Accounts receivable (A/R) financing offers the opportunity to leverage dormant assets (accounts receivable) into additional wealth and retirement security for business owner clients. Professionals and other business owners can protect this large non-productive asset from creditors by borrowing against their receivables to purchase a life insurance and/or an annuity contract. With an A/R program through a lending institution, the receivables are used as collateral for an interest-only bank loan. The loan proceeds may be used to purchase a single premium immediate annuity (SPIA). The annual guaranteed payments from the SPIA are used to pay annual premiums on a cash accumulation type of life insurance policy.
At retirement, the business receivables or other assets can be collected and used to pay off the principal of the loan. The client retains the life insurance policy with significant cash values where tax free withdrawals to basis and loans (FIFO) can be made to provide supplementary retirement income. Below is a step by step description of the transaction as it moves from beginning to end:
Phase 1: Business accounts receivable are pledged as security for an interest-only bank loan with no personal guarantee required. The receivables are now protected from business creditors as long as the UCC-1 security interest lien (Uniform Commercial Code) is in effect. The business makes interest-only payments to the lender during the term of the loan. The interest payments may be deductible as business interest. The CPA of the client should provide tax advice regarding deductibility of interest.
Phase 2: The loan is used to buy a guaranteed period certain SPIA which has an “exclusion ratio” for tax purposes. The after-tax payment from the SPIA guarantees the funds are available to pay an annual premium for a life insurance policy. This stream of annual premiums assures that the life insurance policy will not be a Modified Endowment Contract (MEC) for tax purposes. Both the SPIA and the insurance policy will have collateral assignments in favor of the bank to provide additional security until the loan is paid off at retirement.
Phase 3: At retirement, the loan is paid off by collecting the outstanding accounts receivable and using this after-tax revenue for final loan payoff. If there is still a shortfall, the lender can withdraw the needed amount from the life insurance cash value by virtue of the collateral assignment. Then the UCC-1 lien against the receivables is discharged and the collateral assignments on the SPIA and life insurance policy are also discharged.
Phase 4: Once the collateral assignments are discharged, the life insurance policy can be accessed for tax free withdrawals to basis and policy loans (FIFO). And the death benefit will ultimately pass income tax free to the heirs of the insured.
Professional business owners who have maxed out contributions to their qualified retirement plans are excellent candidates for an A/R program. Case design will vary depending on whether the business entity is a C Corp, S Corp, LLC, or Sole Proprietor. Policy ownership and design will depend on whether the contract will be used for retirement income purposes (personally owned) or for estate planning purposes (owned by Irrevocable Trust). You should obtain the last year-end balance sheet and profit/loss statement from the business owner in order to determine whether the business is suitable for A/R financing. Also, the Form 1120 tax return (C Corps), the Form 1120S return (S Corps), and the Form 1065 return (LLCs and Partnerships) provide useful financial information for A/R suitability purposes.