Last Updated on November 9, 2023
Business owners often struggle with slow-paying customers or long payment terms causing cash flow problems, putting a cramp on finances. This is why more and more businesses are turning to invoice factoring for faster liquidity by getting paid faster.
While factoring has been around for a while, it’s still a relatively unknown alternative funding solution for small business owners. Therefore, questions remain regarding whether factored receivables are subject to taxes.
Continue reading to discover that factors that will play into whether the invoices you choose to factor are subject to taxes.
What Is Invoice Factoring?
Before getting into the taxation aspect, let’s clarify how factoring works.
Invoice factoring is an alternative financing option where business owners sell some or all of their accounts receivables to third parties (factoring companies) at discounted rates in exchange for an immediate advance of 80 to 90% of the invoice value. The third-party buyer (or “factor”) then assumes the rights to collect the invoice payments from your customer.
Discount rates generally range from 10 to 20% of the invoice value. The balance, minus a small factoring fee, is released to your business once your customer pays the factoring company.
Many companies use factoring because it helps speed up access to financial assets, including receiving payments for outstanding invoices. Invoice payment terms have an impact on the length of days you receive payment. Most of the time, payment terms range from between 30 to 90 days, leading to cash flow issues.
For many firms, business loans or bank overdrafts often fill this gap in cash flow concerns. However, business loans come at a cost to the business, making it a less-than-ideal option. This is where an alternative solution comes in – invoice factoring.
Are Factored Receivables Subject to Taxes?
So, invoice factoring presents many potential advantages for a company. But how does factoring fit into the tax system in the United States?
This relationship is somewhat complex. For business owners, it can be difficult to identify whether factored receivables are subject to taxes payable to the federal government.
The IRS considers several factors to determine whether any factored receivables qualify as taxable. The purpose of this determination is to prevent businesses from using invoice factoring to transfer income overseas or engage in tax avoidance or tax evasion regarding the use of invoicing.
There are four main considerations in determining whether your invoice factoring is subject to taxation. The IRS examines each of these elements when assessing whether your invoice factoring is taxable.
1. Where the factoring company is located
When U.S.-based firms use offshore factors, especially U.S.-based factors with offshore parent companies, the IRS considers this a potential red flag for transferring income overseas.
It is not uncommon business practice to get around paying taxes to the IRS by working with parent companies located outside the borders of the U.S. As such, the IRS will closely examine such business relationships when determining whether your invoice factoring is subject to taxation in the U.S.
2. Your relationship with the factoring company
If you and your factoring company are owned by the same parent company, you can expect a comprehensive examination by the IRS to ensure legal compliance in your operations.
This is not to say that such a situation involves an attempt to avoid paying taxes owed. But the IRS does consider this a potential area of concern that warrants close examination to ensure compliance in taxation.
3. What type of factoring agreement you use
Standard factoring agreements involve a factoring company like altLINE simply purchasing your accounts receivable. However, other agreements involve a factoring company merely advancing funds to another company.
If you and a factor are working together by advancing funds on outstanding loans, you retain the ownership of your invoices. In contrast, you do not retain ownership of your outstanding invoices if the factoring company purchases your accounts receivable.
This distinction is often critical when the IRS determines whether your factored receivables are taxable.
4. Your reporting of factoring expenses as a deduction
Commissions, set-up fees, and other factoring expenses are all tax deductible. But the reporting method differs depending on whether you retain the ownership of your receivables or end up selling them to a factoring company as described above.
It is vital to be consistent when reporting factoring agreements on financial statements. The IRS will scrutinize your financial reports to ensure compliance in these areas.
What if Your Company Has a Tax Lien?
If your company owes the IRS payroll taxes or has any other outstanding taxes owed for that matter, a lien may be placed against all company assets. A lien acts as collateral for any debt owed to the IRS. This lien may cover your outstanding invoices owed, which can pose challenges in factoring your outstanding invoices.
In order to engage in invoice factoring, your company will need the IRS to issue what is known as a subordination. A subordination places the IRS in the second position on claims regarding proceeds obtained from your factored invoices. A factoring company assumes the primary position in such a situation.
This is a legal requirement to claim revenue from outstanding invoices with taxes owed to the IRS when a lien is present. However, the IRS has three requirements that must be met prior to issuing a subordination for your business:
- You need to work out a payment plan with the IRS
- You must prove that factoring will increase the likelihood of paying off any debts owed to the IRS
- You must ensure that payments from the factoring company go directly to the IRS
In Summary: Taxes and Factoring
The simple answer is you will report the amount you receive if you sell your accounts receivable to a factoring company. However, you will not have to pay taxes if you retain ownership of your accounts receivable and merely get a cash advance from a factoring company, as it is not considered income.
The answer gets more complex if your company has a lien in place against company assets due to outstanding taxes owed to the IRS. You will need to work directly with the IRS to ensure compliance with tax regulations.