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February 29, 2024

Priority of Federal Tax Lien on Personal Property: Secured Lender vs. IRS

The priority of a federal lien for unpaid income taxes is complex and often misunderstood. Unlike the priority analysis for many other types of encumbrances, in addition to the usual timing analysis (first in time, first in right), the relative priorities between the Internal Revenue Service (IRS) and a secured lender also depend on the type of loan and the type of collateral.

The IRS lien arises at the time the unpaid taxes are assessed. However, the lien is not valid against the holder of a perfected security interest until a proper notice of federal tax lien (NFTL) for the collateral in question is filed against the taxpayer.1 Once the proper NFTL is filed, the relative priorities are determined based on, among other things, the nature and type of loan and the type of collateral. 

Although addressing all situations is beyond the scope of this alert, below is a description of the priority analysis for a lender with a perfected security interest in personal property.

In the case of a fully advanced term loan, the analysis is quite simple. As long as the loan is advanced, the collateral is owned by the borrower, and the security interest is granted and perfected before the NFTL is filed, the lender’s security interest has priority over a subsequently filed federal tax lien.

The difficulty arises when the loan provides for future advances, is secured by after-acquired collateral (i.e. the typical revolving loan situation), or both. In this situation:

  1. The lender’s perfected security interest in existing collateral (and, subject to the discussion in #2 below, certain after-acquired property) has priority over the IRS lien with respect to amounts advanced at the time the NFTL is filed and with respect to future advances which are made (a) pursuant to a loan or credit agreement existing before the NFTL is filed meeting certain requirements under the Internal Revenue Code and (b) within 45 days after the NFTL was filed or, if earlier, before the lender had actual notice or knowledge of the filing of the federal tax lien. The lender’s security interest securing advances made more than 45 days after the NFTL is filed or, if earlier, after the lender having actual knowledge would be junior in priority to the federal tax lien.
  2. The lender’s security interest in certain after-acquired collateral (including inventory and accounts receivable) would have priority over the federal tax lien if it is acquired by the borrower within 45 days after the NFTL is filed. The lender’s security interest in other types of after-acquired property (e.g., equipment) and in inventory and receivables acquired by the borrower more than 45 days after the NFTL is filed would be junior in priority to the federal tax lien.

In both situations, after 45 days has passed from the filing of the NFTL, the perfected security interest is junior even if the lender had no knowledge of the federal tax lien. Only a proper filing of the NFTL is required to constitute proper notice to a secured lender. The IRS is not required to give actual notice to the holders of existing security interests.

Clearly, once an NFTL is filed, the secured lender is in danger of losing its priority with respect to some or all of its collateral and some or all of the loan advances. Therefore, the lender must be in a position and be prepared to act quickly to cease loan advances, prevent the sale of inventory, and prevent accounts receivable collections from being used for any purpose other than paying down the loan. If it does not do so, its collateral position can greatly diminish over time as its security interest for later advances will be junior to the federal tax lien. As accounts are collected and new ones generated and inventory is sold and replaced by new inventory, the lender’s first priority lien on accounts receivable and inventory will be replaced by a second priority position on the new accounts receivable and the replacement inventory purchased.

There are a number of things a secured lender can do to help protect against a possible loss of priority to a federal tax lien. These may include such things as:

  1. Prior to making the loan, confirm that all taxes are current and no tax liens have been filed.
  2. Include covenants requiring that all tax returns must be filed and taxes paid when due.
  3. Include in the loan documents a requirement that the lender be provided with copies of all tax returns when filed and, either on an ongoing basis or upon request, proof that all taxes have been paid.
  4. Make sure failure to pay taxes and the filing of a tax lien are specifically listed as events of default. The filing of a tax lien, and possibly failure to pay taxes, should be excluded from any notice and cure periods.
  5. Include in the loan documents the immediate ability to cease making advances upon the filing of an NFTL.
  6. Include in the loan documents the immediate ability to (a) prohibit or prevent the payment of accounts receivable to any obligation other than the secured loan and (b) take steps to prevent the further sale of inventory (or other collateral).
  7. If the borrower is in financial trouble, consider periodic lien search updates.
  8. Once the lender discovers that an NFTL has been filed, it should immediately evaluate the effect and potential harm from the federal tax lien (including, among other things, the amount of the lien, the type and value of the collateral subject to the lien, and the type of loan) and take immediate appropriate action, which may include the actions described in #6.

Of necessity, the above includes only a general description of some of the actions that can be taken when an NFTL is filed against the borrower’s assets. It is important that, faced with this situation, a lender immediately involves counsel to help create a plan and take the steps necessary to protect the lender’s interests.

The priority of a federal tax lien on a borrower’s assets can be a complicated determination and is potentially detrimental to the lender’s collateral position and its ability to collect the loan. Addressing these potential problems at the loan origination stage and taking prompt action once an NFTL has been filed can help minimize the harm to the lender’s position.

The Thought Leadership Committee of Barclay Damon’s Restructuring, Bankruptcy & Creditors’ Rights Practice Area issues alerts and blogs on an ongoing basis to keep clients, colleagues, and friends up to date on important developments in the insolvency space. If you have any questions regarding the content of this alert, please contact the author, Robert Wonneberger, Thought Leadership Committee chair, at rwonneberger@barclaydamon.com, or Janice Grubin or Jeff Dove, Restructuring, Bankruptcy & Creditors’ Rights Practice Area co-chairs, at jgrubin@barclaydamon.com and jdove@barclaydamon.com.
                                                                                              
1It should be noted that the filing location for the NFTL is based on the location of the assets as opposed to UCC financing statements, which generally must be filed based on the primary residence (for individuals) or jurisdiction of organization (for corporations and other entities) of the borrower. For this reason, additional lien searches in different jurisdictions may be needed in order to determine if there are pending IRS liens.

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