Tax Startups: Innovation Driven by 'No Taxation Without Innovation'

The Complexities of Sales Tax and Emerging Solutions

A curious situation exists in New York City: a toasted bagel with cream cheese is subject to sales tax, while an untoasted version is not. Similarly, in Illinois, confectionery items are taxed, however, those containing flour – like a Kit Kat – are classified as groceries and remain exempt. Even more peculiar, Colorado levies a tax on coffee cup lids, considering the cups themselves essential packaging.

These instances, though seemingly minor, highlight the often-unpredictable nature of sales tax. This fee, paid by consumers on purchases, requires businesses to remit funds to the correct governing bodies. While arguably the most intricate form of indirect taxation, companies must also navigate use tax, property tax, and value-added tax (VAT).

Challenges in Tax Calculation

The conceptual understanding of these taxes is straightforward, but their actual calculation is remarkably complex. This is especially true for sales tax, which is regulated by over 11,000 distinct jurisdictions within the United States.

Businesses cannot reliably predict annual tax obligations using past accounting methods. Local tax laws are subject to frequent changes, fluctuating as much as 25% annually.

Large corporations experience substantial expenditures on financial planning and analysis to ensure sales tax compliance. Small businesses, however, are in a more difficult position. They often lack the resources for professional tax preparation and the internal expertise to manage these filings effectively.

Consequences of Non-Compliance

Regardless of company size, inaccurate sales tax payments can lead to significant penalties, potentially even resulting in business failure.

New Solutions for Indirect Tax Management

Fortunately, a new wave of companies is developing to assist businesses in managing the complexities of indirect taxes.

• TaxJar provides automated sales tax calculation and filing services.
• Taxdoo focuses on VAT compliance for e-commerce businesses.
• Fonoa offers a comprehensive platform for managing indirect taxes globally.

These startups aim to simplify the process and reduce the burden of indirect tax compliance for businesses of all sizes.

The Growing Importance of E-commerce Tax Compliance

Historically, small businesses could navigate tax season relatively easily by primarily serving local customers and operating within a limited number of tax jurisdictions. However, the rise of e-commerce has fundamentally altered this landscape.

This shift occurred in two significant ways. Firstly, even small-scale operations have evolved from traditional brick-and-mortar stores into multifaceted businesses engaging in online transactions through various platforms. These include direct-to-consumer websites, third-party marketplaces like Amazon and Etsy, and wholesale distribution networks.

Consequently, businesses now face the complexity of calculating potentially numerous sales tax rates across diverse channels and associated tax codes, a stark contrast to the single tax type previously managed by many storefront enterprises.

Secondly, e-commerce has dramatically expanded the geographic reach of businesses, enabling sales across state and even national borders. For a long time, this presented an advantage, as outdated laws stipulated that tax obligations were limited to locations with a physical nexus, or established presence.

The 2018 Supreme Court decision in South Dakota v. Wayfair overturned this precedent. The ruling mandates that businesses exceeding specific digital revenue thresholds must remit taxes in all states and localities where they conduct sales.

Many businesses have responded to these increased tax responsibilities with inadequate compliance or outright neglect. However, the economic consequences of the recent pandemic are making such practices increasingly unsustainable.

State and local governments are experiencing significant budgetary deficits, and with sales tax representing a crucial revenue stream – second only to federal funding – they are intensifying tax code enforcement.

Furthermore, governments are enacting new legislation to broaden the definition of taxable goods and services. Given the projected long-term financial impact of the pandemic, a return to previous enforcement leniency is improbable.

Instead, it is highly likely that the COVID-19 pandemic will serve as a catalyst for states to explore innovative methods of maximizing sales tax revenue generated from e-commerce activities. This will require businesses to prioritize tax compliance.

The Need for Enhanced Tax Compliance Solutions for SMBs

Despite demonstrable market demand, a significant gap exists in the quality of tax compliance services offered to businesses by established software providers. Many large organizations depend on their enterprise resource planning (ERP) systems, utilizing sales and use tax modules for liability calculations.

However, these systems often necessitate manual input of tax rates for individual SKUs and locations. This places the responsibility for maintaining accurate and current tax code tables squarely on the company, leading to extensive spreadsheet management and considerable manual effort.

Consequently, finance teams frequently augment their ERPs with on-premise tax compliance software, which can be cumbersome to implement and maintain, especially given evolving regulations. Replacing these established solutions is costly and time-consuming for larger enterprises, creating a barrier to entry for new vendors.

Conversely, a substantial opportunity exists within the small and medium-sized business (SMB) sector, where effective tax software is often absent. This presents a fertile ground for innovative startups focused on delivering new tax solutions.

Avalara: A Pioneer in Cloud-Based Tax Compliance

Recognizing this market need, Avalara emerged in 2004 as a cloud-based sales tax compliance provider. The company has since achieved a market capitalization of approximately $13 billion. While expanding its offerings to serve larger enterprise clients, including Zillow and Adidas, Avalara maintains a primary focus on SMBs.

Avalara streamlines tax processes by reducing the need for SKU-specific data entry and automating various indirect tax calculations. The platform boasts over 700 integrations with popular accounting, ERP, e-commerce, and point-of-sale (POS) systems, alongside a strategic partnership with Shopify.

Despite its growth, Evercore estimates Avalara currently holds less than 3% of the global tax compliance market. This indicates considerable potential for new, cloud-native startups to gain traction within the industry.

Emerging Startups: TaxJar and LumaTax

Two startups are actively addressing the unmet needs in the tax compliance landscape. TaxJar, founded in 2013, specifically targets SMBs with a flexible API, currently serving over 10,000 businesses in managing their e-commerce sales tax obligations.

Strategic partnerships with Square, Stripe, and Amazon have further solidified TaxJar’s position. LumaTax, established in 2016, concentrates on providing software solutions for CPA and accounting firms, enabling them to navigate the complexities of sales tax in the post-Wayfair era.

The early success of both TaxJar and LumaTax demonstrates a strong demand among smaller businesses and their accounting professionals for specialized and effective tax solutions.

Tax compliance is evolving through consolidation

The United States isn't alone in experiencing significant shifts within its tax landscape. Globally, the expansion of e-commerce and the widespread impact of globalization are generating complex challenges for businesses when determining various indirect taxes.

Value-added tax (VAT), the European equivalent of sales tax, is particularly affected, traditionally being calculated based on the destination of the goods or services.

The ease with which consumers can now acquire products from international vendors, such as purchasing a rug from India via eBay or from a Texas-based Overstock retailer, is comparable. This surge in cross-border transactions has created a critical demand for robust tax solutions addressing VAT and other associated taxes.

Brexit has further amplified this need. Several emerging companies are developing solutions tailored to this evolving commercial environment.

Taxdoo, a German company established in 2016, automates VAT calculations, moving away from manual spreadsheets and email exchanges. Fonoa, an Irish startup founded in 2018, provides online marketplaces with an API.

This API enables real-time reporting of sales transactions and management of diverse tax responsibilities based on geographical location for their clientele.

The South Dakota v. Wayfair decision spurred demand for advanced tax compliance software, but the COVID-19 pandemic has elevated this demand to a critical level for business owners.

While Avalara currently dominates the domestic cloud-based tax compliance software market, we are still witnessing the initial phase of innovation. This first wave primarily focuses on digitizing previously manual processes.

Future Trends in Tax Compliance

We foresee that sales tax compliance, mirroring other areas within fintech, will continue to advance rapidly. A second, more refined stage will emerge, characterized by intuitive integrations and versatile systems.

These systems will integrate multiple tax modules and leverage data-driven insights. They will streamline calculation, remittance, and payments.

Furthermore, they will offer users valuable data to support their business expansion. For business owners navigating the challenges of the past year, this will not simply be advantageous; it will be essential.