No-Fear Factor: For professional clients who fear liability, an accounts receivable factoring plan can be a valuable asset protection tool.
Roccy DeFrancesco. Financial Planning. New York: Nov 1, 2003. pg. 1Abstract (Summary)
Accounts receivable factoring is now being used as a planning tool to help high-end clients protect their assets and reduce their income tax. Simply put, factoring is selling an account receivable at a discount (as authorized by Section 453). Most of the time, factoring is used when a company has a large account receivable on the books that would represent a good portion of the profits for the company for the year. Factoring is a good deal for the seller because he gets money today to pay bills or pay owners and employees of the company. Factoring is also good for the purchaser, who can afford to wait to collect 100% of the account receivable bought at a discount. Discounts on accounts receivable range from 5% to 50% depending on the industry. Factoring is common in the medical field because payments from insurance carriers are often slow, due to poor billing practices or heavy paperwork in the medical office. Moreover, professionals such as doctors, lawyers, and increasingly CPAs work in areas where malpractice or errors and omissions claims are plentiful. In professional practices, accounts receivable are typically the only real asset of the company, since the value in a practice lies with the individual owners, not in the company's hard assets.
As long as businesses have been extending credit to their customers, accounts receivable have been a fact of life. And accounts receivable factoring has been around nearly as long as accounts receivable themselves, usually to improve cash flow.
Increasingly, accounts receivable factoring is now being used as a planning tool to help high-end clients protect their assets and reduce their income tax. This article will provide an overview of how one particular type of accounts receivable factoring plan can work to benefit your clientsand why financial advisers should be wary of accounts receivable leveraging plans.
What is factoring? Simply put, factoring is selling an account receivable at a discount (as authorized by IRC Section 453). Most of the time, factoring is used when a company has a large account receivable on the books that would represent a good portion of the profits for the company for the year. That particular account receivable might not get paid prior to year-end from a client who has no money. That means the company will have a cash flow problem and potentially no profit for the year unless it can figure out a way to collect the account receivable.
For a company to send a client to collections and hope to get paid on a large debt prior to year-end is unrealistic. Small- business owners know too well how long it takes to collect from clients who have no money (sometimes it take years). What is the alternative to waiting to go through the collection process? Factoring. Many firms specialize in buying other company's accounts receivable at a discount, confident that it will ultimately get all or most of the debt in a timely fashion.
Factoring is a good deal for the seller because he or she gets money today to pay bills or pay owners and employees of the company. Factoring is also good for the purchaser, who can afford to wait to collect 100% of the account receivable bought at a discount. Discounts on accounts receivable range from 5% to 50% depending on the industry.
Let's look at an example for a medical office. Assume the office has $1 million of "real" accounts receivable (not the fluff that comes from what is billed). A factoring company contracts with the medical office to buy the $1 million for $900,000 and will cut a check today for that $900,000. The factoring company runs the risk that the million dollars will not be collected by the medical office, but when and if the accounts receivable in question are collected, the factoring company will be able to make a nice profit.
Factoring is common in the medical field because payments from insurance carriers are often slow, due to poor billing practices or heavy paperwork in the medical office. Moreover, professionals such as doctors, lawyers, and increasingly CPAs work in areas where malpractice or errors and omissions (E&O) claims are plentiful. In professional practices, accounts receivable are typically the only real asset of the company, since the value in a practice lies with the individual owners, not in the company's hard assets.
If a patient of a physician has a bad outcome from surgery or a client of an attorney or CPA is harmed by flawed professional advice, the professional entity will be sued along with the individual who caused the damage. And the claims for damages in any major lawsuit are likely to be above the liability policy limits of the professional's malpractice or E&O carrier. These days, a jury verdict can come in that's far in excess of policy limits. If that happens, the accounts receivable of the professional office could be in danger.
With accounts receivable factoring, the professional office sells an ongoing stream of its accounts receivable to a factoring company. Thus, the accounts receivable are no longer an asset of the company subject to claims of creditors. So if a malpractice lawsuit returned a verdict against a physician and the practice for $1 million more than the policy limits, a judge could not require the medical practice to liquidate its accounts receivable to pay that verdict, since the office no longer owns them.
If I stopped here, you might wonder why a company without any cash flow needs would want to factor accounts receivable, since the cost in the previous example was a $100,000 factoring fee. First, it's always useful to provide asset protection for accounts receivable when possible. Second, the concept of accounts receivable factoring can act as an income tax reduction tool as well.
How? One company in the marketplace will factor your accounts receivable and through a marketing incentive contribute 88% of that factored amount into a supplemental benefit plan for key company employees or owners. The best way to illustrate how this accounts receivable factoring works to reduce taxes and fund a supplemental benefit plan is through an example.
Take Dr. Smith, age 45, who earns $1 million a year as a cardiologist in his company, Dr. Smith P.C. He hears about factoring plans and decides that he would like to protect his accounts receivable and reduce his income by $100,000 a year if he could also invest money in a tax favorable manner.
Dr. Smith P.C. contracts with a factoring company to sell $500,000 of its accounts receivable at a 5% discount four times a year. (In a medical practice, accounts receivable turn over on average every 90 days). By factoring, Dr. Smith creates a $100,000 factoring fee over the year (5% x $500,000 x 4 = $100,000). After factoring, Dr. Smith then takes home pre-tax income of $900,000 for the year.
The factoring company on a post-tax basis contributes 88% of the factored amount ($100,000 x .88 = $88,000) into an life insurance investment. The 88% represents 89% of the total premium going into the life policy. Using post-tax money, Dr. Smith will become an investor in that same life insurance policy, putting in 11% of the premium ($10,876). He then co-owns the policy with the factoring company.
By contract, Dr. Smith will have access to all the cash value in the policy via policy loans, which provide much greater tax-free income than he would have had from a taxable investment account. (See "An Accounts Receivable Primer" at right.) When Dr. Smith dies, the factoring company will receive its premiums paid plus appreciation at the long-term applicable federal rate (i.e., simple compounding) in the form of a death benefit from the life policy.
There are some potential downsides to this plan that you must consider. Accounts receivable factoring tends to work best if the client funds the plan for a certain periodtypically five, seven, or 10 years. If the client stops prematurely, the life policy will stop being funded in a tax favorable manner. As with any life policy, the client can lower the death benefit. For a brief period, however, the client and factoring company would have owned a policy with too much death benefit. The plan will not work as illustrated, but it should work much better then post-tax investing. But if there is even a remote possibility a client will want to get out in the first year or two, an accounts receivable factoring plan is not the right choice.
In addition, the client does well by being able to borrow all the cash out of the life policy. But the client also has the burden of keeping the life policy in place until death, which is a contractual obligation of the plan. If a client used a variable life policy and the stock market went in the tank (and slashed the cash value of the policy), he or she could be on the hook to pay future premiums out of pocket to keep the policy in place until death. That is why I never sell variable life with an accounts receivable factoring plan and recommend using a policy with a minimum rate of return.
There is one final caution. Remember that if the client stops the factoring plan, his or her accounts receivable will no longer be protected assets.
Even considering these caveats, an accounts receivable factoring plan can do a tremendous service for your clients who are looking for asset protection and reduced income taxes. If you are used to dealing with 419 welfare benefit plansa tough sell with the new regulationsor the popular 412(i) plan, you should explore the accounts receivable factoring plan as a more conservative option for your clients.
But be careful as you start looking at these plans. Many insurance agents are pitching accounts receivable leveraging to their wealthy clients, which is not the same as accounts receivable factoring. A typical accounts receivable leveraging strategy works as follows:
Assume Dr. Smith P.C. borrows money that equals the true amount of accounts receivable on the medical practice's books. That borrowed money is invested in a life insurance policy or annuities owned by Dr. Smith individually. The medical office is told to write off the interest on the loan, and the money funded in the life policy grows. When Dr. Smith reaches retirement age, the loan is paid back, and Dr. Smith keeps the life policy with all its cash value. He would then take tax-free loans from the policy as a supplemental retirement benefit.
This plan may seem attractive, but it has serious defects as presented. The accounts receivable leveraging plan has been around in one form or another for almost 20 years. It's a marginal asset protection tool because the medical practice does not actually sell the accounts receivable. What's more, it is an even less effective wealth accumulation tool.
There are four important problems with the accounts receivable leveraging plans currently in the marketplace:
* The interest on the loan to the medical practice may or may not be deductible. I've read legal opinions on both sides of the fence. If the interest is deemed not deductible, the plan becomes worse from a wealth accumulation standpoint than post-tax investing. And whether or not the interest is deductible, the interest payments still go to a bank, never to be seen again.
* The IRS can argue the client is charged with constructive receipt of the borrowed money in the year borrowed. If that is the case, Dr. Smith would have to pay incomes taxes in year one of the plan on all the borrowed money. That would defeat the plan purpose.
* Dr. Smith would have to recapture as income any cash value in the life policy once the cash surrender value gets above the amount of money that was poured into the life policy. For example, assume Dr. Smith P.C. borrowed $300,000 against office accounts receivable and that the entire amount was put into a life insurance policy. Early on, the surrender charges will keep the cash surrender value below $300,000. When the cash surrender value gets above $300,000, however, the physician must recapture that additional value as income each year.
So if the policy grows at 8% each year, Dr. Smith will recapture $24,000 in income the first year the policy grows above $300,000. That number will grow every year thereafter. Dr. Smith pays the tax every year, but he will not get to use the money until he takes tax- free loans from the policy several years down the road.
* The loan has to be repaid. Dr. Smith will have to find $300,000 post-tax dollars to pay back the original loan. Not surprisingly, sales reps pushing the plan usually ignore this topic. A medical practice with $300,000 on the books to pay back the loan won't have sufficient funds because taxes must first be paid on that $300,000.
Some of the problems with an accounts receivable leveraging plan can be salvaged by a few simple structural changes that are outside the scope of this article. Even so, be aware that the topic is not as clear-cut as the marketers of the plan make it out to be. To avoid the headaches of accounts receivable leveraging, it's better to study and understand a simple accounts receivable factoring plan like the one described in this article.
An Accounts Receivable Primer
Dr. Smith, age 45, factors $500,000 of his accounts receivable (A/ R) for 10 years at a 5% discount four times a year. This also reduces his current income tax, since he takes home $100,000 less per year. Assume a 7.9% pre-tax return in the stock market and 7.9% in the life policy used. Dr. Smith then retires after age 65 and lives 20 years.
Outcome Available funds at age 66-85
Post-tax investment account $95,294 a year after tax
with no A/R plan
A/R factoring life policy $243,871 income tax-free annually
loans via life policy
A/R factoring company $2.2 million return on its
investment
The A/R factoring plan as illustrated provides 155% more per year to Dr. Smith than post-tax investing of the $100,000 foregone each year. RD.
Roccy DeFrancesco, J.D., is one of the founders of www.triarcadvisors.com, a Web site and company devoted to the education of financial and legal professionals around the country. He is also the author of The Doctor's Wealth Preservation Guide. DeFrancesco can be reached at 269-469-0537 or roccy@wealthpreservation123.com.
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