Federal Tax Liens – Part II


This is the second part of a two-part article about the federal tax lien. The last article covered the nature of the lien, focusing primarily on its broad reach, attaching as it does to “all property and rights to property” of the taxpayer wherever situated. In the paragraphs below, we will consider the priority of the federal tax lien as compared to the liens of other creditors claiming interests in the taxpayer’s property. The question of who wins the tug of war between the IRS and other creditors can be crucial to a beleaguered taxpayer’s ability to maintain the operations of his business, to protect his personal assets, to negotiate an offer in compromise, or to properly arrange his affairs in preparation for the strategic filing of a bankruptcy petition. We will also outline the procedures for obtaining the release, discharge, subordination or withdrawal of federal tax liens which may be encumbering your client’s property.2

First in time is first in right

In most cases, the priority of the federal tax lien compared to the secured and perfected claims of other parties is governed by the general rule “first in time is first in right.” Nevertheless, the Internal Revenue Code provides for many special situations and classes of creditors. Some of these creditors will lose to the IRS despite having perfected their security interests before the notice of federal tax lien was filed. Others will prevail against the IRS lien without filing at all.

Interests protected prior to the filing of notice

Some creditors are protected against the IRS prior to the filing of notice of federal tax lien, even if the tax lien has already come into existence by virtue of assessment, notice and demand. (Remember, the federal tax lien can and often does arise as a matter of law, long before any “notice” thereof is filed in the public record.)

Holder of a security interest

IRC §6323(a) sets forth the general rule that the holder of a security interest is protected against an IRS lien as long as the security interest is properly perfected prior to the filing of the notice of federal tax lien.3 The Code defines a security interest as any interest acquired by contract for the purpose of security (payment, performance, indemnity) in existing property for which the holder paid money or money’s worth, and which has priority under local law over subsequent judgment liens arising out of unsecured obligations. This includes the typical real estate mortgage or deed of trust.

Purchaser

A purchaser of property is protected against a federal tax lien if the notice of the lien has not been filed at the time of the purchase.4 For this purpose, the term “purchaser” means someone who acquires property for adequate and full consideration in money or money’s worth without actual notice of the existence of the lien.5 (Some purchasers are also protected in transactions occurring after the filing of the notice of federal tax lien — see discussion of the so-called “superpriorities” below).

Judgment lien creditor

A judgment lien creditor is also protected against a federal tax lien if the notice of lien has not been filed at the time the creditor’s lien interest arises. This requires both the entry of a judgment for the recovery of a certain sum of money, and the proper perfection of the lien on the property in question.6 In Maryland, in order to constitute a lien a judgement must be recorded. Thus, a judgement entered prior to the filing of the notice of federal tax lien will not have priority if it has not also been recorded prior to the filing of the tax lien.

Superpriorities

In some situations, despite having filed a proper and timely notice of federal tax lien, the IRS will still lose to a creditor, a purchaser, or another party who falls within one of the “superpriority” categories set forth in the Internal Revenue Code.7 The more common superpriorities are described below:

Securities

The federal tax lien is not effective against someone who purchases marketable securities from the taxpayer without actual knowledge of the existence of the lien, even if a notice of lien has been filed.8 Similarly, the tax lien cannot defeat the holder of a security interest in securities even though the security interest arose after the filing of the notice of federal tax lien, as long as the holder of the security interest did not have actual knowledge of the tax lien. In order for the IRS to perfect its lien so as to defeat possible purchasers of securities, it must take actual possession of the securities (thus effectively preventing their sale).

Motor vehicles

A filed federal tax lien is not valid against someone who purchases and receives possession of a motor vehicle from the taxpayer, as long as the purchaser did not have actual knowledge of the tax lien at the time of the purchase.9 As a practical matter, liens on vehicles, to be effective, must be filed with the Maryland Department of Motor Vehicles and noted on the vehicle title.

Personal property purchased at retail

It is essential that a retail business have the ability to continue selling merchandise in the normal course of business, despite the filing of a notice of federal tax lien against it. The Internal Revenue Code accommodates this economic necessity by providing a superpriority for someone who purchases tangible personal property in a retail sale, unless the purchaser is aware of the lien and intends by such purchase to hinder, evade or defeat the collection of the federal tax at issue.10 A retail sale means a sale in the ordinary course of the seller’s business in customary retail quantities. Even purchases from a seller who is going out of business are protected, except in the case of a bulk sale or an auction sale.

Personal property purchased in casual sale

Similarly, a filed federal tax lien is not valid against a purchaser of household goods, personal effects or other tangible personal property which is purchased in a casual sale for less than $250.11 A casual sale is one not made in the ordinary course of the seller’s trade or business. The purchaser is protected as long as he does not have knowledge of the existence of the lien at the time of the transaction.

Mechanic’s lien for repairs and improvements

Another superpriority is provided for mechanics liens of up to $1,000 on a personal residence consisting of no more than four dwelling units with the owner occupying one of the units.12

Attorney’s liens

An attorney is protected by a statutory superpriority with regard to legal fees due to be paid from a judgment or settlement. The fees must constitute “reasonable compensation” for the time spent in obtaining the judgment or procuring the settlement in question, and is effective even if the attorney has actual notice or knowledge of the filing of the federal tax lien.13

Insurance loans

In some cases, an insurance company is protected against a filed IRS lien when making a loan to a policy holder and taking an interest in the cash value or proceeds of the policy as security for the loan.14 The priority applies to loans made without actual knowledge of the filing of the notice of federal tax lien. It also covers loans made with actual knowledge of the lien to the extent that such loans or advances are required to be made under an agreement with the policy holder entered into prior to the company becoming aware of the existence of the lien. This situation often arises when an insurance company makes an automatic premium loan to keep a life insurance policy in force pursuant to an agreement (including an agreement found in the terms of the policy itself) entered into prior to the filing of the notice of federal tax lien.

Passbook loans

A similar superpriority is available to protect a bank on a loan secured by an account with the bank when the bank holds the account passbook in its possession until the loan is paid, or blocks withdrawals from an account securing the loan.15 This protection is available only for loans made before the bank has actual notice of the tax lien.

Commercial financing transactions

In addition to the superpriorities, certain other kinds of interests are given a limited priority over the federal tax lien even though they come into existence after notice of tax lien is filed. These include interests under so-called “commercial transactions financing agreements” and similar arrangements.16

The term “commercial transactions financing agreement” means an agreement arising in the normal course of business either to (1) make loans to the taxpayer, secured by “commercial financing security” (i.e. accounts receivable, mortgages on real property, or inventory), or (2) to purchase commercial financing security, other than inventory, which was acquired by the taxpayer in the ordinary course of business.17 However, to enjoy this priority, such an agreement must have been made before the earlier of (1) the 46th day after the notice of federal tax lien is filed, or (2) the date on which the lender or purchaser acquires actual knowledge of such filing.

The lender or purchaser, to be eligible for protection, must have made the loan or purchase in connection with the conduct of its own trade or business. This would include a bank or commercial factor, or a manufacturer who finances the accounts receivable of its customers. The priority over the federal tax lien is limited to the amount disbursed before the 46th day after the date the notice of lien is filed, or if earlier, the date the lender or purchaser has actual knowledge of the filing of the lien. Please understand that this is a limited priority which protects only certain narrow classes of creditors, and only for a brief period of time after the notice of federal tax lien is filed.

Releasing, discharging or subordinating the lien

Despite all of the ink spent on the above explication of situations in which other creditors can have priority over the federal tax lien, in most cases the focus is not on defeating the lien but on removing, discharging or subordinating it. Effectively invoking these procedures for your client can facilitate the survival of his business, permit the refinancing of his assets, or enable the sale of those assets to satisfy the lien or to secure the money to fund an offer in compromise. A number of “certificates” related to the lien can be issued by the IRS upon request, depending on the particular situation:18

Release: completely extinguishes the lien.

Discharge: removes certain property from the lien.

Subordination: relegates the lien to a lower priority.

Nonattachment: denotes that a person of like or similar name is not, in fact, the taxpayer.

Withdrawal: eliminates public notice of the lien.

Certificate of Release

IRC §6325(a)(1) requires that the federal tax lien be released not later than 30 days after the District Director has determined that the liability has been fully satisfied19 or has become legally unenforceable (e.g. by the running of the statute of limitations on collection). The Service must do this on its own, and no request by the taxpayer is required. Normally, this is accomplished automatically when the IRS computer determines that the balance has been reduced to zero on a tax account for which a lien was previously filed. If the notice of federal tax lien covers multiple tax periods, it will not be released until all periods covered are satisfied; nevertheless, upon request the Service can issue a “partial” release in this situation.20

In the past, the IRS was often derelict in accomplishing the release of liens on tax liabilities which had long been paid.21 This caused many constituent complaints to members of Congress, and led eventually to the adoption of strong provisions regarding releases in the Taxpayer Bill of Rights 2. These provisions are now found at IRC §7432, which permits a taxpayer to sue for damages if the IRS knowingly or negligently fails to release a lien. To invoke the right to sue, the taxpayer must first request a release, whereupon the Service has 30 days to issue a certificate of release, if appropriate.22 The request must be filed in writing with the Chief, Special Procedures Function, and must contain the information specified in Pub. 1450 and Regs. §401.6325-1(f), including the name and address of the taxpayer, a copy of the notice of federal tax lien in question, and an explanation of the grounds upon which the issuance of the release is sought.23

Certificate of Discharge

A “discharge” must be distinguished from a release. A release constitutes the complete elimination of the federal tax lien, which thereafter has no effect on any of the taxpayer’s property (unless it is “reinstated”). A discharge, pursuant to IRC §6325(b), merely removes the specified property from the lien; the lien is undisturbed and remains in place as to all other property. Property will be discharged from the federal tax lien pursuant to the taxpayer’s request under three circumstances: (1) the aggregate value of the taxpayer’s other property, less encumbrances with priority over the tax lien, is at least double the tax liability at issue; (2) the IRS is paid the value of its “interest” in the property to be discharged (if there is any such value), or (3) if the property is to be sold, with the IRS’s lien attaching to the in proceeds the same manner and with the same priority as the lien itself.24 The Certificate of Discharge is obtained by filing a application containing the information specified in Pub. 783.25

Certificate of Nonattachment

On occasion, a client will need proof that a federal tax lien does not “attach” to his property in circumstances where certificates of release or discharge are not appropriate or available. From its title, one might assume that the certificate of nonattachment was designed for all such purposes. For example, your clients, a married couple, want to refinance or sell their house, but a notice of federal tax lien is on file for taxes assessed against one of them (but not both). The buyer or lender might demand a release. Having read these articles, and therefore being knowledgeable about such matters, you carefully explain that a release is not available because the tax liability remains unpaid, but that there is no need for a release in the first place because in Maryland a lien for the separate debts of one spouse does not attach to real estate held as tenants by the entireties. This explanation, though perfectly correct, is often met with skepticism by lenders and purchasers. In response, you might cleverly think of obtaining a “certificate of nonattachment” to prove your point.

Unfortunately, the circumstances in which the IRS will issue a certificate of nonattachment are quite narrow. Relying on IRC §6325(e), the IRS will do so only when the lien never attached to the property, and “any person (other than the person against whom the tax was assessed) is or may be injured by the appearance that a notice of lien filed under section 6323 refers to such person.” In the example of the married couple above, even though the lien clearly does not attach, the IRS will not issue a certificate so stating because there is no confusion as to the identity of the taxpayer against whom the lien is filed. As a result, despite it promising title, the certificate of nonattachment is of rather limited usefulness. In those few cases to which it does apply, however, the certificate is obtained by filing a written application containing the information called for by IRS Pub. 1024.

Certificate of Subordination

A more useful device is the certificate of subordination, issued by the IRS pursuant to IRC §6325(d).26 The certificate is issued to evidence the Service’s consent to voluntarily giving another creditor priority over its lien. The IRS will subordinate its lien where it receives an amount equal to the debt to which it is granting priority. This situation often arises when the taxpayer agrees to refinance property to raise funds to make a partial payment against a delinquent tax liability. In such a case the IRS will subordinate its lien to the new lender. The IRS will also subordinate its lien if doing so will ultimately aid in the collection of the tax liability. This might occur when the taxpayer arranges to refinance his existing mortgage at a lower interest rate, even though no new cash results from the refinancing, because the reduced interest will increase the taxpayer’s ability to make monthly payments to the IRS on his delinquent taxes. The certificate of subordination is obtained by filing a written application in the form and containing the information set forth in IRS Pub. 784.27

Certificate of Withdrawal

Finally, under IRC §6323(j), the IRS can exercise its administrative discretion to “withdraw” a notice of federal tax lien, and can even inform the appropriate credit reporting agencies of the withdrawal.28 This action is taken pursuant to a request from the taxpayer, if it is determined that (1) the filing of the notice of federal tax lien was premature or not in accordance with the IRS’s administrative procedures; (2) the taxpayer has entered into an installment agreement which will satisfy the liability in full; (3) withdrawal of the notice will facilitate the collection of the tax liability; or (4) the National Taxpayer Advocate has determined that the withdrawal would be in the best interest of the taxpayer and the government.29 Note that a release extinguishes both the notice of the lien and the underlying lien itself, whereas a withdrawal preserves the underlying lien and merely removes the notice thereof from the public record.

The Internal Revenue Manual provides that the IRS should consider withdrawing the notice of federal tax lien in the following circumstances:

the taxpayer filed for bankruptcy, and the lien notice was filed in violation of the automatic stay; or

the taxpayer has a pending credit that would satisfy the underlying tax (i.e., a carryback, overpayment, adjustment, etc.).

However, in many other situations you may be able to convince the IRS that withdrawing the lien would facilitate collection by enhancing your client’s ability to retain his job, operate his business, borrow money for the payment of taxes, etc. The Manual sets forth a list of questions for the Revenue Officer to consider in deciding whether the requested withdrawal would in fact “facilitate” collection of the tax liability or would be in the best interests of the taxpayer and the government:30

What will be the effect of withdrawing the notice of lien? Are there claims currently subordinate to the Federal Tax Lien which will become superior?

Will the Service receive a lump sum amount against the liability?

What is the likelihood that the taxpayer will dispose of the property if the notice is withdrawn? Is there sufficient equity for this to be a concern?

Is there any possibility that a bankruptcy may be filed if the withdrawal is not obtained? Will tax collection be undermined if the notice is withdrawn and the taxpayer files bankruptcy?

Are there other tools available, e.g. subordination, that will alleviate the taxpayer’s problem without eliminating the protection offered by the filed notice of lien.

Will withdrawal enhance the taxpayer’s ability to obtain additional credit; and how will additional credit affect the taxpayer’s ability to pay the tax?

Is the NFTL the result of a defaulted installment agreement?

Is the taxpayer pyramiding liabilities?

Often your client will be more concerned with the filing of public notice of the lien than with the lien itself. And in those situations, if the previously discussed remedies are not available (release, discharge, subordination or nonattachment), you may wish to argue that the notice of federal tax lien should be withdrawn. By reviewing the questions the Manual directs the Revenue Officer to consider, you can better frame and support your arguments.

Conclusion

The federal tax lien defeats most other claimants to the delinquent taxpayer’s property. However, there are very impor­tant exceptions which you need to understand in order to vigor­ously represent your client’s interests. Furthermore, under appropri­ate circum­stances the IRS will release, discharge or subordinate its lien, certify to its nonattachment, or withdraw the public notice of the lien. By arranging for the Collection Division to take the appropri­ate action, you may be able to provide significant relief for your client.

[1] Mr. Haynes is an attorney with offices in Burke, VA, and Burtonsville, MD, and is a member of the Maryland Society of Accountants’ Newsletter Committee. From 1973 to 1981 he was a Special Agent with the IRS Criminal Investigation Division in Baltimore, and in 1980 was named “Criminal Investigator of the Year” by the Association of Federal Investigators. He specializes in civil and criminal tax disputes and litigation, IRS collection problems, and the tax aspects of bankruptcy and divorce. (phone 703-913-7500; website www.bjhaynes.com)

[2] As in most matters involving the IRS Collection Division, the best source of information for the practitioner is the IRS’s own “Internal Revenue Manual.” There are two places where the federal tax lien is addressed. The first is the very informative “Legal Reference Guide for Revenue Officers,” adopted in 1985. See IRM 57(16)0 et seq. The second is a new “Federal Tax Liens Handbook,” issued on February 22, 2000, and found in Part V — Collection Activity, at 5.12 et seq. To understand what an IRS Revenue Officer has done or can do to or for your client, you must be familiar with the relevant portions of the Manual. Further­more, any request for relief which you advance on behalf of your client must be firmly grounded in and authorized by the Manual, and you should cite the appropriate IRM provisions in all discus­sions and correspondence with the Ser­vice.

[3] IRC 6323(a) provides in part “… (t)he lien imposed by Section 6321 shall not be valid as against any pur­chaser, holder of a security interest, mechanic’s lienor, or judgment lien creditor until notice thereof has been filed by the Secre­tary.”

[4] IRC 6323(a).

[5] IRC 6323(h)(6).

[6] Rev. Rul. 66-383, 1966-2 C.B. 502.

[7] IRM 5.12.1.9 (02-22-2000).

[8] IRC 6323(b)(1).

[9] IRC 6323(b)(1).

[10] IRC 6323(b)(3).

[11] IRC 6323(b)(5).

[12] IRC 6323(b)(7).

[13] IRC 6323(b)(8).

[14] IRC 6323(b)(9).

[15] IRC 6323(b)(10).

[16] These include “real property construction or improvement financing agree­ments” and “obligatory disbursement agreements.”

[17] IRC 6323(c)(2)(a).

[18] In addition to the guidance contained in the Internal Revenue Manual and the applicable Regs. and Rev. Procs., the IRS has issued four publications which explain the functions of these certifi­cates, and the steps to be followed in re­quest­ing their issu­ance: Pub. 1450 – Certificate of Release (Rev. 3/99); Pub. 783 – Certificate of Discharge (Rev. 9/91); Pub. 784 – Certifi­cate of Subor­dination (Rev. 9/91); and Pub. 1024 – Certificate of Nonattachment (Rev. 9/91).

[19] The federal tax lien will also be released upon accep­tance of an offer in compromise, and the payment of the amount offered. IRM 5.12.2.2.4 (3-22-2000).

[20] Regs. 401.6325-1(e); IRM 5.12.2.6.

[21] Some notice of federal tax lien forms used by the IRS (typically after 1982) expire by their own terms if the lien is not refiled by the specified lien refiling date. For these notices, the issuance of a separate certificate of release upon expiration of the statute of limitations on collections is not required. IRM 5.12.2.2.2(2) (2-22-2000)

[22] Temp. Regs. 401.6325-1; IRM 5.12.2.4 (2-22-2000).

[23] IRM 5.12.2.3. (2-22-2000).

[24] IRC 6325(b); IRM 5.12.2.10 (3-22-2000).

[25] See also Rev. Proc. 68-9, 1968-1 CB 756.

[26] IRM 5.12.2.11 (2-22-2000).

[27] See also Rev. Proc. 68-8, 1968-1 CB 754.

[28] The taxpayer must give the IRS written authorization for the disclosure of information to creditors, credit reporting agen­cies or others to be notified of the with­drawal of the notice of federal tax lien.

[29] A request for withdrawal must be in writing and must con­tain the taxpayer’s name, current address, TIN or SSAN, a copy of the lien notice at issue (if available), and a statement regard­ing the basis for the withdrawal. IRM 5.2.12.24 (2-2-99).

[30] IRM 5.12.2.27 (02-02-1999); IRM 5.12.2.28 (3-22-2000).

Former IRS Special Agent, having worked in the IRS Criminal Investigation Division's office in Baltimore, Maryland. In 1980, he was named as Criminal Investigator of the Year by the Association of Federal Investigators. He holds a...