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Federal Tax Lien Can Take Other Secured Creditors By Surprise


The Business Advisor

May 2007

Put yourself in the place of a creditor, secured by a blanket lien (“Secured Creditor”), who, in the ordinary course and in accordance with its contractual rights, pays down its credit advances from the proceeds of the borrower’s accounts receivable coming directly into the Secured Creditor’s lockbox. Suddenly, that Secured Creditor is served with a Notice of Levy issued by the Internal Revenue Service (“Service”) to its taxpayer–who happens to be the Secured Creditor’s borrower (“Mr. Taxpayer”). The Notice states that Mr. Taxpayer has failed to pay income tax, interest and penalties owing to the United States and demands that any property owned by Mr. Taxpayer in the possession of the Secured Creditor be immediately surrendered to the Service until the federal government’s lien is paid in full. As the Secured Creditor, you are naturally thinking that your valid and properly perfected lien against all of your borrower’s personal property cannot be trumped by a federal tax lien. To be safe, however, you call your lawyer at Gibbons and ask, “as between me and the Service, which one of us has the right to Mr. Taxpayer’s receivables?”

Section 6321 of the Internal Revenue Code grants the United States a lien upon a taxpayer’s real and personal property, and the rights to such property, when the taxpayer fails to pay any tax due. 26 U.S.C.A. § 6321 (West 2004). To be enforceable, the federal government first must make a demand upon the taxpayer for payment of the tax, together with any interest and additional amounts due, including assessable penalties and costs. Id. The lien arises at the time the Service makes the tax assessment and continues “until the liability for the amount so assessed (or a judgment against the taxpayer arising out of such liability) is satisfied or becomes unenforceable by reason of lapse of time.” 26 U.S.C.A. § 6322. The “lapse of time” would occur if the federal government failed to enforce its lien before the expiration of the statute of limitations for collection. If suit were brought before that time, the lien would be extended indefinitely. Markham v. Fay, 74 F.3d 1347, 1353 (1st Cir. 1996).

In order for the federal tax lien to be valid as against the lien held by a perfected security interest in property, a construction lien, or a judgment lien, including the Secured Creditor’s lien in this example, the Service must record a notice of the federal tax lien (“Notice of Tax Lien”). 26 U.S.C. § 6323(a). With respect to personal property of the taxpayer, the Notice of Tax Lien must be filed in the office that is designated by the laws of the state in which the property is situated, meaning the residence of the taxpayer at the time the Notice is filed. 26 U.S.C.A. § 6323(f)(1)(A)(ii) and (2)(B). With respect to real property, the state law of the state in which the property subject to the lien is situated also determines the place for filing of the Notice of Tax Lien. 26 U.S.C.A. § 6323(f)(1)(A)(i) and (2)(A).

Of particular interest to our Secured Creditor, however, are the provisions of 26 U.S.C.A. § 6323(c), which govern the relative priority as between the Service and an asset-based lender to assets such as accounts receivable or inventory. Even in instances where a secured creditor’s security agreement with a taxpayer antedates the Notice of Tax Lien filed against the taxpayer and the UCC-1 financing statement covering the taxpayer’s inventory and/or receivables is recorded before the Notice of Tax Lien, that statute limits the priority of a secured creditor’s lien against a taxpayer’s receivables vis-à-vis the Service’s tax lien. Under section 6323(c)(2)(A)(i) and (B) of the Internal Revenue Code, a secured creditor’s lien takes priority over the Service’s tax lien only to the extent of advances that a secured creditor makes to the taxpayer during the forty-five (45) days immediately following the filing of the Notice of Tax Lien and only as to receivables of the taxpayer arising during the same period.

If the taxpayer fails or refuses to pay the tax within 10 days after notice and demand for payment by the Service, the Service may issue a Notice of Levy. 26 U.S.C.A. § 6331(a). The Notice of Levy takes priority in right to payment over the property of the taxpayer in the taxpayer’s possession (or in the possession of a third-party nontaxpayer (such as the taxpayer’s bank or employer) if the Notice of Levy is addressed to the nontaxpayer), subject to the security interest and lien of a properly perfected secured creditor. The levy can be made upon all property of the taxpayer and the rights to such property, except for limited exemptions. By the levy, the government acquires the “power of distraint and seizure by any means.” 26 U.S.C.A. § 6331(b). Multiple levies may be made until the government is fully paid. 26 U.S.C.A. § 6331(c). The Notice of Levy spells out the provisions of the Internal Revenue Code relating to the levy and sale of the taxpayer’s property; the levy and sale procedures; the appeals process; alternatives that the taxpayer may pursue, including satisfaction of the tax and related liability by means of installment payments; and property redemption rights and procedures. 26 U.S.C.A. § 6331(d)(4). The addressee of the Notice of Levy (whether the taxpayer or a nontaxpayer in possession of taxpayer property) is required to surrender property that is the subject of a Notice of Levy to the Service, unless at the time of the demand such property is subject to an attachment or execution under any judicial process. 26 U.S.C.A. § 6332(a). The penalty for failing to surrender property that is subject to a levy is 50% of the amount recoverable, none of which can be credited against the tax liability. 26 U.S.C.A. § 6332(d)(2). Any person who receives the Notice of Levy and fails to surrender to the Service property of the taxpayer in his or her possession is personally liable to the federal government in an amount equal to the value of the property that he or she failed to surrender, together with costs and interest on such sum. 26 U.S.C.A. § 6332(d)(1).

In light of applicable law discussed above, the answer to the Secured Creditor’s question is this: if the Service has properly recorded its Notice of Tax Lien with respect to Mr. Taxpayer’s personal property, whether or not the Secured Creditor held a pre-existing security interest and lien in and against that property, from and after the 46th day after the filing of the Notice of Tax Lien, any receivables coming into the possession of the Secured Creditor through the lockbox would have to be surrendered to the federal government.

1Even though the Service has filed its Notice of Tax Lien, the government’s lien does not take priority over certain other interest holders, including, among others, a purchaser of a security where the holder of security interest in such security lacks actual notice or knowledge of the existence of the federal tax lien; holder of a motor vehicle lien; a purchaser in the ordinary course of personal property purchased at retail without notice and with no intention of hindering the collection of the tax; purchaser of personal property (not for resale) with a value of less than $1,000.00, provided that the purchaser lacked actual notice or knowledge of the existence of the federal tax lien or that the sale is one of a series of sales; possessory lien for repair or improvement against tangible personal property; real estate tax and special assessment liens; construction lien for repairs and improvements having a contract price of $5,000.00 or less on multifamily residential property, with four or less dwelling units one of which is occupied by the owner; attorney’s liens; certain insurance contracts; and certain deposit-secured loans. 26 U.S.C.A. § 6323(b).