Paul L. Caron

Friday, June 26, 2009

Taxes as a Cause of Small Business Bankruptcies

Rafael Efrat (California State University-Northridge, College of Business and Economics) has published The Tax Burden and the Propensity of Small-Business Entrepreneurs to File For Bankruptcy, 4 Hastings Bus. L.J. 175 (2008).  Here is the Conclusion:

Consistent with the growing tax burden on small-business owners, as well as the growing body of evidence linking higher tax burden with limited entrepreneurial growth and higher closure rates, this study has found that tax problems constitute an important reason for bankruptcy filings for a sizable number of entrepreneurs. Interestingly, those entrepreneurs that attribute their business collapse to tax problems do not come from disadvantageous background. Instead, the average entrepreneur in the bankruptcy sample that has faulted tax problems for his financial woes was typically older male, white, native-born, well-educated and an experienced business owner. Nonetheless, the typical entrepreneur with tax problem in the bankruptcy sample was facing enormously higher debt burden with more than five times as much debts as other entrepreneurs in the bankruptcy sample.

While this study confirmed the prevalence of tax problems as a cause of business failure, it did not ascertain the exact nature of the tax problems faced by many of these entrepreneurs in bankruptcy. Future research might explore the pervasiveness and the nature of tax debts among bankruptcy petitioners; ascertain the amount of tax debt bankruptcy entrepreneurs typically report at the time of bankruptcy filing; identify the tax burden at the time of bankruptcy filing relative to outstanding debt and income of the petitioners; and determine the characteristics of bankruptcy petitioners that tend to report tax obligations.

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The commenters above neglect to mention the fact that the cheapest source of working capital for a small business is to raid the so-called "trust fund" taxes that are withheld from employees' paychecks. This source of working capital is irresistible for many small business owners. Fundamentally, the small business owners steal from their employees -- and all taxpayers -- in order to keep their operations afloat. Next, when the IRS discovers this tax fraud, the small business owner files a bankruptcy petition, e.g., the cheapest injunction in town, to frustrate the tax collector (and other creditors as well). Pointing the finger at the IRS as the root of small business bankruptcies misses the mark. Only someone who has never worked in tax administration or litigated a trust fund case could make such a naive claim.

Posted by: Anonymous | Jun 28, 2009 8:30:45 PM

FOrgot to say, I don't think the problem is federal either - it is definitely state and local

Posted by: Shawn | Jun 27, 2009 2:46:15 PM

As a small business owner in Southern California for the last 7 years, I've found that my best bet for meeting tax burdens was to outsource the processing. As an S-Corp, actual corporate taxes are small, but payroll taxes are critical (sales tax isn't a big issue for us as 95% of revenues are from services). Therefore, using a company such as Paychex, while incurring some additional fees, means that I simply don't worry about that part of my regulatory burden. Could they make a mistake? Sure, but in 7 years they haven't.

What taxes do I worry about? Well, 4 years ago I moved from an unincorporated county location to Los Angeles City proper and my business license tax was absurdly large. Nearly 1% of the last year's gross revenues. And since we are a service business, we can't claim sales outside city limits to defray some of that. If the city was providing some meaningful services, maybe it wouldn't feel so predatory, but I already have to pay an alarm permit (and a fee for false alarm responses) so that the police department doesn't fine me. And LA DWP charges all sorts of additional fees on top of my basic utilities. Add on to that the taxes on my capital equipment I pay every year (the bill says voted indebtedness - got to love that) and the city and county take between 2 and 2.5% of my gross every year. Now, I'm fortunate, I planned a business with very high operating margins (60% gross and 30% net) so I can absorb it and any forseeable increases, but I can see how people in fields with much tighter operating margins (food, gas stations, etc.) could be feeling squeezed and try to game the system

Posted by: Shawn | Jun 27, 2009 2:45:10 PM

It wasn't taxes per se that did in my retail business in an upscale California town. But year-in/year-out, city, state and nation took 8+% in sales tax and roughly a third of profit in income taxes plus various fees and compliance expenses. My best year, by contrast, was 5.5% profit. So, for every dollar I could make at my best, the government made three to four or more with none of the risk.

Did they become a partner to help me grow? No, most dealings with the city were adversarial. Their parking enforcement drove customers to the malls (outside the city!), and their zoning enforcement bordered on the insane at times. From their pov, if I failed, another tenant would be in and running within a month or two.

What the government's big take did result in was the feeling that if the business would ever amount to anything, I'd need more of a go-for-broke mentality. Broke is exactly what I got.

Posted by: Charlie | Jun 27, 2009 2:04:37 PM

It's not just the taxes, it's the future taxes that cause bankruptcy. If I start a business and lose $30,000 the first few years getting is started, I'm not just behind the $30,000 I have to borrow. I have to pay 40-60% tax on incoming profit to pay that down (federal, state, fica, unemployment, plus costs of filing and bookkeeping). There are ways to make it solely a business affair, but you have to start with enough money and business credit to avoid putting your personal credit on the line, and those folks aren't the majority of small businesses.

When you look at five years of needing high incomes to pay off debt and taxes just to break even, the businessman inside you says, maybe I'll just declare bankruptcy and start over. The only thing stopping us is decency and the desire not to fail at a business.

Don't be fooled. A lot of small businesses are still functioning because of 2-3% lines of credit with their banks. If gas prices continue to move up, if interest rates rise more than a few points - heck, if credit is cut any more, we're all out of business, and the bankruptcies will start flowing.

We've laid off all the staff we could and tightened our belts, but you can't force someone to work just to feed bankers and bureaucrats.

Posted by: Jim Durbin | Jun 27, 2009 1:08:45 PM

I would imagine that a high tax state would also be a high regulation state (like California) as well.

Posted by: Horst Graben | Jun 27, 2009 11:31:00 AM

The study needs to clarify what KIND of tax burden is the cause cited for bankruptcy. This blog post is being mentioned by some (e.g. Instapundit) as evidence of federal taxes in general being too high. I submit that the issue is not federal income taxes at all--but rather how small business owners manage (or fail to manage) cash flow.

In my experience as a business owner, and as a consultant, small business owners are driven into bankruptcy or liquidation when they run out of cash--and they run out of cash on the day when they are faced with a) making payroll, or b) paying the next quarter's tax deposit.

Withheld payroll taxes are a temptation common to most small businessmen. In theory you are supposed to deposit withheld payroll taxes when you pay your employees--but if you're small enough (which is why they call you a small business, eh?) you can choose to make your tax deposits monthly or (if you're small enough) quarterly. Faced with the ups and downs of a small business, many small business owners choose to defer making their deposits until the last possible minute.

And thus Temptation enters.

An unexpected expense occurs--you get a whopping order today, for delivery next week; you have to hire a dozen temps right away, but the customer pays on 30 day terms. It's a cash flow problem--it happens all the time.

You have to write a check to the temp agency today--so you write the check, draining your company checking account. You fret for a moment that your bookkeeper is going to yell at you--but you go ahead and dip into the "cushion" of your tax withholding funds. Not to worry, you tell yourself, the customer will pay the bill by the end of July, so you'll have the money you need to pay the tax deposits.

Except you didn't look at the calendar. There are five Fridays in July, and you have payroll due on THREE of them; you're already facing a cash-flow squeeze. Then the customer's check is late--and you're in an awkward position: you need cash to make payroll, you need cash to make your normal monthly expenses, and you need cash to pay the tax deposits.

And neither your employees nor the tax authorities can be held off with promises that the customer's check is in the mail.

Many, many, many businesses face this problem--it was at precisely this moment when Fred Smith, founder of Federal Express, flew to Las Vegas and won enough money playing poker to make his tax deposits and make payroll as well.

Faced with the need to pay your staff or pay the taxes, what would you do? Most people pay the staff, stiff the feds, and call the lawyers. They need the protection of a Chapter 11 filing.

The immediate cause for bankruptcy is unpaid tax debts; the root of the problem is every small business's need to continually generate what financiers call "trailing free cash."

If a small business is not generating trailing free cash, the tax rate (percentage of income, percentage of payroll, percentage of fixed assets, percentage of employees with red hair, what have you) is unimportant--sooner or later the business will run out of cash.

Key point: small business bankruptcies are frequently directly related to tax issues--but the real problem is poor cash flow management; the tax rate has very little impact.

Posted by: John Murdoch | Jun 27, 2009 11:26:39 AM

Payroll (cost of doing business taxes) rather than (net) income taxes are the more likely source, no?

Although "pass through" income taxes may be a problem for businesses that need to reinvest lots of income.

Posted by: edh | Jun 27, 2009 11:15:11 AM

In California at least, there are so many small businesses not filing their taxes that they dominate business sectors and set market prices. Anyone who tries to be completely legit and pay all taxes in those sectors fails due to a higher cost basis.

These businesses are run by first-gen immigrants from countries where paying taxes is only done by suckers, and they have large numbers of under-the-table workers. If CA ever tried to enforce the tax laws, whole sectors of the remaining economy would collapse.

I often wonder why academics don't ever find these guys and study them. After all, they eat lunch in them!

Posted by: Foobarista | Jun 27, 2009 11:04:42 AM

My small business pays taxes to a variety of agencies. I have no problem with paying the taxes so much as I have with those entities not informing the taxpayer in clear terms (a regulation, for example)what is the basis for calculating the tax. Thus, when an audit occurs it all comes down to ad hoc decisions by the auditor as to what the tax amount is. It's as if they are playing the classic con game of hiding the pea under the shell and you are expected to guess the result without any information to assist you. To paraphrase Al Pacino, as Scarface, their attitude boils down to: "Tax laws? We don't need no stinkin' tax laws."

Posted by: Peter MacKinnon | Jun 27, 2009 11:01:55 AM

It costs me thousands of dollar per year in fees to my accountant, mostly to respond to tax dunning notices that more than half the time are not my fault. In the past 30 days, I've had threatening letters from the IRS and the state, laden with penalties and interest, that I've had to respond to in less than ten days. In both cases, there were obvious errors that were not my fault. In one case, the tax folks keyed in a $1000 payment as ten dollars, so the system thought I owed $990, even though they could have checked to see what the amount of the check was for (they happily cashed the $1000 check at the time). In the other case, the IRS said I owed $13,000 and was going to go straight to my business checking account and take it. It was, again, a filing error that was not my fault, and it took my accountant less than 20 minutes to identify the problem.

Posted by: Andrew | Jun 27, 2009 10:45:46 AM

I thought most small business fail because it is usually the first time for the owners and the lack of experience causes them to not generate enough transactions to meet expenses. I started a small computer training business and found it very hard to attract sufficient customers to meet my rent. I lacked planning first and experience second to estimate my market and size of the office. The tax issues were not difficult since I am an accountant, yet I still failed because of the basic issue of not enough revenues.

THe second time around though is much better since I know my market and the amount of investment to turn a profit.

Posted by: Pat | Jun 27, 2009 10:18:26 AM

In addition to the taxes themselves, don't forget the amount of time, energy, and resources we have to expend to stay in compliance with the ever changing and ever expanding tax laws. And of course, having my state borrow at their whim from the federal government for unemployment funds while being able to pass those costs on to me at whatever terms they set doesn't help much either.

Budgeting gets increasingly more difficult given the uncertainty of what our tax burden will be next year, what's going to happen with depreciation, what the FICA limits may be, how much more my state will demand from me for unemployment fund shortfalls, etc. For those of us working on thin enough margins, we only need a few extra straws to tip the balance against us. As Charles Dickens had Wilkins Micawber say, "Annual income twenty pounds, annual expenditure 19 pounds 19 shillings and six pence, result happiness. Annual income 20 pounds, annual expenditure 20 pounds and six pence, result misery." A few extra tax dollars can result in another dozen people being laid off. This is truly a vicious cycle that feeds on itself.

Posted by: charles austin | Jun 27, 2009 10:00:40 AM

taxation in business is one of the major thing to handle because lack of knowledge thereof may result in bigger business problems.thanks for the very profound article.

Posted by: Jenny Molina | Jun 26, 2009 9:10:37 PM

Tax problems are among the most common problems I see in small business bankruptcies. It may not be the overall "size" burden, but the accounting is very complicated for an owner-operated business with a thin margin. They can't figure out how to withhold correctly, how to add sales taxes, they get behind on the reports or calculate incorrectly, then things snowball.

Posted by: mark | Jun 26, 2009 6:31:44 AM