And on the 46th Day, Who Wins? A Primer on Federal Tax Liens, the 45-Day Rule, and Future Advances

Part One of this article discussed Article 9 security interests and future advances, and federal tax liens. This final installment addresses exceptions for purchasers, holders of security interests, and certain others.

Exceptions for Purchasers, Holders of Security Interests, and Certain Others

The IRS Code provides certain exceptions to the priority established by tax liens at the time of assessment. Under Code '6323(a), the tax lien is not valid against a purchaser, holder of a security interest, mechanic's lienor, or judgment lien creditor to the extent that such a creditor's secured interests in the debtor's property have been perfected under local law before the notice of tax lien has been recorded. Priority for these creditors is measured against the tax lien from the date the notice of tax lien is recorded and not from the date of assessment. The exception for these creditors reflects the legislative policy of the Federal Tax Lien Act of 1966 to conform the tax lien to the principles of secured interests under the UCC. As the Bankruptcy Court in In re May Reporting Services, Inc., 115 BR 652, 656 (DSD 1990) explained, the “validity of a tax lien against certain creditors only after notice is in accord with commercial lending's underlying policy of providing adequate notice to other creditors of the government's security interest ' the tax lien noticing system attempts to conform federal tax lien provisions to the U.C.C.'s concepts.” In this regard, the notice of tax lien protects secured creditors “against secret liens in the government favor.” Id. Until recordation of the tax lien, the IRS' interest in the debtor's property is unperfected. Note, however, that the tax lien still attaches to property owned by the debtor in existence as of the date of assessment.

For purposes of '6323(a), a “purchaser” is defined as any person who acquires an interest (other than a lien or security interest) in property for adequate and full consideration that is valid under local law against subsequent purchasers without actual notice. A purchaser may include one who enters into a lease of property, or a written executory contract or option to purchase, lease, or renew such lease in, property. A purchaser takes priority over tax liens if the transaction is completed before the notice of tax lien is filed.

With respect to holders of security interests under '6323(a), the Code defines a security interest as any interest in property acquired to secure payment or performance of an obligation or to indemnify against loss or liability. The Code requires three conditions to be satisfied, independent of any requirements of the state law under which the interest arose, in order to qualify as a security interest for '6323 purposes: 1) the holder of the security interest must have parted with “money or money's worth”; 2) the collateral to which the security interest attaches must be in existence at the time; and 3) the security interest is protected under the relevant state law against a subsequent judgment lien arising from an unsecured obligation. To the extent these conditions are satisfied prior to the filing of a notice of tax lien, the holder of the security interest takes priority over the tax lien.

Super-priorities

In addition to the '6323(a) creditor exceptions, Code '6323(b) enumerates certain other categories of “super-priority” creditor interests with respect to which a tax lien is not valid regardless of whether the notice of tax lien has been filed previously. Among these interests are good faith purchasers of securities or motor vehicles without knowledge of the tax lien, attorneys' liens, and deposit-secured loans.

Although not enumerated in '6323, it is generally accepted that purchase money security interests (“PMSI”) are among the super-priority interests that are valid against the tax lien regardless of whether notice was recorded before the PMSI arose. The IRS adopted this policy approach in Revenue Ruling 68-57, ruling that it “will consider that a purchase money security interest or mortgage valid under local law is protected even though it may arise after a notice of Federal tax lien has been filed.” Although not unanimous, the case law appears to be in general agreement with this approach. In addition, although it is not likely that the IRS will change its position, PMSI holders should endeavor to keep abreast periodically of the current IRS policy with respect to the PMSI priority status so as not to be caught unaware.

The 45-Day Rule

The Code's 45-day rule allows, under limited circumstances, an advance made within 45 days after the notice of tax lien filing to effectively be treated as a super-priority. Generally, the 45-day rule, set forth in ”6323(c)(2) and 6323(d), provides protection for certain creditor's security interests arising out of an advance made within 45 days after the notice of tax lien filing and which is the result of a written security agreement entered into before the notice of tax lien filing. Specifically, the Code sets forth a 45-day “safe harbor” ' allowing certain creditors' priority over the tax lien for security interests arising from advances made within 45 days after the notice of tax lien filing pursuant to either: 1) a written commercial transaction financing agreement under '6323(c)(2), or 2) a written security agreement entered into before the notice of tax lien filing and which covers property in existence at the time of the notice of tax lien filing. In both cases, the written agreement must be protected under local law against any judgment lien arising out of an unsecured obligation. Similarly, in both cases, the safe harbor period will terminate at the earlier of the end of the 45-day period or the date on which the lender possesses actual notice or knowledge of the existence of the tax lien. Thus, if the creditor discovers the existence of a tax lien on day 35, advances made after that date will be subordinated to the tax lien.

By its terms, '6323(d) covers all of a creditor's property existing at the time of tax lien filing, but does not extend to after-acquired property. Section 6323(c)(2), on the other hand, covers only specific types of after-acquired property; that is, property acquired after the notice of tax lien filing but within the 45-day safe harbor period (primarily “commercial financing security” property, including accounts receivable, inventory, and real property mortgages).

As noted, under '6323(d), cash advances made within the safe harbor period have priority over a previously filed notice of tax lien if the advances are made pursuant to a written security agreement entered into before the notice of tax lien filing, are secured only by the taxpayer's property owned at the time the notice of tax lien was filed, and are superior to judgment lien arising out of unsecured obligations. In Revenue Ruling 72-290, the IRS ruled that optional advances (advances made at the option of the lender but not otherwise required under the written security agreement) will be treated as a security interest superior to the tax lien if made within the safe harbor period, without actual notice or knowledge of the tax lien filing, and otherwise pursuant to a perfected security agreement.

The Code's 45-day rule parallels in certain respects Article 9's 45-day rule with respect to future advances. As noted, Article 9-323(b) provides that a security interest arising from an advance will not have priority over a person who becomes a lien creditor if the security interest secures an advance that is made more than 45 days after the person became a lien creditor unless the advance is made without actual knowledge of the lien or pursuant to a commitment entered into without knowledge of the lien. Thus, in both cases, security interests are afforded a 45-day window of protection, although in Article 9's case, such protection appears to continue beyond that period to the extent that the advance or the commitment from which it arose is made without actual knowledge of the lien. The significant difference is, of course, that Article 9 cannot govern the terms of priority with respect to federal tax liens.

As a matter of legislative policy, the Code's 45-day rule is designed to ease the burden on certain creditors who would otherwise be required to search lien records for each and every advance by allowing such advances to be made without the need to repeatedly search for a filed notice of tax lien provided that the advance or the purchase is accomplished within 45-days of the date of filing and that the creditor does not have actual knowledge of the tax lien filing.

In light of the above, it is time to return to the hypothetical scenarios described at the outset of this article and review the answers to the questions posed.

Scenario 1

The Lender's $15,000 business loan to Company on Aug. 3, 2006 has priority over the notice of tax lien filing under the 45-day rule for the following reasons: 1) the Lender's security interest was already perfected under local law as of July 6, 2006, the date the notice of tax lien was filed (i.e., it would have priority over a creditor with a judgment lien arising out of an unsecured obligation); 2) the Lender advanced the $15,000 without actual knowledge of the existence of the notice of tax lien; and 3) the loan was made within 45 days after the notice of tax lien was filed. However, the notice of tax lien has priority over the Lender's subsequent $3,000 advance made on Aug. 4, 2006. At this time, the Lender possessed actual knowledge of the existence of the tax lien filing, and therefore the 45-day safe harbor for advances terminated on that date. The Lender's interest is therefore subordinated to the tax lien to the extent of the $3,000 advance. Similarly, the notice of tax lien filing has priority over the Lender's $2,000 advance to Company on Oct. 31, 2006. The Lender continues to have actual knowledge of the tax lien filing, and, in any event, the Lender advanced the $2,000 well after the expiration of the 45th day.

Because this appears to be a commercial transaction financing interest (since the secured property is inventory and accounts receivable), the Lender's advances made on Aug. 3, 2006 and Aug. 4, 2006 are secured by the property acquired by Company before the end of the 45-day period after the notice of tax lien was filed.

Scenario 2

Because the Lender's security interest in Company's inventory did not arise under a written agreement entered into before the filing of notice of the first tax lien on Dec. 31, 1968, the tax lien is superior to Lender's security interest except to the extent of Lender's PMSI. Because Lender's interest qualifies as a PMSI with respect to the inventory purchased under the letter of credit, the tax liens attach only to the equity acquired by Company, and the rights of the Lender in the inventory so purchased are superior even to the tax lien filed on Dec. 31, 1968, without regard to this section.

Scenario 3

Lender's security interest has priority over the tax lien for the following reasons: 1) Lender made the $10,000 advance before the 46th day after tax lien filing; 2) Lender made the advance pursuant to a written agreement entered into before the notice of tax lien filing; and 3) Lender's security interest is protected under local law, as of the date of tax lien filing, against a judgment lien arising out of an unsecured interest. Note that if Lender had actual knowledge of the tax lien filing at the time Lender made the advance to Taxpayer, Lender's security interest would not have priority over the tax lien because the 45-day safe harbor period would have terminated on the date Lender acquired such knowledge. In addition, Lender is not protected under Code '6323(a) as a holder of a security interest (having signed the security agreement before the notice of tax lien was filed) because Lender did not part with “money or money's worth” before the notice of tax lien was filed on Jan. 10, 1998, even though Lender had made a firm commitment to Taxpayer before that date.

Conclusion

Navigating the interrelated rules of the Code and Article 9 to determine the priority of tax liens and other creditor interests in property will never cease to be a blurry-eyed endeavor for lenders, sellers, and those who assist them. As with Article 9, the Code's 45-day rule provides a degree of consistency and clarity to a small part of this world for those creditors advancing funds to debtors in the normal course of their businesses.

Francis X. Buckley, Jr. is the partner-in-charge of Thompson Coburn LLP's Chicago office and is a member of the firm's Bankruptcy and Creditors' Rights Practice Group. He is a Fellow in the American College of Bankruptcy. Nicholas H. Kappas is an associate in Thompson Coburn LLP's Tax practice group and resides in the firm's St. Louis office. The authors gratefully acknowledge the assistance of Yekaterina Chudnovsky, J.D. candidate, DePaul University 2009.

Part One of this article discussed Article 9 security interests and future advances, and federal tax liens. This final installment addresses exceptions for purchasers, holders of security interests, and certain others.

Exceptions for Purchasers, Holders of Security Interests, and Certain Others

The IRS Code provides certain exceptions to the priority established by tax liens at the time of assessment. Under Code '6323(a), the tax lien is not valid against a purchaser, holder of a security interest, mechanic's lienor, or judgment lien creditor to the extent that such a creditor's secured interests in the debtor's property have been perfected under local law before the notice of tax lien has been recorded. Priority for these creditors is measured against the tax lien from the date the notice of tax lien is recorded and not from the date of assessment. The exception for these creditors reflects the legislative policy of the Federal Tax Lien Act of 1966 to conform the tax lien to the principles of secured interests under the UCC. As the Bankruptcy Court in In re May Reporting Services, Inc., 115 BR 652, 656 (DSD 1990) explained, the “validity of a tax lien against certain creditors only after notice is in accord with commercial lending's underlying policy of providing adequate notice to other creditors of the government's security interest ' the tax lien noticing system attempts to conform federal tax lien provisions to the U.C.C.'s concepts.” In this regard, the notice of tax lien protects secured creditors “against secret liens in the government favor.” Id. Until recordation of the tax lien, the IRS' interest in the debtor's property is unperfected. Note, however, that the tax lien still attaches to property owned by the debtor in existence as of the date of assessment.

For purposes of '6323(a), a “purchaser” is defined as any person who acquires an interest (other than a lien or security interest) in property for adequate and full consideration that is valid under local law against subsequent purchasers without actual notice. A purchaser may include one who enters into a lease of property, or a written executory contract or option to purchase, lease, or renew such lease in, property. A purchaser takes priority over tax liens if the transaction is completed before the notice of tax lien is filed.

With respect to holders of security interests under '6323(a), the Code defines a security interest as any interest in property acquired to secure payment or performance of an obligation or to indemnify against loss or liability. The Code requires three conditions to be satisfied, independent of any requirements of the state law under which the interest arose, in order to qualify as a security interest for '6323 purposes: 1) the holder of the security interest must have parted with “money or money's worth”; 2) the collateral to which the security interest attaches must be in existence at the time; and 3) the security interest is protected under the relevant state law against a subsequent judgment lien arising from an unsecured obligation. To the extent these conditions are satisfied prior to the filing of a notice of tax lien, the holder of the security interest takes priority over the tax lien.

Super-priorities

In addition to the '6323(a) creditor exceptions, Code '6323(b) enumerates certain other categories of “super-priority” creditor interests with respect to which a tax lien is not valid regardless of whether the notice of tax lien has been filed previously. Among these interests are good faith purchasers of securities or motor vehicles without knowledge of the tax lien, attorneys' liens, and deposit-secured loans.

Although not enumerated in '6323, it is generally accepted that purchase money security interests (“PMSI”) are among the super-priority interests that are valid against the tax lien regardless of whether notice was recorded before the PMSI arose. The IRS adopted this policy approach in Revenue Ruling 68-57, ruling that it “will consider that a purchase money security interest or mortgage valid under local law is protected even though it may arise after a notice of Federal tax lien has been filed.” Although not unanimous, the case law appears to be in general agreement with this approach. In addition, although it is not likely that the IRS will change its position, PMSI holders should endeavor to keep abreast periodically of the current IRS policy with respect to the PMSI priority status so as not to be caught unaware.

The 45-Day Rule

The Code's 45-day rule allows, under limited circumstances, an advance made within 45 days after the notice of tax lien filing to effectively be treated as a super-priority. Generally, the 45-day rule, set forth in ”6323(c)(2) and 6323(d), provides protection for certain creditor's security interests arising out of an advance made within 45 days after the notice of tax lien filing and which is the result of a written security agreement entered into before the notice of tax lien filing. Specifically, the Code sets forth a 45-day “safe harbor” ' allowing certain creditors' priority over the tax lien for security interests arising from advances made within 45 days after the notice of tax lien filing pursuant to either: 1) a written commercial transaction financing agreement under '6323(c)(2), or 2) a written security agreement entered into before the notice of tax lien filing and which covers property in existence at the time of the notice of tax lien filing. In both cases, the written agreement must be protected under local law against any judgment lien arising out of an unsecured obligation. Similarly, in both cases, the safe harbor period will terminate at the earlier of the end of the 45-day period or the date on which the lender possesses actual notice or knowledge of the existence of the tax lien. Thus, if the creditor discovers the existence of a tax lien on day 35, advances made after that date will be subordinated to the tax lien.

By its terms, '6323(d) covers all of a creditor's property existing at the time of tax lien filing, but does not extend to after-acquired property. Section 6323(c)(2), on the other hand, covers only specific types of after-acquired property; that is, property acquired after the notice of tax lien filing but within the 45-day safe harbor period (primarily “commercial financing security” property, including accounts receivable, inventory, and real property mortgages).

As noted, under '6323(d), cash advances made within the safe harbor period have priority over a previously filed notice of tax lien if the advances are made pursuant to a written security agreement entered into before the notice of tax lien filing, are secured only by the taxpayer's property owned at the time the notice of tax lien was filed, and are superior to judgment lien arising out of unsecured obligations. In Revenue Ruling 72-290, the IRS ruled that optional advances (advances made at the option of the lender but not otherwise required under the written security agreement) will be treated as a security interest superior to the tax lien if made within the safe harbor period, without actual notice or knowledge of the tax lien filing, and otherwise pursuant to a perfected security agreement.

The Code's 45-day rule parallels in certain respects Article 9's 45-day rule with respect to future advances. As noted, Article 9-323(b) provides that a security interest arising from an advance will not have priority over a person who becomes a lien creditor if the security interest secures an advance that is made more than 45 days after the person became a lien creditor unless the advance is made without actual knowledge of the lien or pursuant to a commitment entered into without knowledge of the lien. Thus, in both cases, security interests are afforded a 45-day window of protection, although in Article 9's case, such protection appears to continue beyond that period to the extent that the advance or the commitment from which it arose is made without actual knowledge of the lien. The significant difference is, of course, that Article 9 cannot govern the terms of priority with respect to federal tax liens.

As a matter of legislative policy, the Code's 45-day rule is designed to ease the burden on certain creditors who would otherwise be required to search lien records for each and every advance by allowing such advances to be made without the need to repeatedly search for a filed notice of tax lien provided that the advance or the purchase is accomplished within 45-days of the date of filing and that the creditor does not have actual knowledge of the tax lien filing.

In light of the above, it is time to return to the hypothetical scenarios described at the outset of this article and review the answers to the questions posed.

Scenario 1

The Lender's $15,000 business loan to Company on Aug. 3, 2006 has priority over the notice of tax lien filing under the 45-day rule for the following reasons: 1) the Lender's security interest was already perfected under local law as of July 6, 2006, the date the notice of tax lien was filed (i.e., it would have priority over a creditor with a judgment lien arising out of an unsecured obligation); 2) the Lender advanced the $15,000 without actual knowledge of the existence of the notice of tax lien; and 3) the loan was made within 45 days after the notice of tax lien was filed. However, the notice of tax lien has priority over the Lender's subsequent $3,000 advance made on Aug. 4, 2006. At this time, the Lender possessed actual knowledge of the existence of the tax lien filing, and therefore the 45-day safe harbor for advances terminated on that date. The Lender's interest is therefore subordinated to the tax lien to the extent of the $3,000 advance. Similarly, the notice of tax lien filing has priority over the Lender's $2,000 advance to Company on Oct. 31, 2006. The Lender continues to have actual knowledge of the tax lien filing, and, in any event, the Lender advanced the $2,000 well after the expiration of the 45th day.

Because this appears to be a commercial transaction financing interest (since the secured property is inventory and accounts receivable), the Lender's advances made on Aug. 3, 2006 and Aug. 4, 2006 are secured by the property acquired by Company before the end of the 45-day period after the notice of tax lien was filed.

Scenario 2

Because the Lender's security interest in Company's inventory did not arise under a written agreement entered into before the filing of notice of the first tax lien on Dec. 31, 1968, the tax lien is superior to Lender's security interest except to the extent of Lender's PMSI. Because Lender's interest qualifies as a PMSI with respect to the inventory purchased under the letter of credit, the tax liens attach only to the equity acquired by Company, and the rights of the Lender in the inventory so purchased are superior even to the tax lien filed on Dec. 31, 1968, without regard to this section.

Scenario 3

Lender's security interest has priority over the tax lien for the following reasons: 1) Lender made the $10,000 advance before the 46th day after tax lien filing; 2) Lender made the advance pursuant to a written agreement entered into before the notice of tax lien filing; and 3) Lender's security interest is protected under local law, as of the date of tax lien filing, against a judgment lien arising out of an unsecured interest. Note that if Lender had actual knowledge of the tax lien filing at the time Lender made the advance to Taxpayer, Lender's security interest would not have priority over the tax lien because the 45-day safe harbor period would have terminated on the date Lender acquired such knowledge. In addition, Lender is not protected under Code '6323(a) as a holder of a security interest (having signed the security agreement before the notice of tax lien was filed) because Lender did not part with “money or money's worth” before the notice of tax lien was filed on Jan. 10, 1998, even though Lender had made a firm commitment to Taxpayer before that date.

Conclusion

Navigating the interrelated rules of the Code and Article 9 to determine the priority of tax liens and other creditor interests in property will never cease to be a blurry-eyed endeavor for lenders, sellers, and those who assist them. As with Article 9, the Code's 45-day rule provides a degree of consistency and clarity to a small part of this world for those creditors advancing funds to debtors in the normal course of their businesses.

Francis X. Buckley, Jr. is the partner-in-charge of Thompson Coburn LLP's Chicago office and is a member of the firm's Bankruptcy and Creditors' Rights Practice Group. He is a Fellow in the American College of Bankruptcy. Nicholas H. Kappas is an associate in Thompson Coburn LLP's Tax practice group and resides in the firm's St. Louis office. The authors gratefully acknowledge the assistance of Yekaterina Chudnovsky, J.D. candidate, DePaul University 2009.