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Accounts receivable are generated by a business from the sale of goods or services. Basically, customers receive a credit extension for deliverable goods before payment is made on invoices. Waiting for payment can put the business in a cash flow crunch and it chooses to sell its accounts receivable to a factoring company.
Under a factoring agreement between the business and the factoring company, the business receives a cash advance for a percentage of the unpaid invoices. This is a discount from the original face value of the invoices in the likelihood that some receivables are never paid. The IRS has reporting requirements that may or may not affect your tax liability.
How the IRS Analyzes Reported Factoring Receivables
Generally, the IRS uses several facts to determine the tax liability of businesses that use factoring services. If your business is audited, the agency will examine:
• Name and location of the factoring company
• Relationship between your business and the factoring company
• Whether both entities are part of a consolidated group
• Whether the factoring company is classified as a Controlled Foreign Corporation (CFC)
• Name of the accounting firm or financial advisor that might have assisted with structuring the factoring agreement
• The type of factoring agreement between your business and the factoring company
• Securitization process, if any, used for the factored accounts receivable purchased by the factoring company
• Your business tax return to see deductions taken for the factoring agreements
Receivables Subject to Taxation
In some situations, factoring agreements are between two domestic entities, e.g. your business and the factoring company. When this is the arrangement, the IRS may not follow some of the audit steps to figure tax liability. The most likely reason for this is because the transaction is structured for state tax purpose. Federal tax does not apply. Further, your business and the factoring company could have a securitizing arrangement for the accounts.
Generally, tax implications for factoring receivables differ based on ownership of the accounts. When the factoring company owns the accounts receivable, payment received on outstanding invoices is reported as income. However, when your business retains ownership of the accounts, payment from the factoring company is not taxable income. Consulting with a professional tax advisor will help to ensure you are complying with reporting requirements.
When Sold Receivables are Not Taxable
Income earned from factoring receivables is no longer taxable, according to a letter ruling from the IRS in August 2011. Basically, factoring receivables is not part of Subpart F income when you sell invoices to a third-party factoring company. The only exception is if factoring receivables results in a gain from the sale and does not produce income. In other words, the act of factoring receivables does not automatically convert the cash advance into an income.
This is important of you are considering factoring receivables through a controlled foreign corporation that the IRS determines during an audit. Subpart F income is usually taxed to shareholders when the income is earned.
To illustrate, let's say that your business is a CFC and owns a factoring company as a disregarded entity that is separate from your federal business taxes. The factoring company buys your receivables and has no tax liability in the U.S. The transaction is considered a sale of receivables, rather than borrowing, for income tax purposes.
The new ruling acknowledges that the cash advance your business receives from the factoring agreement is substituted for the income that you would have collected from the invoices. Therefore, you are not required to report the advance from a CFC.
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