Here’s Your “No Bull” Advice and “Big Picture” Rundown About Federal Tax Deductions and IRS Reporting for Domestic Factoring Financing
- Are factoring fees tax deductible?
- If your factoring agreement calls for invoice sale advance payments to incur interest charges until your customers pay invoices in full, then are the interest charges tax deductible?
- How will you choose to deduct your factoring expenses on your tax return?
- How are your accounts receivable and the factoring of invoices going to be reported to the IRS?
- Last, but not least, your tax advisor will determine what, if any, state tax issues you may face. Here, we are only looking at issues about federal taxes for factoring arrangements. So, be sure to get with a tax advisor regarding the applicability of state taxes for your situation. (For example, it may be relevant whether your state has a Gross Receipts Tax, GRT, in addition to or rather than a Corporate Income Tax, CIT.)
In addition to a few fundamental receivables factoring and tax related topics in this article, there are many various bookkeeping and accounting principles that may or may not apply specifically to your business. This article is meant to provide understanding and guidance. Don’t rely on this article without having your tax and accounting experts advise you.
Easy Answers May, or May Not, Be All You Want to Know
The first question has an easy answer. Then again, it also has a more complex follow-up answer. The short answer is, yes, your factoring fees are tax deductible.
‘How’ to report the factoring fees on your return is more to look at later in this article. Simply put, how you will deduct your factoring fees on your return will depend on how you have been capturing the fees in your bookkeeping and reflecting them on company financial reports.
Similarly, tax reporting of factoring receivables depends on how the receivables are recorded in your accounting and company financial reports. We will look more closely at the tax liability of receivables factoring also later in this article.
If that’s all you want to know for now, then you’ve already got a handle on the basics. You will put your trust in the expertise of your bookkeeper, accountant, or tax preparer to choose your record-keeping methods and IRS reporting options.
Though if you’re interested, there is more to uncover that can help you better understand how factoring impacts your company financials and business tax liability. There are a few different choices that can be considered about how factoring fees and accounts receivable invoices can be reported on your business tax return. It may also be helpful to know which certain types of factoring agreements the IRS has been scrutinizing in recent years.
Familiarizing yourself with the tax issues of factoring is a good chance to dig deeper into understanding factoring overall. You will also gain more know-how about how your accountant is interpreting your factoring agreement to track revenue and expenses for your company financial reports.
Good Advice Online is Tough to Find About Tax Preparation for Factoring
Clear and specific information about tax issues for factoring agreements is hard to find on the web. We did extensive search engine hunting and also a deep dive at the Internal Revenue Service IRS.gov website. It is clear that nobody has been able to provide a straight-forward and thorough review of this topic before now.
There are a lot of simplistic answers across the Internet about invoice factoring. Yet before now, there has been no meaningful explanation for why and how factoring fees are tax deductible. Nor has there been before now a broader and deeper look at other receivables factoring big picture tax issues. To consider the total cost of ownership of your factoring arrangement, you want as many of the tax issues for invoice factoring laid out for you as simply as possible.
IRS Auditors are Targeting Certain Receivables Factoring Arrangements
It is important to note which kind of factoring agreements have been getting the most attention from the IRS. For at least ten years, the IRS has been especially focused on two types of factoring arrangements:
- The first type of factoring arrangement receiving special attention from the IRS is where the “factor” (in other words, the factoring company) is located outside of the United States.
- The other type of factoring arrangement being targeted by the IRS is when the factor turns out to be a subsidiary company of the parent company who received factoring financing.
In these two cases, the IRS is looking for attempts to avoid paying taxes with end-runs around showing the true value of a company’s accounts receivable.
You may notice mentioned the misuse of transfer pricing when discounting factored invoices in certain factoring arrangements. This activity being looked at by the IRS is particularly relevant when a factor is a subsidiary of its parent company domestically or internationally.
The IRS has also been looking closely at factoring agreements where fees appear to be far off from the usual rates in the marketplace and, in other cases, where the percentage of receivables written off as bad debts don’t seem to be a right fit for a company’s overall financial picture.
You can rest easy about whether your factoring agreement will attract an audit from the IRS knowing that your factoring company is U.S.-based and is obviously a corporate entity unaffiliated with your company.
Factoring Is Not a Loan, But What About That Interest?
One important thing to remember is that factoring is not a loan. Although factoring is used to obtain cash for your business and it is often referred to as “financing,” it is not a loan. When looking at financing options, you may come across loans that use a company’s accounts receivable as collateral. Don’t confuse that type of a loan with factoring.
What may also trip you up is that, even though factoring is not a loan, your factoring agreement may include an interest rate and terms for interest charges. So, what’s going on here? When an advance amount is paid to your business toward the discounted purchase price of an invoice, often interest will be accrued on the advance amount until the customer pays off the invoice in full to the factor. At which time, the factor will then deduct interest charges and any other agreed-upon charges and fees from the remaining (not advanced) amount of the discounted purchase of the invoice. Since interest on a debt is a common tax deduction, this issue may be relevant for your factoring arrangement.
For one thing, the potential tax deductibility of the interest on the advance depends on whether your factoring arrangement is considered recourse financing or non-recourse financing. Usually, factors purchase invoices from clients without recourse. In other words, using a non-recourse financing arrangement. This means that if a purchased account is not collected by the factor, due solely to the financial inability of the account debtor to pay, then the factor must still pay its client the agreed purchase price. Whereas in a recourse financing arrangement, if the factor is not paid according to specified terms, then the purchase price of an account is charged back to the client by the factor.
Whether the advance payment toward the discounted purchase price of the invoice is considered debt is then determined by whether the factoring arrangement is recourse or non-recourse. If the advance is due back to the factor in the case that the customer does not pay the invoice (such as in recourse financing), then the advance is considered a debt. Whereas if the advance payment is not due back to the factor under most circumstances (such as in non-recourse financing), then the advance is not considered a debt because it will likely not be ever charged back to the client.
What matters is that, as a rule of thumb, interest is typically tax deductible only if the interest is on debt for which the borrower is clearly liable to the lender. Your tax advisor should advise you accordingly.
Factoring Your Receivables Means Accounting for a Few Differences in Bookkeeping and Reporting
Accountants and tax advisors will be the first to tell you that accounting rules for keeping your business books do not jive with IRS rules for reporting taxable income. So, what that means is book income can differ from taxable income. So, this is just a heads-up. When you’re reviewing your company’s expenses and income overall, there will be income and expenses on your tax return not included on your books and income and expenses on your books not included on your tax return. Crazy, right? Defer to the expertise of your tax preparer to use the proper IRS forms with your return to sort it out. So, for now, don’t sweat it and move on.
When it comes to your bookkeeping and financial reporting, factoring receivables can be straight-forward in some respects and yet also require specialized attention by your bookkeeper or accountant. An example of a simple truth is that the sale of a receivable to your factor, without recourse, merely lands the receivable on your balance sheet as a sale.
An example of bookkeeping complexity can include tracking what your business owes your factor. Your bookkeeper will maintain your ledger to present a liability on your balance sheet showing what you owe your factor at any given point in time. This liability should match the balance on your client statement. Then, at the end of each month, your client balance statement should be reconciled to your accounting system and your debtors should be reconciled to your debtors balance in your accounting system.
To fully understand what it means to have your invoices being factored is to remember that factoring is an asset-based financing option. As such, factoring is essentially an advance on the total value of a receivable. This is different from incurring bank financing interest as an expense that impacts your Cost of Goods Sold (COGS) as shown on your income statement. The impact of factoring on your COGS is that factoring fees are applied against the advance from the factor and not against your product’s COGS.
Depending on your bookkeeper’s chosen accounting methods, another effect of factoring on your COGS may be to dilute the value of your inventory by the price discount of accounts/invoices sold to your factor.
Easy Tax Preparation Starts with Well-Prepared Bookkeeping and Financial Reports
Your accounting system specifically tailored for your business in combination with the factoring of receivables reflected in your company’s financial reports, will guide your tax advisor’s tax reporting decisions. Regarding your factoring arrangement, your tax preparer should:
- determine how to categorize the expense of your factoring fees,
- present if factoring fees have been netted against items such as sales,
- reconcile any factoring deductions that are book/tax differences,
- report any cases of securitization of factored accounts receivable,
- ensure that factoring reflected on company financial statements are presented uniformly on the tax return,
- and ensure that all supporting documentation for information on the tax return is complete and on-file as of when the return is filed with the IRS.
Given recent IRS interest in auditing factoring agreements and the nuances of options for tracking and reporting your factoring arrangement, it’s important to turn to a trustworthy and long-standing factoring company. As well, you want to be confident in the advice of the professionals managing your company books and preparing your taxes.