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Tax debt can be considered a financial issue, but for a lot of people, it’s also a behavioural issue. Successful business owners and managers are intelligent, disciplined and very competent. However, there are numerous individuals who find themselves paying taxes in the face of an unanticipated tax bill, a lack of remittance, or an increased outstanding debt with the Canada Revenue Agency (CRA).
Few people are prepared for this reality, and it can come as a shock to the people concerned and others. When successful individuals are running a business, handling employees and major financial commitments, how could they have trouble with taxes?
Understanding the psychology of decision-making is the key to it. The reasons for tax debt among entrepreneurs are often due to behaviours of avoidance, cash flow pressures, competing priorities and optimism, not a lack of financial knowledge. Recognizing them can let a business leader detect potential risks at an earlier stage and make positive moves before these concerns become a large-scale financial liability.
Understanding the Nature of Tax Debt
It takes time for many entrepreneurs and executives to accumulate tax debt, rather than happening all at once. A business can have short-term cash flow issues, unpredictable expansion, late payments from customers or rising expenses. As a result, cash set aside for taxes sometimes gets diverted to payroll, stocking, expansion, and/or other short-term demands.
At first, it may seem like a sensible choice. The business goes on for another month, the staff gets paid, and the business goes on. Taxes, however, do not go away. There is the potential for interest and penalties to build up, making a temporary solution a long-term financial burden.
Tax debt is unique in that it can cause stress due to regulatory responsibilities and compliance needs. Many people get more and more comfortable avoiding direct conversation as they become more unbalanced.
Why Tax Debt Happens: Beyond the Numbers
Although financial pressures are often the cause, psychological and organizational factors are commonly a part of the problem.
Optimism is an attribute that is inherent in entrepreneurs. This attribute allows them to be bold, start businesses, and seek opportunities for expansion. But business owners can also be optimistic, assuming that they will have the cash flow in the future to cover the payments they make today.
There’s also a problem of decision fatigue among many executives and professionals. There are numerous strategic, operational and financial choices that need to be made each day. Tax planning is frequently relegated to the back burner since it is not as urgent as the needs of the business.
Another factor is emotional avoidance. Tax debt can cause anxiety, embarrassment, or even frustration. Some don’t address the issue, but postpone opening correspondence from CRA, put off talking to advisors or don’t even look at their tax situation at all.
Poor financial management can also exacerbate the issue in expanding businesses. If not forecasted and supervised, tax obligations can build up unnoticed and turn into major issues.
Common Warning Signs
Tax debt does not come as a surprise. Some of the patterns are commonly found before an actual problem arises.
If business leaders regularly have enough money to pay taxes but are trying to pay operating costs, if they don’t pay taxes and wait for future income to make them up, or if they regularly file returns with insufficient money to pay the return balance, they are paying attention to the proper thing.
Other red flags are: more and more short-term borrowing, poor ability to predict cash flow, failure to report the financial obligations in time, and increased stress thereupon, talk of financial tasks.
Timely identification of these signs can save you from a small problem becoming a big expense.
Why Intelligent People Make Poor Tax Decisions
There are a number of cognitive biases that can explain this phenomenon.
- Optimism Bias
Business people are confident that their financial condition will be better as their business does better in the future. Confidence is a good thing, but it can make people delay making tough choices when it comes to money.
- Overconfidence
Seasoned executives might think they can deal with the tax matters later on, as they have managed other business challenges successfully. Unfortunately, the cost of tax liabilities is an issue that gets worse over time.
- Present Bias
It is always a natural human inclination to focus on the things that matter to you right now, rather than anything in the future. It’s much more pressing to pay suppliers, fund growth plans, or deal with operational issues than it is to save for future taxes.
- Avoidance Behaviour
Some people turn off the problem when they get stressed out because of tax debt. This temporary emotional relief can allow the problem to escalate to a very large size before action is taken.
It is important to know these behavioural tendencies because consciousness is frequently the first step to better decision-making.
The Consequences of Unresolved Tax Debt
Tax debt affects more than just the interest and penalties.
At the financial level, unpaid balances can cause cash flow issues, affect the ability to borrow and limit opportunities for business growth. Tax issues can prevent business owners from getting loans or expanding their business.
Personal repercussions can also occur. Emotional problems often accompany financial pressure, and the financial burden can lead to poor marital, emotional, and life relationships. Worrying about CRA collections could make it difficult for entrepreneurs to focus on the other strategic aspects of their business.
Other tax matters that can impact reputation and credibility for executives and professionals are also a concern. Tax compliance is a good measure of financial management for stakeholders, lenders and investors.
Unpaid taxes can negatively impact wealth building, retirement planning, succession goals, and more over time.
Real-World Examples
For example, a technology firm with quick growth in revenues. The owner is highly concerned about growth and wants to hire workers, but does not plan for the tax liability from the growth. The time the tax is due each year has already passed, and money has been invested in the business.
In another case, an incorporated professional has variable income and expects to have enough income in the future to pay taxes. After several years, the accumulated balances, interest and penalties make a huge financial burden compared to the original amount.
During an economic downturn, family firms may have similar problems since owners may want to keep the company running and retain employees before paying taxes.
In each case, the problem is not necessarily that they’re not smart enough or good at business. Instead, it’s about the combined effect of people’s actions, economic stress and indecision.
Strategies for Prevention and Management
The key to tax debt management is proactive planning.
Business owners should create a separate tax pool and use tax as a necessary cost and not an unnecessary future payment. By regularly forecasting cash flows, it is possible to anticipate shortages of cash before they become a real problem.
Good internal controls are also essential. Effective bookkeeping, on-time financial reporting and periodic tax review give visibility into emerging tax risks.
Entrepreneurs and executives should also have regular meetings with their advisers throughout the year instead of waiting until near the filing deadline. Continued planning provides opportunities to anticipate challenges in advance.
The Value of Professional Guidance
Professional advisors deliver so much more than technical skills on tax. They provide objective input, accountability and direction in times of uncertainty.
Advisors can use financial performance tracking, compliance management and the detection of potential risks to make well-informed decisions before things go awry. They can also help create a realistic payment plan, enhance cash flow management and incorporate tax planning into business goals.
This outside perspective can make a huge difference for entrepreneurs and executives who have a lot going on.
How Faber LLP Can Help
Tax debt can build up over time, as a result of cash flow, priorities, and financial decisions being delayed. Taking care of this in the initial stages can help to avoid unnecessary interest, penalties, and financial stress.
We help entrepreneurs, executives, and business owners proactively plan for taxes, manage cash flow, and strategically plan for their finances at Faber LLP. We can help you find some pragmatic solutions that work for you if you are trying to avoid tax debt or if you have tax debt to manage at the CRA.
Call Faber LLP today to talk about your tax situation and the value of proactive planning for long-term financial success.