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Planning > A/R Financing Scams
"If it smells like stink, it's stink." ~ Kansas farmers' saying
When interest rates were low, some tax and insurance planners started doing arbitrages based on the difference in the rate of interest that they could borrow against a client's accounts receivables and the internal rate of return on an annuity or life insurance policy that the loan proceeds went into. Later, some promoters took these strategies and organized them into turnkey systems whereby they could help the client acquire the loan, have the lender take the annuity or life insurance policy to be bought as the primary collateral, and then have the accounts receivable used as secondary collateral so that they could claim that the loan interest payments were tax deductible.
In the last several years, numerous such programs have been created and they all have their quirks and variations. But the theme is still the same: Borrow money against the accounts receivable and use the money to buy an annuity or life insurance product. Some programs are better than others, and some program vendors are just downright dishonest in how they portray the claimed benefits of their programs. Hopefully, the following information will help you spot the dishonest ones.
High Interest Rates
Accounts receivable financing is all about an arbitrage between the rate at which you can borrow money against the rate at which you can safely invest it. When interest rates go over 7% it is impossible to safely illustrate investments that will exceed this amount. Thus, the very real possibility exists that the program will go backwards and the client will lose money over time.
Don't think that the tax deduction will necessarily help this arbitrage. As shown below, many A/R financing programs are designed in a way that the interest payments will not be deductible, even though the program vendors claim otherwise.
Even with high interest rates, some unscrupulous promoters continue to offer their programs by making false statements about the economic benefits of their programs. In truth, the only way that these programs can work is if the annuity or life insurance policy outperforms the interest being paid (and the time value of the interest payments) – but this requires them to either make very aggressive projections of how the product will perform, lie about the tax treatment of the interest payment (see below), or both.
Bottom Line: If you cannot obtain an A/R Financing loan for less than 7%, then do not enter into this transaction. Economically, it will not work!
The Simple Interest vs. Compound Interest Fallacy
The A/R financing scam artists claim that there is an arbitrage between the simple interest paid on the loan against the compound interest that is earned within the insurance product. This misrepresentation is fraudulent.
While it is true that the interest paid on the loan is simple while the insurance product earns compound interest, it ignores one simple fact: If the loan payment were not made, there would be that much more money to invest outside the program and the loan payments would instead be put into an identical insurance product that would also earn compound interest.
What the scam artists will tell you is something like: "Assume that your interest is $20,000 per year. Over 10 years, that means that your cost is $200,000. When you take the loan $20,000 into an annuity or life product, it will grow compounded, so that at the end of 10 years you will have much more money!"
The fallacy is that if you didn't make the $20,000 per year interest payment, you would have invested the $20,000 into something else – and it would have earned compound interest too! The A/R financing scam artists don't tell you that.
In other words, their argument completely ignores the time value of the loan interest payments. If you didn't have to pay interest on the loan, you would have that much more money to invest on a compounded basis.
So, in fact the "simple interest versus compound interest arbitrage" is simply a myth. It does not exist. While this is a common claim made in A/R financing programs, it is wrong, misleading, and downright dishonest.
Bottom Line: If a vendor gives you the "simple interest versus compound interest" argument, Run!
The Asset Protected Income Stream Fallacy
Some A/R financing vendors claim that their program provides "asset protection" even after a judgment has been entered against their client. In other words, they claim that the UCC-1 will continue to protect the accounts receivable and provide the client an income stream even with a judgment hanging over the client's head.
This claim is misleading. The creditor would simply foreclose on the accounts receivable, and liquidate them. These proceeds would pay off the loan, and the UCC-1 against the accounts receivables would disappear. The creditor could then collect against any future receivables that are earned by the client.
Note also that some vendors sell their program to people who are in states that do not protect the cash value of annuities or life insurance by statute, and take no further steps to protect the value of those products.
What A/R financing does is to give a temporary protection to the accounts receivable so that they cannot be frozen or seized. But A/R financing as it is traditionally performed cannot and does not give long-term protection to the accounts receivable if the creditor forecloses and then seeks the future income payments.
Bottom Line: Claims that an A/R financing program will continue to protect receivables and allow the business owner to have an income stream even after there are demonstrably false claims.
The Interest Deductibility Fallacy
Some programs are no more complex than taking the loan proceeds and distributing them to the business owner, who then directly buys an annuity or life insurance policy in their own name.
These programs are very dangerous from a tax perspective, since the IRS might be able to make the argument that the entire arrangement is simply a "step transaction" to purchase an annuity or life insurance with tax-deductible dollars (which is how some of the programs are marketed).
Few of the programs will give solid guarantees about the tax treatment, but will try to hint around that the interest is deductible and then say "you need to contact your own tax professional". Other programs will circulate an opinion letter written for the program, which of course a particular business owner could not rely upon to avoid penalties.
Bottom Line: Have a qualified tax attorney review and opine on the arrangement in each particular case. Do not take the vendor's word that the interest is deductible, and do not delude yourself into believing that an opinion letter given to the program generally can be relied upon to avoid penalties in a particular case.
The Non-Recourse Trap
Some programs are starting to offer "non-recourse financing" which means that the business owner is personally on the hook for the loan. While this is not a scam, it is potentially a serious design defect. If the loan is a recourse loan, meaning that the business owner has guaranteed it, then the business owner might have additional "basis" equal to the amount of the loan in the his business. This additional "basis" provides some added tax comfort when the business owner takes the money out of his business because it is sound fall-back position if his other position for taking money out of his business fails.
If you think about it, most A/R financing programs are effectively non-recourse programs anyway, since the cash value in the annuity or life insurance policy is always available to pay off the loan. While there might be some slight exposure to the business owner in the early years because of surrender charges, this slight exposure is not enough to make up for the great tax risk that the business owner may face because the loan is non-recourse and he will not be able to establish additional basis.
Bottom Line: While non-recourse financing is not a scam, it is a serious design defect and should be avoided whenever possible.
How To Avoid Being Scammed
There are at least two things that you can do to avoid being scammed:
First, shop around and compare several programs. The dumbest thing that you can do is to go with the first program that you hear about. There are more than a dozen programs available – check at least a few out and compare.
Second, hire an independent tax attorney to review the program and opine on its benefits. Do NOT hire a tax attorney who has been retained by the program administrator or the insurance agent who contacted you about the program. Find a tax attorney who is independent and not on somebody else's payroll, and have them make an honest and objective appraisal of the benefits and disadvantages of the program for you.
For More Information
Visit http://www.farbook.com which is the website of life insurance agent Ron Adkisson who has written a book on A/R financing programs and who regularly writes articles discussing their benefits and disadvantages.