Invoice factoring is a financing option that many businesses turn to for cash flow management. But, when it comes to taxes, factoring can raise several questions and considerations. Let’s address some of the common tax-related questions involving when using invoice factoring.
Although we have supported thousands of businesses with factoring over the past 25 years, we are not trained tax attorneys. Codes vary by location and change over time. Please discuss with your professional tax advisor how this information applies to your specific situation.
Invoice Factoring Defined:
Before getting into tax specifics, let’s make sure everyone is clear about the definition of factoring. Invoice factoring is when a business sells its accounts receivable (unpaid) invoices to a 3rd party factoring company. The factoring company will then advance a percentage of the invoice amount to the business. After the invoices are paid by their customer, the remaining balance, less a factoring fee(s), is returned to the business.
Basic “Tax Tips” When Factoring
While we’ve covered the primary questions surrounding taxes and invoice factoring, there are some basic considerations to keep in mind:
Document, Document, Document:
It goes without saying, that thorough record-keeping is essential to ensure compliance with tax regulations. You can never be clear enough when documenting for both your accountant and the IRS.
Work with a Reputable Factoring Company:
Choose a factoring company with a solid reputation. This ensures that all transactions are transparent, ethical, and adhere to tax regulations.
Work with a Trusted Tax Professional
Given the complexity and ever-changing specifics of state and national tax regulations and their potential impact on your business, it’s vital to consult with a tax professional or accountant who specializes in small business taxes. They can provide tailored guidance based on your unique circumstances.
Now, let’s get into the specific tax-related questions about invoice factoring.
Are There Tax Implications of Factoring Receivables?
Depending on your location and specific circumstances, factoring can affect the taxes of the business, and these implications can vary. Here are some key considerations:
Income from Factoring Funds:
Income Recognition: One of the first tax considerations when it comes to invoice factoring is income recognition. When a business sells its invoices to a factoring company, it receives an immediate cash payment. This cash infusion is not a loan; it’s a sale of an asset (the accounts receivable). Therefore, the money received through factoring is typically treated as income on the business’s financial statements. Consequently, the business may owe taxes on this income, which can affect its overall tax liability. The amount received through factoring must be reported as part of the business’s taxable income in the year it is received.
Sales Tax Requirements:
Sales Tax on Fees: Because factoring is “selling” an invoice, factoring fees may be subject to sales tax in some states. Your local tax laws and obligations should be clarified with your tax attorney.
Are Factoring Fees Tax Deductible?
The invoice factoring fees are the charges levied by factoring companies for their services. These fees can vary depending on the factoring company and the specific terms of the agreement.
The deductibility of factoring fees is determined by the Internal Revenue Service (IRS) guidelines. In general, ordinary and necessary business expenses are deductible, which may include fees paid for invoice factoring services. However, there are some important considerations. To be deductible, factoring fees must meet the IRS criteria of being ordinary and necessary expenses for the business. If the fees are deemed excessive or unnecessary, they may not be fully deductible.
The deductibility of factoring fees may also depend on whether the fees are categorized as interest expenses or discounts. Interest expenses are typically deductible, while discounts may have different tax treatment. It’s essential to consult with a tax professional for precise guidance.
What does this all mean? When agreeing to work with the factoring company, get a clear breakdown of all their fees, charges, interest, etc. If their “fee” consists of both interest and service charges, be sure to make your tax professional aware. Interest charges may be tax-deductible as a business expense while service charges are generally not tax-deductible. Confirm with your tax professional to determine eligibility for these deductions.
Do Factoring Companies Send Out 1099s? Do I Send a 1099 to the Factoring Company?
In the context of invoice factoring, the responsibility for 1099 reporting typically falls on the business selling its invoices (the client) rather than the factoring company.
Client Responsibility: As the client, you are required to report the full invoice amount as income on your tax return in the year you receive payment from the factoring company. This is because the IRS considers the amount received through factoring as income earned by your business.
Factoring Company Reporting: Factoring companies do not usually send a 1099 form to their clients. Instead, they report the payment to the IRS as a business expense, which is essentially the fee they charge for their services.
Because it is up to you, it is vital to maintain accurate records of the transactions. This includes documenting the invoices sold, the factoring fees and interest paid, and the dates of all transactions. This documentation is essential for accurate tax reporting.
What are the Tax Implications of Recourse vs. Non-recourse Factoring?
Whether the factoring is recourse or non-recourse, the fees or charges paid to the factoring company are generally deductible as business expenses.
In the event of non-payment, who is affected by the tax write-offs is dependent on which type of factoring it is. A little refresher: for non-recourse factoring, the factoring company bears the risk if the customer does not pay the factored invoice. In recourse factoring, in the event of non-payment, the factoring company will try to collect from the customer but ultimately the business is liable for repayment.
Taxes Using Non-Recourse Factoring:
- Because the risk of non-payment is held solely by the factoring company, the business typically cannot claim any deduction for invoices that remain unpaid in non-recourse factoring. The factoring fees or charges are still deductible as business expenses.
Taxes Using Recourse Factoring:
- In the case of resource factoring, if an invoice remains unpaid and the business is required to buy it back (as per the recourse agreement), the business can potentially claim a bad debt deduction for the unpaid amount, provided all IRS criteria for bad debt deductions are met.
Again, a qualified tax attorney should be weighing in on this unique situation.
Clarity About Taxes and Factoring in the 2011 IRS Ruling
Taxes and factoring have not been as clear-cut as they are now. However, in 2011, the Internal Revenue Service ruled in a case that outlined the tax treatment of certain income, including income derived from factored receivables. Though not specifically about factoring, the ruling outlined in “SEC Comment Letter dated September 19, 2011” clarified the tax implications for businesses that engage in invoice factoring setting the precedent.
- The Nature of Factored Receivables: The IRS emphasized that the nature of a transaction determines its tax treatment. If a business sells its accounts receivable outright to a factoring company, the proceeds from that sale are considered taxable income. However, if the business retains ownership of the receivables and merely receives an advance against those receivables, the advance is not considered taxable income.
- 2011 Makes it Non-Taxable: The 2011 ruling specifically deemed income from certain factored receivables as non-taxable. The clarification reduced the confusion by businesses when reporting income from factored receivables on their tax returns.
- Conditions for Non-Taxability: While the ruling deemed most income from factored receivables as non-taxable, the ruling did outline exceptions. Factoring income could be taxed if the act of factoring created a gain in income.
There are also stipulations outlined if the factoring company is based outside the United States. However, the details around this are a little more complex and really should be run through your tax person to ensure this is done to IRS specifics.
Though the ruling did not intend to, it indirectly clarified the vague tax implications of using factoring making for a more confident understanding of today’s tax requirements.
By staying informed and organized, you can make the most of the benefits of invoice factoring while minimizing tax-related challenges. And, if you have questions about the benefits of factoring for your business, do not hesitate to contact us.Back to blog