Prospective clients are often surprised when a factoring company asks for copies of their tax documents during the application process. Factoring companies may ask for the following documents where applicable:
- IRS Form 941
- Federal tax returns
- State tax returns
A prospective client’s confusion about this requirement is understandable. After all, why does a company that is financing your invoices need information about your company’s tax returns?
Factors request tax returns to ensure the client is up to date in their taxes. Otherwise, the factor risks losing the funds they advanced the client. This article explains why tax returns are essential in setting up a factoring account. It also shows the strategy that factoring companies use to finance businesses with tax problems.
1. Why do factoring companies ask for tax documents?
In a typical factoring transaction, your company sells its invoices to the factor in exchange for a quick payment. As part of this process, the factoring company secures its interest in your accounts receivable by filing a UCC lien. The factor’s lien must have a first position on your invoices.
Factoring companies ask for your tax documents to verify that your company is up to date in its taxes. The tax documents are reviewed during underwriting and are used to ensure there are no open tax liabilities or liens against your company.
Having a tax lien affects your chances of getting financing. Tax liens usually encumber all of your company’s assets. Furthermore, they may have specific priority rules which can allow tax authorities to take a first position against your company’s assets. This situation puts the factoring company in a position where it could lose money.
2. How do factoring companies handle tax problems?
Factoring is a common solution for companies with tax problems. These companies usually have cash flow problems and are undergoing a turnaround. However, companies with tax problems can use factoring only if the following criteria are met.
a) Your company must have a payment plan
Factoring companies will work with your company only if it has a payment plan with the relevant tax authority. Payment plans enable you to repay the tax debt and usually stop enforcement activity.
b) Tax authorities must be willing to subordinate their lien
Tax authorities that have filed a lien against your company will need to subordinate their lien. This subordination enables the factoring company to obtain a first position against your accounts receivable.
A tax authority (e.g., IRS) will consider subordinating their lien position if you can show it’s to their advantage. You must prove to them that factoring can stabilize your cash flow and help you turn the business around. This argument requires preparation and a viable plan.
c) The factoring company must handle certain tax payments
Most tax authorities that consider subordinating their lien will do so only if the factoring company manages your monthly payments. This strategy provides some assurance to the tax authority that the tax account will remain up to date. Note that this agreement does not relieve you of your tax liability. Instead, the factoring company agrees only to pay tax authorities monthly before paying your company. The payments come from the proceeds of your advances and rebates.
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Disclaimer: Tax problems are a serious matter that must be handled promptly and by an expert. Consider retaining a CPA or tax attorney if you need help. This article is not intended as financial or tax advice.