Tax Tech — how it helps you make free money and what’s next

I am pretty sure many people have seen this MainStreet promotion on either LinkedIn or Twitter recently. By plugging into startups’ payroll systems, MainStreet matches startups with eligible tax incentive programs (federal and state ones) and helps them to apply for tax credits. When I first learned about MainStreet on Twitter from some other VC folks last year, it sounded like a no-brainer to me — why would I, if I were a startup founder, hesitate to use MainStreet if they can help me to get $50K+ free money back from the IRS in 20 minutes?

Startups apply for economic incentives through MainStreet’s platform, and then MainStreet takes a 20% cut of any successful application. Notably, that cut is only taken when the incentive is actually disbursed (there’s no upfront cost), and there is also no on-going subscription fee to use the platform.

Source: TechCrunch

Big Problem

MainStreet is just one of the many startups that I have seen from the emerging Tax Tech space in recent years. It is not difficult to understand why tax tech is deeply needed by businesses, and here are the primary problems:

1. Fundamental complexity: the tax system is always super complicated, making it hard — if not impossible — for individuals and small businesses/startups to understand, comply, and optimize.
2. Fragmented information: there are many economic development programs with tax incentives that businesses can take advantage of, while many of them are not being fully utilized as startups may not know these programs/credits at all or do not know how to get qualified.
3. Manual qualification and application process: even if the startups know these programs, they still need a tax professional to help them analyze the data (e.g. payroll, business operations), see if the company is qualified for those incentives, and then file applications. This process is very manual and expensive.
4. Strong demand post-COVID: it will take a while for the economy to recover from the impact of COVID-19, and any cost-saving technology will be very helpful during this economic downturn.

You may still wonder what kind of tax incentive programs are there, and I did some quick research to show you some examples.

According to the State Business Incentives Database, there are 2,336 incentive programs in the US including 645 tax credit programs and 310 tax exemption programs.

In terms of types of tax incentives, there are just so many: jobs and investment tax incentives, tax incentives targeted at specific industries (technology, film, agriculture, manufacturing, etc.), and geographically targeted tax incentives.

Beyond the tax incentives from the economic development programs, there are also some programs carried out during COVID to help businesses to recover. For example, according to the IRS website, certain employers are eligible to claim the Employee Retention Credit.

On the other hand, there are many traditional tax credits that small businesses and startups can take advantage of. These tax credits include:

1. General Business Tax Credit
2. Credit for Small Employer Health Insurance Premiums
3. Credit for Paid Family and Medical Leave
4. Alternative Fuel Credits
5. Alternative Motor Vehicle Credit
6. Disabled Access Credit
7. Credit for Employer-provided Childcare Facilities and Services
8. Rehabilitation, Energy, And Reforestation Investment Credit
9. Increasing Research Activities Credit
10. Small Employer Pension Plan Startup Costs Credit
11. Work Opportunity Credit
12. Empowerment Zone Employment Credit
13. New Markets Credit
14. Tax Cuts and Jobs Act
15. Extended Paid Leave Benefits Credit
16. More.

Now you may not be surprised anymore when you see the revenue growth chart of MainStreet. It is basically the most beautiful revenue growth that investors want to see, and it makes a lot of sense because the company creates a win-win-win result. For startups, MainStreet is helping them to get free money, and there is zero upfront cost for startups to use MainStreet. For governments, “we can report back to cities and states showing exactly what their tax dollars or tax credits are being utilized for,” MainStreet’s CEO & Founder Ludlow said during a TechCrunch interview, “So the accountability is orders of magnitude greater than they had before. So already, there’s this better system for tracking the success of incentives.”

Horizontal Strategy — MainStreet

The strategy that MainStreet uses to help startups is a horizontal one. According to the same TechCrunch article, right now, MainStreet’s core clientele are startups applying for payroll credits and research and development credits, but MainStreet’s CEO & Founder Ludlow says that MainStreet is working to expand beyond its tech roots to all small businesses such as restaurants. The company also wants to expand the number of economic development programs that startups can apply for. Given the myriad of governments and programs, there are hundreds if not thousands of more programs to onboard onto the platform.

In short, MainStreet will help small businesses from different industries to apply for tax incentives from many programs.

Vertical Strategy — Benepass

Another interesting company that I have met from this space is called Benepass. Instead of helping businesses to apply for all eligible tax incentives, Benepass focuses on helping employers & employees to pay less tax by taking advantage of the pre-tax benefits such as Health FSA & HSA, Transit & Parking, Dependent Care, and Student Debt Repayment.

For example, according to the IRS, some transit and parking benefits are excluded from taxation. This exclusion applies to the following benefits:

• A ride in a commuter highway vehicle between the employee’s home and work place.
• A transit pass.
• Qualified parking.

According to Employer’s Tax Guide to Fringe Benefits, Employers can generally exclude the value of transportation benefits that they provide to an employee during the year from the employee’s wages up to the following limits:

• $270 per month for combined commuter highway vehicle transportation and transit passes. ($3,240 per year)
• $270 per month for qualified parking. ($3,240 per year)

However, not every employer is utilizing these pre-tax benefit credits, while the employees are still paying for their daily commuting expenses with their salaries.

By utilizing these pre-tax credits, both the employer and the employee can save on their tax. Assuming an employee will spend $270 or more on commute and $270 or more on parking each month, if the employer pays the employee $6,480 as benefit, they will save the following amount:

• Employer: $3,240 * 2 * 7.65% (employer pays 7.65% of the FICA tax) = $523.26 per year per employee
• Employee: $3,240 * 2 * ~25% (depending on the employee’s income tax rate) = $1,710 per year

If a startup has 50 employees, the company will save $26.16K in tax every year, the employees can save $1,710 annually, and this is just by utilizing the pre-tax commute benefits. (Correct me if I am wrong, as I am not a tax professional.)

However, in our real life, it is just so hard for the employers to track the employees’ commuting expenses and compensate the employees in advance. That’s where Benepass comes in. By helping the employers to issue a bank card to their employees, Benepass will enable the employers to track each expense and see if it will be qualified for the fringe benefits.

With ~60 million SME employees in the US, it should not be hard to believe that this is a multi-billion-dollar market opportunity.

Companies to Watch

With these two examples, now we may wonder if there are more companies like MainStreet and Benepass. Here’s a list of tax-related FinTech companies that I found. Feel free to take a look!

Questions

1. Moat? On the technology side, I don’t think what MainStreet or Benepass is building is rocket science. Then what will be the market entry barriers of these tax tech companies? Business development capabilities? Operational efficiency? Marketing skills?
2. Exit opportunity? I assume an acquisition from a company such as Intuit will be more likely to happen than an IPO. However, I could be wrong if tax tech companies such as MainStreet can provide more and more product offerings and become a big company themselves.
3. Macro risks? Though tax has been a long-standing headache for individuals and businesses, it is unpredictable how long the tax incentive programs will exist and how many of them will exist in 10 years. For example, according to the TechCrunch article, the big question for MainStreet in 2020 is navigating the crisis around the COVID-19 pandemic. While more small businesses than ever need help navigating credits, state and local governments have suffered huge shortfalls in revenues as taxes have dried up and Washington continues to debate over what, if any aid, to offer. There’s no money for economic development, yet, economic development has never been more important than right now.