Salk & Huvard, P.C. Attorneys At Law

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1 Cohen, Salk & Huvard, P.C. Salk & Huvard, P.C. Attorneys At Law Bennett L. Cohen 630 Dundee Road, Suite I20 Cohen Bruce Alan Salk Northbrook, Illinois Salk Bruce K. Huvard Huvard Barry I. Mortge Tel Mortge Christyl L. Marsh Fax Marsh Leonard M. Cohen Cohen ( ) Writer s Direct Dial May 1, 2003 SECURED LENDING ALERT THE PERILOUS FEDERAL TAX LIEN Secured lenders need to to be be extremely vigilant regarding the the risk risk of being of being primed primed by by federal tax liens. Even though a a secured lender has has properly perfected its its first first priority priority security interest in all assets of of its its borrower, it it can can still still be be primed by by a federal a federal tax tax lien lien filed after the lender s security interest is is perfected as as to to certain future advances made by the lender and as to certain after-acquired collateral. Although this risk is is particularly high for revolving loans due to to the the twin twin 45-day rules rules described below, below, such such risk risk not is not limited to revolving loans and can also apply to to multi-disbursement loans loans and and delayed disbursement loans, where advances may ultimately be be made more than days after after the lender s federal tax lien search. It is prudent for all lenders to periodically review the basic rules pertaining to to federal tax liens. The failure to to pay pay federal federal income, income, withholding, social social security security or other or other federal federal taxes leads to to a a delinquency assessment against against the taxpayer, the taxpayer, which which assessment assessment constitutes a lien in in favor of of the the United States upon upon all all property and and rights rights to property to property belonging to the taxpayer on the date of of assessment. Fortunately, such such lien lien does does not not become valid against third parties (including secured parties), until until a notice a notice of federal of federal tax lien is filed in the appropriate office. 1. PLACE TO FILE AND SEARCH FOR A A NOTICE OF OF FEDERAL TAX TAX LIEN. The requisite place to to record (and (and search search for) for) a notice a notice of federal of federal tax lien tax in lien Illinois Illinois depends on the type of property involved and the type of taxpayer: 1

2 For Filings Against Real Property -- the proper place to to record (and search for) for) a a notice of federal tax lien in in the the State of of Illinois Illinois is in is the in the office office the of Recorder the Recorder of the of county the county where the real property is located. For Filings Against Personal Property (whether tangible or intangible) - the proper place to record (and search for) a notice of federal tax lien in the State of Illinois is as follows: (a) Corporations and Partnerships (whose principal executive office is is in in Illinois), Trusts and Decedent's Estates - the office of the Secretary of of State of of Illinois (effective August 15, 1989). (b) All other taxpayers - - in in the the office of of the the Recorder of of the the county county where where the the taxpayer resides at the time of filing of the notice of lien. It is interesting to to note that that the the Uniform Federal Lien Lien Registration Act, Act, as adopted as adopted in in Illinois, was never never amended to require to require federal federal tax liens tax against liens limited against liability limited liability companies, to be filed in in the the office of of the the Illinois Secretary of State of State (770 (770 ILCS ILCS 110/2). 110/2). Thus, a federal tax lien filed in Illinois against a limited liability company would be filed in the Recorder of of the county where the the limited limited liability liability company company resides resides (presumably where it has its principal office). The Commerce Clearing House (CCH) Federal Tax Tax Reporter contains contains an invaluable an invaluable all-state table of proper filing offices to to search for for federal federal tax tax liens. liens. The writer The writer has has observed that some search services are not often aware of of the the proper office office to to search search for federal tax liens for the particular type of collateral or taxpayer involved. Fortunately, it has become a a common practice for for lenders to obtain to obtain tax tax lien lien searches searches in both in both the the state and county offices, which avoids the risk of of picking the the wrong office to to search for for federal tax liens. It should be noted that a notice of of federal tax lien in in general must be be re-filed at at 10-year intervals. 2. GENERAL RULE OF PRIORITY. The basic priority rule is is that that a a lender will will have have priority priority ahead ahead of the of IRS the IRS in collateral in collateral owned by its borrower on on the the date of of the the federal tax tax lien lien filing, filing, if the if the lender's lender's security security interest in such collateral is is perfected prior prior to the to the date date of the of federal the federal tax lien tax filing. lien filing. Stated another way, by virtue of of the tax tax lien lien filing, the the IRS IRS will will gain gain priority in all in all of the of the borrower's collateral acquired by the borrower after the federal tax lien filing. Important exceptions to this general priority rule are discussed below. 3. THE TWIN 45-DAY RULES. Under Section 6323(c) and Section 6323(d) of of the the Federal Tax Tax Lien Lien Act Act of 1966 of 1966 (the (the "FTLA"), special priority is given to to (i) (i) certain Article 9 9 security interests that that come come into into existence after the tax lien filing (i.e., (i.e., certain after-acquired collateral), and and (ii) certain (ii) certain future advances made after the tax lien filing, respectively. 2

3 In order to qualify for the superpriority for after-acquired collateral, the collateral must be (1) Qualified Property (as (as defined below) covered by by a (2) a Commercial (2) Transactions Financing Agreement (as defined below) entered into before the tax tax lien lien filing, and and that that (3) is properly perfected under the the Uniform Commercial Code Code (the (the "Code") "Code") as of as the of the time of the tax lien filing. "Qualified property" under the FTLA means "commercial financing security" - negotiable instruments, accounts receivable, executory contract rights, rights, chattel chattel paper, paper, securities, documents of title, and inventory (including raw materials and and goods in in process). This This superpriority does not apply to goods other than inventory, such as equipment and farm products, nor does it include general intangibles such as patents and copyrights. A Commercial Transactions Financing Agreement is defined to mean a written security agreement to make loans to to be be secured by by commercial financing security acquired by by the taxpayer in the ordinary course of of business, but but only only to the to the extent extent that that any any future future advances are made within 45 days after tax lien filing and and before the the lender has has actual knowledge of the filing. The following twin 45-day rules protect a lender as to both optional future advances and after-acquired property made or acquired within 45 days after the tax lien filing, provided the three requirements in the third preceding paragraph have been met: (a) 45-DAY RULE AS IT AFFECTS PRIORITY OF FUTURE ADVANCES. Under Section 6323(d) of of the the FTLA, a a lender is entitled is entitled to priority to priority over over the IRS the IRS as toas to future advances made by the lender within 45 days after the federal tax lien filing unless the lender has earlier knowledge of such tax lien filing. Another way way to to state this this is that that a lender has priority as to future advances for the earlier of 45 days after the federal tax lien filing or actual knowledge of of such filing. The The IRS IRS has has the the burden burden of showing of showing that that the lender had actual knowledge of the tax lien filing. Let s see how this rule works. Assume ABC Bank makes a a $1,000,0000 revolving loan to XYZ Corp. on on January 1, , 2003 and and properly properly perfects perfects a blanket a blanket first priority first priority security interest in all present and future assets of of XYZ XYZ Corp. Corp. A notice A notice of federal of federal tax tax lien is filed against XYZ Corp. in the proper office on March 1, 1, 2003 and the the Bank does not become aware of such tax lien filing until until June June 1, 1, What What is the is effect the effect of theof the federal tax lien filing with regard to to the the Bank s future advances? Forty-five Forty-five (45) (45) days days after the date of the federal tax lien filing (April 15, 15, 2003), the the federal tax tax lien lien begins to to prime the lender s security interest with with respect to all to advances all advances made made by ABC by ABC Bank Bank under the revolving loan after after April April 15, 15, As you can see, under the the typical typical revolving loan, the result of not timely discovering a filed notice of federal tax lien can be devastating for the secured lender. Under the hypothetical above, it it should be be noted that that (i) (i) although the the advances made made by the Bank within days after the the federal tax tax lien lien filing filing would would be be given given priority priority over over the IRS, such priority would only pertain to collateral owned by the borrower on the date 3

4 of the federal tax lien filing and also Qualified Property (as (as defined in in Section 3 above) 3 such as after-acquired accounts and and inventory, acquired acquired within within said said 45-day 45-day period. period. The Bank s protected future advances made within said 45-day period would not not apply to collateral acquired by by the the borrower after after the the federal federal tax lien tax lien filing filing which which does does not not constitute Qualified Property, such such as equipment, as equipment, general general intangibles intangibles and farmand farm products, and (ii) as as stated earlier, if the if the Bank Bank learns learns of the of the federal federal tax lien tax prior lien prior the the expiration of the 45-day period, the Bank s future advances made after after it learns it learns of the of the federal tax lien filing would be primed by the IRS. Once a lender discovers that that a federal a federal tax tax lien lien has has been been filed, filed, all advances all advances should should cease unless and until the federal tax lien is is paid paid and and properly released (which means means that the original release signed by by the the IRS IRS is actually is actually filed filed in the in office the office in which in which the the notice of tax lien was was filed). The The same same principle principle would would also apply also to apply a commercial to a commercial factor. The The factor should stop stop purchasing accounts until until the the federal tax tax lien lien is is paid paid and and released. (b) 45-DAY RULE AS IT AFFECTS PRIORITY IN AFTER-ACQUIRED COLLATERAL. Under Section 6323(c) of of the the FTLA, FTLA, a lender's a lender's security security interest interest after-acquired in after-acquired collateral is superior to to the the federal tax tax lien lien as to as any to after-acquired any collateral collateral of theof the borrower which comes into into existence within within days days after after the federal the federal tax lien tax filing. lien filing. Since Section 6323(c) applies only only to Qualified to Qualified Property Property (as defined (as defined Section in Section 3 3 above), this priority section does does not not apply apply to after-acquired to collateral collateral consisting consisting of of equipment, farm products and general intangibles. It It should be be noted that in in contrast to to the above-described 45-day rule for for future advances, if Qualified Property is acquired is acquired within 45 days after the federal tax lien filing, the the lender s actual knowledge of of the the IRS IRS filing is irrelevant for purposes of the 45-day rule for after-acquired collateral. Let s see how this rule works. Assume ABC Bank makes a a $1,000,0000 revolving loan to XYZ Corp. on on January 1, , 2003 and and properly properly perfects perfects a blanket a blanket first priority first priority security interest in all present and future assets of of XYZ XYZ Corp. Corp. A notice A notice of federal of federal tax tax lien is filed against XYZ Corp. in the proper office on March 1, 1, 2003 and the the Bank does not become aware of such tax lien filing until until June June 1, 1, What What is the is effect the effect of theof the federal tax lien filing with regard to to the the Bank s priority in the in the borrower s after-acquired accounts and inventory? Forty-five (45) (45) days days after after the the date date of of the the federal tax tax lien lien filing filing (April 15, 2003), the federal tax tax lien lien begins to to prime prime the the Bank s Bank s security security interest interest all in all accounts and inventory acquired by the borrower after April 15, An An exception to to this rule is discussed in subsection (c) below. Since equipment financing is so is important so important to commercial to commercial lenders, lenders, it is crucial it is tocrucial to understand that the twin 45-day rules rules do do not not provide provide a safe a safe harbor harbor for lenders for lenders who who finance or rely on after-acquired equipment. For For example, if ABC if ABC Bank Bank makes makes a loana loan against all equipment now owned or or hereafter acquired by by the the borrower and and includes an optional future advance clause in its security agreement, the Bank s future advances made within 45 days of the federal tax lien filing (and without knowledge of of the the tax tax lien) are protected, but only with respect to equipment owned by the borrower before the tax tax lien filing. Any after-acquired equipment acquired by by the the borrower after after the the tax tax lien lien 4

5 filing is not Qualified Property and the IRS will obtain a priority in in all all such after-acquired equipment. This This means means that that lenders lenders relying relying on after-acquired on equipment equipment should should be be checking the federal tax lien records every days in in order order to to be be certain certain that that the the IRS IRS cannot claim a a priority. In those cases where where the the lender s lender s security security interest interest in equipment acquired after the filing of the federal tax lien, qualifies as a purchase money security interest under the Code, the the lender may may be be able able to prime to prime the IRS s the IRS s tax lien. tax lien. However, whether a purchase money security interest in in equipment will prime a a federal tax lien is not certain (see Section 5 below). It is also important to note that the FTLA and implementing regulations strongly suggest that the lender's pre-tax lien security agreement must contain an after-acquired property clause and a future advance provision to take advantage of the priorities established by by the twin 45-day rules discussed above. Most Most security security agreements agreements contain contain these these standard provisions and ABC Bank s hypothetical loan to XYZ Corp. discussed earlier is based on the assumption that ABC Bank s security agreement contains these standard provisions. (c) PRIORITY IN PROCEEDS. The priority provided by the twin 45-day rules applies to identifiable proceeds of of pre-45- day collateral (constituting Qualified Property such such as as accounts, inventory or contract or contract rights), even though the the proceeds arise arise after after expiration of the of the 45-day 45-day period. period. Thus, Thus, accounts arising from from pre-45-day inventory inventory contract or contract rights will rights be protected. will be protected. However, commingled cash proceeds arising from the sale of of pre-45-day inventory will will not be protected if if they are are not not identifiable. In addition, In addition, second second generation generation proceeds proceeds (proceeds of proceeds) are not likely to be protected. An important Illinois bankruptcy decision which protected a lender's priority in in proceeds of pre-45-day collateral is In re National Financial Alternatives, Inc., 96 B.R. 844 (Bkrtcy. N.D.ILL 1989). In In that that case, case, the the court court held held that a that secured a secured lender lender with a perfected with a perfected security interest in accounts receivable of a borrower was entitled to to a a priority ahead of of a federal tax lien, to to the extent that that (a) (a) the the accounts were were themselves acquired by by the the borrower prior to the expiration of of the 45-day period following the the filing filing of of the the notice notice of of federal tax lien, or or (b) the accounts were were proceeds of contract of contract rights rights or inventory inventory acquired by the the borrower prior prior to the to expiration the expiration of saidof said 45-day period. The The term term "contract rights" to date has been held to require a written contract. A number of years ago, the writer was asked on on behalf of of a secured a lender lender to combat to combat the IRS over priority to to an an ambulance company s accounts receivable. The The accounts accounts receivable in question were clearly created more than days after the the federal tax tax lien lien filing and the IRS IRS insisted that that it had it had priority priority in such in such accounts. accounts. Fortunately, Fortunately, upon upon further investigation, it was determined that the accounts arose under a written contract between the account debtor and the ambulance company which had been entered into into prior to the federal tax lien filing. After citing the the In In re re National case to to the the IRS IRS attorney, the IRS attorney quickly conceded that that the the secured secured lender s lender s security security interest interest thein the disputed accounts had priority over the IRS s claim. 5

6 4. SECTION 6323(d) 45-DAY RULE FOR FUTURE ADVANCES. In addition to to the the twin twin 45-day rules set set forth forth above, above, Section Section 6323(d) 6323(d) of the of FTLA the FTLA provides yet another priority provision for lenders, although its its scope is is limited. Under Under this Section, a a filed filed tax tax lien lien is subordinate is subordinate to a security to a security interest interest that comes that into comes into existence after a tax tax lien lien filing filing by by reason reason of optional of optional (or mandatory) (or future future advances advances made within 45 days of such filing. However, this this superpriority will will apply apply only only when when (i) (i) the lender makes the future advance without actual knowledge of of the the tax tax lien lien filing, filing, (ii) (ii) the security interest is is in in property existing at at the the time time of of the the tax tax lien lien filing, filing, and and (iii) (iii) the the security interest is protected under local law against an an unsecured judgment lien lien as as of of the time of the tax lien filing. This superpriority is is not not limited to "Qualified to Property", Property", but it but is limited it is limited to collateral to collateral owned by the borrower on the date of the tax lien filing. 5. PURCHASE MONEY PRIORITY. Lenders qualifying for purchase money priority under under the the Code Code do so do to so prime to prime prior prior perfected security interests that are filed ahead of of them. Another possible benefit benefit of aof a lender qualifying as the holder of a purchase money security interest under the Code, is is that the lender may be able to prime a federal tax lien. Legal commentators have argued that although the FTLA does not not specifically provide that a purchase money security interest interest will will prime prime an existing an existing federal federal tax lien, tax thelien, the legislative history makes it it clear that a a purchase money creditor enjoys enjoys priority priority over over a a prior filed tax tax lien lien on on the theory theory that that the taxpayer the taxpayer only acquires only acquires the equity the in equity the in the property. There has also been some case law law to to support this this priority rule. rule. However, However, the fact that the FTLA itself is silent on this priority issue is unsettling for lenders. 6. ERISA LIEN. The Pension Benefit Guaranty Corporation ( PBGC ), a division a division of the of the United United States States Labor Department, administers the Employee Retirement Income Security Act Act of of ( ERISA ). ERISA provides that when an employer fails to to meet the financial obligations imposed by a pension plan plan guaranteed by by the the PBGC, PBGC, the the employer s employer s assets assets will be will be subjected to a lien in favor of the PBGC. The ERISA lien arises on on the the date of of the the termination of of the the plan plan and and is subject is subject to the to the same notice filing requirements as is the federal tax lien. Except as as otherwise provided by law, the ERISA lien has the same priority as as the federal tax tax lien. A federal A federal tax lien tax lien search should pick up any filed ERISA lien. 6

7 7. CONCLUSION. In conclusion, since the IRS is one of the most voracious creditors that a secured lender may face, a case can easily be made that any lender extending revolving credit should obtain a federal tax lien search every days! A similar A similar argument argument can be can made be made for for multi-disbursement loans or or delayed delayed disbursement loans, loans, where where advances advances may may ultimately be made more than 45 days after the the lender s last last federal tax tax lien lien search (in (in which case, such searches would would be be obtained obtained prior prior to each to each subsequent subsequent advance). advance). Having said this, the writer is aware that very few lenders out there are actually getting a federal tax lien search every every days days for revolving for revolving loans. loans. However, However, in light in of light the of the substantial risk involved and the relatively insignificant cost involved (when compared to such risk), lenders may may want want to reconsider to reconsider how how often often they obtain they obtain federal federal tax lien tax lien searches. A A federal tax tax lien lien search in in the the Illinois Secretary of of State s office provided by by one of the national search services is is $ On On an annual annual basis, basis, a search a search every every days comes out to only $ This This a is small a small price price to pay to pay to avoid to avoid losing losing priority priority to to the IRS. At At least least one one national national search search firm firm provides provides federal federal tax lien tax alert lien searches alert searches meaning that the 45-day searches can be scheduled in in advance and do do not not need to to be be ordered every days. The The annual annual cost for cost this for alert this service alert service for federal for tax federal lien tax lien searches would be $120 according to the national search service the writer contacted. This article is informational in in nature and is is not not intended to to constitute, nor nor should it be it be relied upon as, legal advice to any recipient. Bennett L. Cohen, Esq. 7