By: John B. Newman, Retired

Under the Uniform Commercial Code, lien priority is generally established by the date of filing of the financing statement – “first in time, first in right.”  The principal exception to this priority rule is the rights of the Internal Revenue Service.

If a taxpayer fails to pay any tax after demand from the IRS, the tax amount due, with interest, penalties and costs, is a lien upon all of taxpayer’s real and personal property.  This lien is called a “silent lien” because it comes into existence without notice to any party other than the taxpayer.  In order for the lien to gain priority against other liens, the IRS must file a notice of tax lien.  When the IRS files an official notice of tax lien, the lien then has priority over any subsequently perfected security interest in any collateral of the debtor/taxpayer.

More troubling for secured lenders is that in certain circumstances the filed IRS lien can also take precedence over previously-filed financing statements.  This occurs where there is after-acquired collateral such as accounts receivable or inventory that is constantly being replaced by the debtor.  While between two secured parties the first-filed lien on accounts receivable or inventory has priority over the second-filed lien, this is not the case with an IRS lien.

In the Federal Tax Lien Act of 1966 (26 U.S.C. §6323), Congress drew a bright line settling the priority of liens in after-acquired property between the IRS and a private lender such as a bank.  Under the Act, the bank’s security interest in receivables is superior to the IRS lien if all of the following apply:

  • the lender’s security agreement was entered into prior to the tax lien filing
  • the loan was extended prior to the tax lien or within 45 days afterwards without the lender’s actual knowledge of the tax lien
  • the debtor acquired the collateral within 45 days after the tax lien filing

The Act works as follows:  As in the typical case, assume a bank is financing receivables.  Assume the debtor turns over all of its receivables in 75 days.  If 120 days pass after the IRS files its lien, then the bank will have no remaining receivables because the only remaining receivables will be those which were created more than 45 days (120 minus 75) after the IRS filed its lien.

The Act makes it essential to search for federal tax liens when making or monitoring a loan secured by after acquired-property such as accounts receivable or inventory.  While monitoring the loan, it is advisable to check regularly on federal tax liens, to obtain certifications from management that all taxes are paid current and to ascertain that there are no tax liens or audits pending or threatened.  If any are pending, they should be watched closely.

If the IRS does file a lien, it is undoubtedly an event of default under the loan agreement with the debtor.  The lender should act immediately to protect itself, understanding that it only has 45 days to seize all of the receivables or watch them erode to the IRS day by day thereafter.  Proper due diligence, both before and after a loan is made, is essential to protect lenders from being primed by IRS liens.

This publication is intended for general information purposes only and does not constitute legal advice. The reader should consult legal counsel to determine how the law may apply to specific situations.