I. INTRODUCTION
For many bankers, confronting issues arising from the federal tax lien law has been likened to “tortured meanderings.” But with some basic understandings of the rules of priorities between a financial institution’s own lien and a federal tax lien, bankers should be able to assess their relative position, and in the future, preserve their rights in collateral.
II. PRIORITIES
A. General
As a general rule, the Internal Revenue Service (IRS) will issue a federal tax lien. A federal tax lien automatically arises for the amount of unpaid federal taxes and covers the taxpayer’s real and personal property (even property acquired after the lien was created). Although Nebraska state law is used by the IRS to determine whether the taxpayer has a property interest in an asset, the Nebraska statutes that exempt certain types (or amounts) of property from a creditor’s claims (e.g., homestead exemption) are not applicable to the federal tax lien.
Prior perfected security interests and other properly secured property are not a real threat to secured lenders until the IRS files a notice of lien. The notice is filed by the IRS in the county where the assets are located. Conflict between a financial institution and the IRS may arise when the IRS levies on property covered by the federal tax lien. At this point, the institution may demonstrate its lien priority by proving its lien was “first in time.” In order to prove first in time, the institution must show that its lien was perfected prior to the filing of the federal tax lien and that the institution’s lien was “choate” at the time the IRS filed its notice of lien. To be “choate” means that the lienholder’s identity, covered property under the lien and the amount of indebtedness secured by the lien is firmly established.
Should the institution’s security in the borrower’s assets not be properly perfected according to state law then, generally, the collateral will be deemed inferior to the IRS lien. E.g., failure to properly file a financing statement or the lack of appropriate signature may result in unperfected liens.
Loan notes providing for multiple advances or secured by after-acquired property are generally not considered “choate” liens. The federal tax lien will be superior to a financial institution’s lien when the institution’s security covers an advance on a line of credit after the IRS notice of lien is filed. Generally, an institution’s lien is also defeated when the covered collateral was acquired by the borrower after the filing of the federal tax lien.
B. Federal Tax Lien Act
The Federal Tax Lien Act of 1966 (the “Act”) allows specific security interests to be protected, even when arising after a notice of tax lien is filed. The following is a summary of the Act’s criteria:
1. There must be a written security agreement granting a security interest in the taxpayer’s property. The security interest, according to the Act, is not effective until the secured property is acquired. Under State law, an institution’s security interest must defeat other competing nonconsensual liens. Generally, the security interest covers only the amount of money advanced.
2. The following types of property are protected by the Act: inventory, accounts receivable, mortgages on real property and paper of a kind ordinarily arising in a commercial transaction. The property must be acquired by the borrower/taxpayer no later than 45 days after the date of the federal tax lien’s filing.
3. The financial institution and the borrower/taxpayer must have entered into a written agreement to make a loan before the federal tax lien was filed and the loan must be funded within 45 days after the tax lien was filed or prior to the institution’s knowledge of the tax lien filing, whichever occurs first.
COMPLIANCE NOTE: To avail itself of the Act’s protection, a financial institution should review federal tax lien records to determine whether its lien is first in time in the case of lines of credit with multiple advances. A check of the federal tax lien records would be prudent prior to approving line of credit advances.
III. LIEN FORECLOSURE
Prior to foreclosing on a borrower’s real or personal property, a federal tax lien search of the records should be made. If a federal tax lien has been filed and such lien is determined inferior to the institution’s lien, the IRS must still be notified by the institution of its intended foreclosure action, either by registered or certified mail or by personal service, to the Internal Revenue Service (IRS) official, office and specified in IRS Publication 786, “Instructions for Preparing a Notice of Non-Judicial Sale of Property and Application for Consent to Sale,” or its successor publication. The relevant IRS publications may be downloaded from the IRS Internet Site at http://www.irs.gov/.
A written notice must be given not less than 25-days prior to a foreclosure sale, containing the following:
1. Name and address of person submitting the notice of sale;
2. Copy of each Notice of Federal Tax Lien (Form 668) filed on the property to be sold;
3. Detailed description and location of the property affected by the notice;
4. Date, time, place and terms of the proposed sale; and
5. Approximate amount of principle and interest accrued which is secured by the lien and a description of expenses (legal fees, selling costs, etc.) to be charged against sale proceeds. Should the notice of sale fail to sufficiently describe the property or is otherwise inadequate, the Act allows the IRS director to alert the bank, but such alert must be accomplished more than 5 days prior to sale or the notice of sale is deemed sufficient.
In the event of a judicial proceeding of foreclosure, the institution must notify the IRS at the commencement of the proceeding if a federal tax lien has already been filed. If a tax lien is not on file, the institution has no duty to continue record searches once the proceeding has commenced.
In the case of a nonjudicial sale, the institution must give the IRS at least 25 days notice if the IRS previously filed its tax lien more than 30 days before the scheduled sale date. Subsequent tax lien searches are then unnecessary.
When the IRS has been notified appropriately, the foreclosure sale extinguishes the federal tax lien on such property. An improperly filed federal tax lien is also extinguished by the foreclosure sale. A financial institution’s failure to properly notice the IRS allows the federal tax lien to become a senior lien to that of the institution’s lien and the government may then initiate collection remedies to enforce its claim to the property. Even in the event a scheduled sale is cancelled, it has been held that an IRS lien becomes superior to the institution’s lien when the IRS is not properly notified. This is another good reason to conduct an appropriate federal tax lien search prior to commencement of a foreclosure action.
IV. SET-OFF V. IRS LIEN
On occasion, a financial institution may desire to set-off funds that a borrower maintains against an outstanding debt. Set-off, if properly accomplished, may defeat a federal tax lien (but much litigation, with various results, has been waged over this issue).
Generally, an institution must exercise its right of set-off prior to the filing of a federal tax lien. The debtor’s rights to the deposits must be extinguished completely (e.g., a “hold” on funds does not extinguish a debtor’s rights). If the debtor has access to deposited funds when the IRS files its lien, the IRS may claim on interest in the account and defeat an institution’s attempted set-off. The actual IRS levy attaches to property in which the taxpayer has an interest and cannot attach to an account where the taxpayer is a mere signatory with no property interest in the account.
B. Case Law
In Horton Dairy, Inc. v. United States, 986 F.2d 286 (8th Cir. 1993), the IRS levied on assets of the borrower and the bank claimed priority based upon a security interest in the same assets and a right of set-off of funds in the bank account. The court held that the bank’s security interest was unperfected and accordingly the IRS lien had priority. With respect to the funds in the bank account, the court held that any state law, lien or right of set-off was junior and inferior to the federal tax lien. The court held that an unexercised right of set-off was “inchoate” and did not have priority nor would it defeat a government tax lien. The court held that in general the set-off must be exercised and accomplished prior to the levy and assertion of the tax lien. The necessary elements for an effective set-off are: the decision to exercise the right, some action that accomplishes the set-off, and some record which evidences that the right of set-off had been exercised.
Compare this 8th Circuit case with the following 10th Circuit case.
In U.S. v. Cache Valley Bank, 866 F.2d 1242 (10th Cir. 1989), the court held that a federal tax lien has priority over a bank’s right of offset irrespective of the timing of the filing of an administrative levy. The borrower, a concrete company, was involuntarily dissolved on December 31, 1983. Prior to that time, the Internal Revenue Service made a series of tax assessments totaling $92,256.70 against the borrower for unpaid federal employment taxes. The government properly filed notice of a tax lien arising from those assessments on December 17, 1980. The borrower failed to pay the assessments upon demand.
On October 8, 1980 and on January 16, 1981, the Cache Valley Bank’s predecessor in interest made two unsecured loans to the borrower of $12,500 and $25,000, respectively. The loan documents provided that the bank “may offset” against those loans “any bank account or any other amounts owed by Bank in any capacity to the [borrower].” The borrower held a checking and savings account with Cache Valley Bank.
At approximately 9:20 a.m. on July 27, 1981, the bank received notice of an IRS levy purporting to attach all property of the borrower then in the bank’s possession. The bank’s vice president examined that borrower’s accounts and determined that its funds on deposit at that time were negligible. Accordingly, he returned the notice of levy to the IRS with the notation, “7/27/81, 9:30 a.m.; MG, NO FUNDS AVAILABLE.” Later that same day, deposits totaling $28,416.06 were made to the borrower’s checking account. On July 28, 1981, the bank offset the entire amount in the borrower’s checking account against the two loans of $12,500.00 and $25,000.00.
The government filed suit to enforce the tax lien claiming the entire amount in the borrower’s checking account as subject to the tax lien. The bank argued that its right of offset should prevail over the tax lien unless both the tax lien and the levy attach and are served before the bank exercises its right of offset and then only to funds on deposit when the levy was received. The Tenth Circuit Court of Appeals disagreed and held that the federal tax lien arises when unpaid taxes are assessed and continues until the resulting liability is either satisfied or becomes unenforceable through lapse of time. The lien attaches not only to property in existence at the time it arises, but also to after-acquired property. The court further held that the transfer of property subject to the lien (for example through the bank’s exercise of its right of setoff) does not affect the lien because no matter into whose hands the property goes, it passes with the lien attached. It appears that the only exception would be where the third party holding the property has a prior lien on it, or comes within one of the exceptions of the relevant statute. The court held that the mere contractual or statutory right of offset did not constitute a prior claim or interest sufficient to defeat the federal tax lien. The court also suggested that some “discrete act” by the bank “to proscribe the taxpayer’s control or constructive possession of the account” might have somehow altered the result, as might a clause in the loan agreements placing “restrictions on the taxpayer’s right to withdraw funds from its bank account.” The opinion does not suggest the type of proscriptions or restrictions that would protect the bank’s right of set-off against such deposits. In the absence of such proscriptions or restrictions, once a federal tax lien arises and has not lapsed, moneys deposited into the taxpayer’s account are subject to the lien and cannot be reached by the depository bank through right of off-set. Since the court felt that the time the lien attached was the significant event, it appears that the court would have reached the same decision in the absence of the levy by the IRS at approximately 9:20 a.m. on July 27, 1981.
Because of this case, a bank may consider language to include in loan agreements to place sufficient restrictions on the borrower/taxpayer’s right to withdraw funds from one or more of its deposit account to proscribe the borrower/taxpayer’s control or constructive possession of the account. Another approach would be to consider taking a security interest in the borrower’s deposit account. The best approach may be to include language in loan agreements to require the borrower to provide sufficient financial reports to determine whether all taxes are being paid as they become due.
V. PENALTIES
Unless a delinquent taxpayer’s property is subject to prior judicial attachment or set-off, an institution in possession of such property must surrender it to the IRS. Refusal to properly surrender property to the IRS may subject the institution to liability for the amount of unpaid taxes plus interest and costs (limited to value of property possessed by the institution). A 50% penalty may also be assessed by the IRS against the institution absent a showing that there was “reasonable cause” to resist the levy (e.g., good faith dispute over amount held by the institution or dispute over legality of the IRS levy.) When an institution has a security interest in a delinquent taxpayer’s property, the priority issue must be litigated with 90 days after the levy.
VI. CONCLUSION
Since a financial institution’s right to set-off may run head-on into an IRS tax lien, it is important to understand the implications of notice and timing. Another related area involves tax levies and set-off rights. NOTE: Please refer to the NBA Compliance Handbook, Volume II, Deposit Account Section article entitled “Internal Revenue Service: Tax Levies and Set-off” for a discussion of IRS Notice of Levy, response to such notice, property subject to or exempt from levy, treatments of CDs and joint accounts, holding periods, set-off issues, penalties for noncompliance and IRS requests to review customer books and records.