There are not many results for the tax effect of factoring fees when you do a quick Google search. Why? The tax policy updates are indirect and related to interest deductions requiring a deep dive into the tax code.
When a company sends invoices to a factoring company (factor), it receives a discounted price, typically 70%-90%, upfront in cash. Once the customer pays the invoice, the remainder is provided minus any fees.
We’ll go through a high-level overview of bookkeeping and some tax treatments for companies who use invoice factoring. Thankfully, for those receiving factored funds at arms-length (outside their business structure), the tax treatments are relatively straightforward. The sticky tax questions are mostly for those in the business of lending.
Bookkeeping for Factoring Transactions
After enrolling for invoice factoring, your bookkeeping or accounting staff will have a couple of questions, such as:
1. Which invoices or accounts will have factoring fees? Since not all invoices are required to be factored in, those that are should have their account statements tracked individually.
2. Are the terms recourse or non-recourse?
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- Recourse means that if the client doesn’t pay their invoice(s), you have to return the advanced cash to the factor.
- Non-recourse or without recourse means the risk of nonpayment is on the factor. If your client doesn’t pay, you still keep the advance, but you do not receive the reserve amount.
3. The terms of the agreement, such as:
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- Dates to transfer accounts receivable
- The discount (percentage advanced),
- Interest charge, and
- Fees.
This list is not meant to be all-encompassing. This information will help ensure the journal entries are set up correctly.
The bookkeeping can feel pretty technical, but once set up can be standardized.
Tax Effects of Factoring
Let’s use an example to help walk through the potential tax effects. For this example, we’ll assume the terms are factoring with recourse.
Say you factor $1 million and receive an advance of 80% ($800K) with an administrative fee of $20K due when paid. What’s the tax effect? Well, it depends.
First, the $800K advance has no effect on your income statement because the bulk of the transaction stays on the balance sheet. When the invoice was recorded, so was the income. The advance decreases your outstanding accounts receivable and is recorded as cash. This means that the revenue was already on your income statement, with no additional effect on your revenue numbers.
Record the remaining $780K ($800K – $20K fee) as an increase in cash and an increase in factoring liability when it’s received from the factor. The $200k amount held back along with the $780k is recorded as a reduction of the receivable upon customer payment of the invoice. The other side of the entry is a $780k reduction of the factoring liability and an increase of $200k to cash (if the factor sends the remainder else it’s a reduction in factoring liability also). Additionally, the factor will charge a monthly interest amount on outstanding line draws which is recorded monthly as interest expense. The $20K fee will be recorded as a “Fee Expense” and is generally deductible as an ordinary and necessary business expense.
Note with Liquid Ally there are no application or add-on fees.
Business Interest Deduction Limit Code Sec 163(j)
Since the IRS Code defines factoring fees as interest, any deduction is ruled by Code Sec 163(j). At the end of 2017, the Tax Cuts and Jobs Act created a limitation on how much interest expense a business taxpayer can deduct. The limitation is generally limited to the total of:
- Business interest income for the year (not including investment income)
- 30% of adjusted taxable income, but not less than zero
- Floor plan financing interest (Code Sec. 163(j); Reg.§1.163(j)-2(b)).
Feel cross-eyed yet? Don’t worry. Either your tax accountant or tax software usually has a button to click that will tally all this up for you.
COVID Response (Code Sec 163(j)(10))
In response to the pandemic, for tax years 2019 and 2020, businesses can include up to 50% of their adjusted taxable income in determining their deductible interest. This could increase your deductions depending on your discount rate and taxable income.
Small Business Exemption
Like many things in the tax code, there is an exemption. The limitation doesn’t apply if you meet the gross receipts test. The gross receipts test takes the average gross revenue for the previous three tax years ($26 million for tax years 2020 and 2021). If the average is less than the threshold, the business interest limitation generally doesn’t apply
There are additional exemptions and treatments which are beyond the scope of this article. They relate to how interest is treated by entity structure and industry classifications.
Non-Payment of Recourse Receivables
What if someone doesn’t pay an invoice sent to the factor? Great question.
Any portion withheld and unpaid would be recorded as “Allowance for Bad Debt” or “Allowance for Doubtful Accounts.” Writing the account off as “Bad Debt Expense” is declared by the company’s internal policy stating the timeframe for when the debt is declared “worthless” or uncollectible. For tax purposes, generally, bad debts are deductible in the year they become worthless.
Conclusion
The most crucial part of determining the tax effect of your factoring fees is to keep good records. The recordkeeping can feel mind-boggling if accounting and tax is not your forte. We recommend that you consult a tax advisor to ensure your tax deductions are presented correctly.
Here at Liquid Ally, we have the benefit of being run by a CPA (Certified Public Accountant) who appreciates how financing and recordkeeping can feel overwhelming. Our goal is to help you understand all parts of your lending agreement, including the tax impact. Ultimately, factoring so your business can optimize and stabilize its cash flow.
Contact us today to see how we can help.