Federal Tax Liens are often the final nail in the coffin of an operating company’s slide into insolvency. The recording of a Federal Tax Lien will effectively shut off the flow of commercial financing dollars and is also deemed a statutory lien not subject to avoidance by a Trustee under 11 U.S.C. §§545 and 547(c)(6). The IRS, often referred to as “the most voracious creditor of them all,” is armed with far-reaching lien rights. In that regard, it is important to remember that State-created exemptions that protect individuals against judgment creditors are not effective against the effect of a Federal Tax Lien, which includes the homestead exemption and individual retirement accounts. See, e.g. United States v. Mitchell, 403 U.S. 190 (1971); Deppisch v. United States (In re Deppisch) (1998 BC, SD Ohio) 227 BR 806.
What follows is the statutory background regarding Federal Tax Liens and addresses key issues that come up in contests between Article 9 security interests and practical issues facing Bankruptcy Trustees and Assignees for the Benefit of Creditors in the liquidation context.
There are several sections of Title 26 that typically come into play regarding Federal Tax Liens.
- 26 U.S.C. §6321 – “Lien for taxes.” This is the operative section for the creation of liens for unpaid taxes “in favor of the United States upon all property and rights to property, whether real or personal, belonging to such person.” This means ALL property rights, choate and inchoate.
- 26 U.S.C. §6322 – “Period of lien.” The lien arises from the time of assessment and continues, “until the liability … is satisfied or becomes unenforceable by reason of lapse of time.”
- 26 U.S.C. §6323 – “Validity and priority against certain persons.” This is the section that deals with the interplay between secured creditors involved in lending to an operating business and the impact of the properly recorded Federal Tax Lien. The Federal Tax Lien “shall not be valid as against any purchaser, holder of a security interest, mechanics’s lienor or judgment lien creditor” until it is properly recorded under the same locational rules for the perfection of an Article 9 security interest. The “forty-five day rule” is found throughout this section of the statute which, simply stated, protects secured lenders for advances made and collateral taken only within 45 days of the date of recording of the Federal Tax Lien. Thereafter, the IRS has a priority as to inventory and accounts receivable created as a result of the business operations of the taxpayer. An exception appears to be present for purchase money transactions, although there is no clear provision in Title 26 that recognizes that priority, but there is case and tax regulation authority recognizing the priority.
- 26 U.S.C. §6327 – “Cross references.” This section reminds the reader that the Bankruptcy Code specifically deals with tax liabilities and the specific “recognition” of Federal Tax Liens in the Bankruptcy context in 11 U.S.C. §§523, 545, 724 and 1328.
- 26 U.S.C. §7425 – “Discharge of Liens.” This section deals with, among other matters, the notice procedure that a secured creditor must follow in order to have a junior lien discharged against the collateral being foreclosed upon. There is a strict 25-day notice requirement.
- Four hypotheticals:
Accounts and the 45-Day Rule
If (1) a security agreement was signed by the taxpayer before the tax lien filing, (2) the commercial financing security was acquired by the taxpayer within forty-five days of the tax lien filing, and (3) the security interest is properly perfected under State law, the secured creditor will prevail.
Facts: Bank loans money to debtor and perfects a security interest in inventory and accounts. Raw materials are purchased and converted into work in process and finished good inventory. A Federal Tax Lien is recorded. Inventory is sold from which accounts receivable are generated for a period of 45 days after the date of the recordation of the Tax Lien. On the forty-fifth day the debtor builds out additional inventory from work in process and raw material inventory already on hand and sells it after the forty-sixth day and creates additional accounts receivable that are sent to the secured creditor’s lockbox.
Result? The Court in Donald v. Madison Industries, Inc., 483 F. 2d 837, 834 (10th Cir. 1973) held that to the extent that finished product contained raw materials on hand before the forty-sixth day, the product was acquired in time to be protected from the Federal Tax Lien; to the extent that ingredients or labor were added after the forty-fifth day, the finished product was not property from which the accounts created therefrom would maintain their priority as against the IRS. The Court put the burden on the secured party to prove what portion of the finished product’s value was attributable to property owned by the debtor before the forty-sixth day. Because the bank failed to meet this burden, the IRS was given priority to all but the inventory finished before the forty-sixth day.
Purchase Money Security Interests
Although a security interest that is perfected after the recording of a Federal Tax Lien normally loses to the IRS, case law and the IRS itself have created an exception giving purchase money security interests priority over the tax lien. See, Slodov v. United States, 436 U.S. 238 (1978); First Interstate Bank of Utah, NA v. IRS, 930 F. 2d 1521 (10th Cir. 1991) and Rev. Rul. 68-57, 68-1 CD 553 (1968). Title 26, however, is silent on the issue. Note that UCC 9-317 gives the holder of a PMSI 20 days in which to get its UCC-1 recorded in order for the security interest to “take priority over the rights of a buyer, lessee or lien creditor which arise between the time the security interest attaches and the time of filing.” The financing statement must be filed “before or within 20 days after the debtor receives delivery of the collateral.”
Facts: Federal Tax Lien is recorded on January 1 in Sacramento. On January 5 a supplier delivers a piece of equipment to the Debtor, obtained a signed and dated delivery receipt from the trucking company, and retains a purchase money security interest (“PMSI”) on the equipment. The supplier files its UCC-1 Financing Statement on January 24.
Result? Although the supplier was not the holder of a security interest on January 1, it nonetheless has a priority over the IRS. The Supreme Court in Slodov justified this priority rule in that it “reflects [the purchase money lender’s] contribution of property to the taxpayer’s estate and therefore does not prejudice creditors who are prior in time.” 426 U.S. at 258, note 23. What happens in the hypothetical if the UCC-1 is recorded on January 4? January 25th? January 26th?
If the taxpayer owns a piece of equipment subject to a security interest that is disposed of prior to the recordation of a Federal Tax Lien, an Article 9 security interest attaches to the proceeds and takes priority over the tax lien. If the taxpayer disposes of the collateral after the recordation of the tax lien, and the proceeds are identifiable in the form of cash, chattel paper, an account, an instrument, or a trade-in, are such proceeds continuously perfected as against the IRS? An analogy to the “proceeds, product, offspring or profits” found in Section 552(b) of the Bankruptcy Code is present, although 26 U.S.C. §6323 is silent on the point. The test should be whether the secured creditor’s lien is continuously perfected under State law.
Facts: Lender has a perfected security in debtor’s inventory dating from 1970. A fire destroys the entirety of the inventory on December 23, 1971. Federal Tax Lien is recorded in May of 1972. Litigation is initiated and the insurance company reluctantly pays the lender an amount representing the value of the destroyed inventory in June 1973. Further litigation over the right to the insurance proceeds is brought due to the recordation of the Federal Tax Lien and a dispute over whether or not the insurance is “proceeds” under New York law.
Result? Lender wins, the Court finding that “the proceeds of the insurance are merely the collateral in another form.” PPG Industries, Inc. v. The Hartford Fire Insurance Company, et al, 531 F. 2d 58 (2nd Cir., 1976). What is the result if the Federal Tax Lien had been recorded in May of 1971 instead?
Nonjudicial Foreclosure Sales
A secured lender exercising default remedies must send notifications before disposing of collateral, in accordance with Commercial Code §9611 and 9612. “In a transaction other than a consumer transaction, a notification of disposition sent after default and 10 days of more before the earliest time of disposition set forth in the notification is sent within a reasonable time before the disposition.” (Emphasis added). Thus, the California legislature has established what a ‘reasonable time’ for notification is within the context of a UCC sale. However, 26 U.S.C. §7425 requires 25 days notice to the Secretary of the Treasury in order to cut off junior Federal Tax Liens. The notice must be by personal service, or by registered or certified mail.
Facts: Debtor is in default. Debtor files Chapter 11. Secured Lender obtains relief from stay to liquidate inventory collateral. Federal Tax Lien was filed 60 days before Chapter 11 case was filed. Secured Lender gives 10 days notice of the sale to the Debtor, the 20 largest unsecured creditors, and to the IRS. Secured Lender holds sale, and sells inventory in bulk to XYZ Corporation. The IRS thereafter demands to be provided with the identity of the purchaser at the sale, and sends a levy notice to the purchaser and to the Secured Lender.
Result? Several problems. First, the inventory at the time of the commencement of the case may be subject in whole or in part to the Federal Tax Lien. Second, the sale did not cut off the Federal Tax Lien and the buyer did not get good title from the secured lender because 25 days notice was not given to the IRS. If the Secured Lender is forced to disgorge the sale proceeds, does the Secured Lender still have a claim in the Chapter 11 case since it ‘foreclosed’ upon its collateral? What if there were several buyers at the Secured Lender’s sale instead of the collateral being sold in bulk?
More facts to think about: What if the Debtor obtained the use of cash collateral and converted raw material inventory that was sitting for six months prior to the filing of the Chapter 11 to finished goods inventory during the course of the Chapter 11 case? Will the secured lender lose its priority to the proceeds from the inventory as a result of its being transformed into finished goods after 45 days from the recording of the Federal Tax Lien, albeit under the supervision of the Bankruptcy Court, vis-à-vis the IRS? Is that why the IRS and the State are included “for notice purposes” at as many addresses as possible on the master mailing matrix? Can the Bankruptcy Court enter an Order preserving the priority of the Secured Lender against an indefeasible statutory lien of the IRS when the collateral is “transformed” during the course of the Chapter 11 case?
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