Sale of Accounts Receivable: Accounting and Tax Rules

The sale of accounts receivable is a financial strategy where a company sells its outstanding customer invoices to a third party to receive immediate cash. Businesses use this method to improve cash flow, enabling them to cover operational expenses, invest in growth, or manage seasonal demands. This approach is particularly common for businesses that have long payment cycles, as it converts future revenue into present funds without incurring traditional debt.

Methods for Selling Accounts Receivable

A primary method for selling accounts receivable is factoring. In this arrangement, a business sells its invoices to a financial company called a factor, which provides an upfront cash advance, often between 80% and 95% of the invoice value. The factor then collects payment from the customer. Once paid, the factor remits the remaining balance to the business, minus a service fee. Factoring arrangements are structured in two ways: with recourse or without recourse, which is determined by which party bears the risk of customer non-payment.

Recourse Factoring

In a recourse factoring agreement, the business selling the invoices retains responsibility for any bad debts. If a customer fails to pay an invoice, the factor has “recourse” and can demand the business buy back the unpaid receivable. Because the seller bears the credit risk, this arrangement results in lower fees and a higher initial cash advance. Companies may opt for this method if they are confident in their customers’ ability to pay, but they must be financially prepared to cover potential buybacks.

Non-Recourse Factoring

Under a non-recourse factoring arrangement, the factor assumes the risk of customer non-payment due to credit-related issues like insolvency. If the customer does not pay, the factor absorbs the loss, and the business is not required to buy back the invoice. To compensate for this increased risk, non-recourse agreements have higher fees and may offer a lower initial advance rate. This option is preferred by businesses that want to eliminate credit risk and focus on core operations rather than collections.

Accounting for the Transaction

The accounting for the sale of accounts receivable depends on whether it qualifies as a true sale or a secured borrowing. This is governed by accounting standards like ASC 860, which focuses on the transfer of control. The classification dictates how the transaction is recorded on the balance sheet and income statement, impacting financial metrics.

For a transfer to be treated as a sale, the seller must surrender control over the receivables by meeting three criteria. The first is that the transferred assets must be isolated from the seller and its creditors. The second is that the buyer must have the right to pledge or exchange the assets. The third is that the seller must not maintain effective control, such as through an agreement to repurchase the assets before maturity.

If these conditions are met, the transaction is recorded as a sale. The seller removes the accounts receivable from its balance sheet and recognizes a gain or loss. For example, if a company sells $100,000 of receivables for $95,000 in cash, it would debit Cash for $95,000, debit a Loss on Sale of Receivables for $5,000, and credit Accounts Receivable for $100,000.

If the transfer does not meet the sale criteria, it is accounted for as a secured borrowing. The accounts receivable remain on the seller’s balance sheet, and the cash received is recorded as a liability. This treatment is common in recourse factoring, where the seller’s continuing involvement can be interpreted as maintaining control. Using the same example, the journal entry for a secured borrowing would be a debit to Cash for $95,000 and a credit to a liability account, such as “Loan Payable.” The factoring fee is treated as an interest expense over the loan period.

Tax Implications of the Sale

The tax treatment of selling accounts receivable is distinct from its accounting treatment and is guided by tax codes. The Internal Revenue Service (IRS) views proceeds from the sale of receivables as ordinary income rather than capital gains. This is because accounts receivable arise from the sale of goods or services in the ordinary course of business.

When a business sells its receivables, the amount received from the factor is included in its gross income for tax purposes. The timing of this income recognition depends on the company’s accounting method, whether it is cash-basis or accrual-basis. For an accrual-basis taxpayer, income is recognized when the sale of the receivable occurs, while for a cash-basis taxpayer, it is recognized when the cash is received.

The costs associated with the sale are generally tax-deductible as ordinary and necessary business expenses. This includes the primary factoring fee, which is the discount the factor takes from the face value of the invoices. For instance, if a business sells a $1,000 invoice for $950, the $50 difference is treated as a deductible expense, reducing the company’s taxable income.

Any losses incurred, such as in a recourse arrangement where the business must buy back a defaulted invoice, can also have tax consequences. The loss resulting from the uncollectible debt may be deductible. The specific character of the deduction depends on the facts and circumstances of the transaction.