In New York City, if you order a toasted bagel with cream cheese at a deli, you have to pay sales tax. Ask for that same bagel unprepared? You won’t. In Illinois, candy is subject to sales tax, but candy with flour is considered a regular grocery item. Meaning: A Kit Kat is tax-free, but M&Ms will cost you extra. And in Colorado, your daily coffee cup is considered essential packaging, while the lid is not, making it subject to a nonessential packaging tax.
These examples may seem trivial, but they illustrate the idiosyncrasies of sales tax — a fee consumers pay on their purchases that must ultimately be reconciled with the appropriate jurisdictions. Though sales tax is arguably the most complex type of indirect tax, businesses must also contend with other indirect taxes such as use tax, property tax and value-added tax (VAT).
Given the market needs for tax compliance, it’s somewhat shocking how poorly companies are being served by the majority of legacy software companies.
Such taxes may be easy to understand conceptually, but their calculation is convoluted in practice — particularly for sales tax, which is governed by more than 11,000 unique jurisdictions in the U.S. alone. There is no reliable methodology businesses can use to calculate annual remittances based on previous years’ accounting formulas because local tax code changes as much as 25% every year.
For large corporations, sales tax compliance drives sky-high financial planning and analysis spending, and small businesses face an even worse predicament because they can neither afford outsourced tax preparation nor have the expertise to handle this filing. No matter a company’s size, failure to pay the correct amount of sales tax can result in severe penalties and even bankruptcy.
Now, a new legion of startups is emerging to help companies manage the intricacies of indirect taxes, including TaxJar, Taxdoo and Fonoa.
Why does this matter now?
Smaller businesses have, until fairly recently, managed to limp through tax season by selling goods and services locally, and thus operating within relatively consolidated tax jurisdictions. But e-commerce changed this in at least two profound ways.
The first is that even the smallest businesses have transformed from simple brick-and-mortar ventures to complex entities transacting in multiple places online, including via their own storefronts and websites, third-party vendors such as Amazon and Etsy, and wholesale channels. Previously, a small business may have calculated a single type of sales tax — traditionally for storefront enterprises. Now, they may have to calculate different taxes across an increasing number of channels and their resulting tax codes.
Second, e-commerce expanded companies’ geographic reach, allowing them to sell across state and country lines. Until recently, this was an unqualified advantage to small businesses, which benefited from outdated laws requiring most businesses to pay taxes only where they had established nexus, or physical presence. But the 2018 Supreme Court case of South Dakota v. Wayfair put an end to that, with the court ruling that businesses with digital revenue levels above a certain threshold must pay taxes in all states and municipalities in which they sell.
To a large extent, businesses have met the resulting increase in their tax obligations either sloppily or not at all. But the economic fallout from the pandemic is making such noncompliance far less tenable as state and local governments face fiscal shortfalls. With states traditionally relying on sales tax as a primary source of revenue (second only to federal receipts), local governments are beginning not only to enforce their tax codes more vigilantly but also to create new laws that broaden the scope of taxable goods and services.
Given that the financial losses of the pandemic are projected to extend for years, it is unlikely states will revert to their previously relaxed standards of enforcement. Instead, it is far more plausible that COVID-19 will prove an opportunity for states to find new ways to capitalize on sales taxes related to e-commerce.
Small and medium businesses need more options for tax compliance
Given the market needs for tax compliance, it’s somewhat shocking how poorly companies are being served by the majority of legacy software companies. Most large retailers commonly rely on their enterprise resource planning (ERP) vendors, which enable them to calculate tax liabilities using sales and use tax modules, but still require companies to enter tax rates for specific SKUs and locations.
This means the onus remains on the company to populate rate tables with up-to-date tax code, leaving lots of Excel spreadsheets and hours of manual processing for business owners. Finance departments must, in turn, frequently supplement their ERPs with on-premise tax compliance software that is clunky, difficult to deploy and requires yearly maintenance in accordance with changing regulations.
These solutions, although not optimal, often cost significant time and money to replace, making it difficult but not impossible for new tax-solution vendors to replace incumbent programs for large enterprises. On the other hand, many small- and medium-sized businesses typically have no effective tax software in place, representing a green field for startups offering new tax solutions.
One of the first players to realize this opportunity was Avalara, a cloud-based provider of sales tax compliance software founded in 2004 that now has a market cap of nearly $13 billion. Although Avalara continues to move up-market with products catering to enterprise customers (it counts Zillow and Adidas among its clients), the company remains focused primarily on small- and medium-sized businesses, alleviating the burden of supplying SKU information and automating a variety of other indirect taxes. Avalara has over 700 integrations across accounting, ERP, e-commerce and POS systems and a partnership with Shopify.
While Avalara has continued to grow, investment bank Evercore estimates that Avalara corners less than 3% of the global tax compliance sector. This leaves lots of room for new, cloud-based startups to make inroads. Already, two startups have emerged to tackle tax compliance. The first, TaxJar, founded in 2013, targets SMBs with a customizable API and is already being used by more than 10,000 businesses to help manage their e-commerce sales tax. The company has further cemented impressive partnerships with Square, Stripe and Amazon.
The other, LumaTax, founded in 2016, provides CPA and accounting firms with software to help them “stay ahead of the sales tax curve in a post-Wayfair world.” The early success of these companies speaks to just how eager many small vendors (and their accountants) are for tailored tax solutions.
The future of tax compliance lies in consolidation
America is not the only country undergoing seismic changes in its taxable economy. Internationally, e-commerce and the far-flung effects of globalization are creating unprecedented complications for companies calculating a variety of indirect taxes, most saliently sales tax’s European counterpart, value-added tax (VAT), which is traditionally calculated based on destination.
It is now as easy to purchase a rug from India on eBay as it is to order one from an Overstock vendor in Texas. The resultant increase in cross-border sales has produced a pressing need for comprehensive tax solutions for VAT and other related taxes, a need even further intensified by Brexit.
A handful of young startups are developing tools for this new era of commerce. The German-based Taxdoo, founded in 2016, calculates VAT by replacing spreadsheets and email threads with an automated platform. Another startup founded in 2018 and based in Ireland, Fonoa, equips online marketplaces with an API that allows them to report sales transactions through a real-time dashboard and manage a variety of tax obligations for their customers based on locale.
If South Dakota v. Wayfair created a new market need for intelligent tax compliance software, COVID-19 has made that necessity nearly existential for business owners. While Avalara has led the way domestically in cloud-based tax compliance software, we believe we are still in the first wave of such innovation, which consists primarily of bringing analog systems online.
We anticipate that sales tax compliance, like other segments of fintech, will continue rapidly evolving toward a second, more sophisticated stage defined not only by its user-friendly integrations but by multitasking systems that combine even more tax modules and data-driven intelligence.
Such innovation will facilitate calculation, remittance, payments, and more — while providing users with valuable insights to power their growth. As business owners work to recover from the difficulties produced by the last year, this will not be a luxury; it will be imperative.