions showing no signs of slowing down, leveraging 3PLs has become an increasingly attractive option for ecommerce brands. However, brands must remain vigilant about ecommerce taxes to avoid another supply chain issue – this time in the form of unexpected financial liabilities.