What You Should Know About Taxes and Factoring

tax planning

Last Updated on May 26, 2021

Are you a business owner dealing with the trouble of sending invoices out and waiting for the due date to get paid? Sometimes, this can put a real crimp on your cash flow – as you need to pay for other miscellaneous expenses or even payroll. That is why more businesses turn to invoice factoring for faster liquidity by getting paid faster.

What Is Invoice Factoring?

Since most businesses operate on a net 30-day payment plan, business owners wait as much as a month before getting paid, resulting in cash flow issues. Without sufficient financial reserves, many small businesses face challenges in keeping up with their outstanding debts.

Invoice factoring is an invoice finance option that sells some or all of the business’s accounts receivables to third parties (factoring companies)at discounted rates. This is a way to improve the cash flow of a business. Third-party buyers then assume the rights to collect the invoice payments.

Discount rates generally range from 10-20% of the invoice value. The balance, less the factoring fees, is given once the customers pay 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 in determining whether any factored receivables qualify as taxable. The purpose of this determination is to prevent firms 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 factoring companies, especially U.S.-based companies with parent companies located offshore, 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

Factoring agreements may involve a factoring company purchasing accounts receivable. Other agreements involve a factoring company merely advancing funds to another company.

If you are merely advanced 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 in how factoring agreements are reported and how reporting expenses appear 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. This can pose challenges in factoring your outstanding invoices.

So to engage in invoice factoring, your company will need the IRS to issue what is known as a subordination. This act serves to place 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, and a lien is present. However, the IRS has three requirements that must be met prior to issuing a subordination for your business:

  1. You need to work out a payment plan with the IRS
  2. You must prove that factoring will increase the likelihood of paying off any debts owed to the IRS
  3. You must ensure that payments from the factoring company go directly to the IRS

The Short Answer Is… Maybe

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.