Federal Tax Liens: Be on the Lookout for Tax Lien Notices – Perfection and Priority Can Be Tricky

In re Aquatic Pools, Inc., 567 B.R. 376 (Bankr. D. N.M. 2017)

The IRS filed a proof of claim that included unpaid taxes, prepetition penalties and prepetition interest. The chapter 11 debtor objected to the IRS’ proof of claim to the extent that it included a secured claim for prepetition penalties accruing after the IRS filed its notice of tax lien – contending that it was not properly perfected.

The debtor was in the business of installing swimming pools. It did not have any real estate, but did own construction equipment, vehicles and other personal property. The IRS filed eight Notices of Federal Tax Liens Relating to Unpaid Taxes for tax periods ending in 2004 through 2014. Each notice included the following:

[W]e are giving notice that taxes (including interest and penalties) have been assessed against the following named taxpayer. We have made a demand for payment of this liability, but it remains unpaid. Therefore, there is a lien in favor of the United States on all property and rights to property belonging to this taxpayer for the amount of these taxes, additional penalties, interest, and costs that may accrue.

After the debtor filed bankruptcy, the IRS filed a proof of claim for ~$378,000, including a secured claim of ~$167,500. The secured claim included ~$77,000 in taxes, ~$81,600 in prepetition penalties and ~$8900 in prepetition interest. After the court disposed of a number of other objections by the debtor, the only remaining issue was whether the IRS’ secured claim included prepetition penalties.

The debtor conceded that the notices were properly filed 2 perfect the specific amounts stated in the notices, but claimed that penalties accruing after the notice filing dates were not properly perfected, and thus could be avoided using “strong-arm” powers.

In particular, section 544 of the Bankruptcy Code provides that transfers can be avoided to the extent that they are voidable under non-bankruptcy law by either (1) a hypothetical creditor that extends credit and obtains a judicial lien, or (2) a hypothetical creditor that extends credit and obtains an execution against the debtor that is returned unsatisfied. (This it is also the section that includes the avoiding powers of a bona fide purchaser of real property.)

As the court notes, this means that a debtor can take priority over and avoid liens that are unperfected as of the date of the bankruptcy petition. However, there is a complication when statutory liens are involved. A different section (section 545) provides that a statutory lien can be avoided to the extent that:

[It] is not perfected or enforceable at the time of the commencement of the case against a bona fide purchaser that purchases such property at the time of the commencement of the case, whether or not such a purchaser exists, except in any case in which a purchaser is a purchaser described in section 6323 of the Internal Revenue Code of 1986, or in any other similar provision of State or local law.

Some have argued that section 545 is the exclusive avoidance provision applicable to statutory liens. However, the 10th Circuit ruled that section 544 may also be used to avoid statutory liens. Consequently, the bankruptcy court assumed that the debtor could proceed under either or both sections to avoid unperfected federal tax liens.

Turning to the process for creating a federal tax lien, the court outlined the procedure as follows:

  • If a person is liable for taxes and fails to pay them after a demand, “including any interest, additional amount, addition to tax, or assessable penalty, together with any costs that may accrue in addition thereto,” there is a lien in favor of the United States on all property belonging to the taxpayer.
  • The lien arises by operation of law after the demand for payment.
  • It attaches to property and is perfected against the taxpayer without the need for further action.
  • However, it is not valid against certain third parties, including a judgment lien creditor, until a notice of federal tax lien is filed – at which point the tax lien is perfected as against those parties.

Thus, as between a federal tax lien and a judgment lien creditor, the tax lien is not perfected until a notice has been filed, but once it is filed the federal tax lien takes priority over the judgment lien creditor.

Normally bankruptcy courts look to state law to define property rights. However, in this case the tax liens were created by federal law, so the validity was determined under federal law. By statute a federal tax lien secures “additional penalties, interest, and costs that may accrue.” Consequently, courts have consistently held that the lien extends to accruals beyond the date of assessment. Further, the lien, including accruing interest in the penalties, is perfected when the notice is filed. Thus, accruing penalties have priority over a post notice judgment lien creditor.

The debtor argued that a bona fide purchaser could buy the property without knowing that it was encumbered by after accruing penalties. The court it concluded that this argument lacked merit because the notice contained language disclosing that the claim secured by the lien included additional penalties, interest and costs – thus putting the purchaser on inquiry notice.

In a last ditch effort the debtor argued that a hypothetical bona fide purchaser’s due process rights would be violated because they might buy property without knowledge of the accruing penalties. Putting aside the question of whether a hypothetical purchaser has due process rights, the court rejected the argument since a buyer would have actual or constructive notice of the penalties accruing after a tax lien notice is filed.

Consequently, the court found that the IRS claim for penalties accruing after the tax lien notices were filed was perfected so that the debtor could not avoid the lien securing the penalties.

It is important to remember that a federal tax lien notice may not be filed the same place that documents are filed for perfecting other types of liens. Standard Secretary of State UCC or County register of deeds searches may or may not disclose federal tax lien notices. To facilitate uniformity, there have been versions of a uniform federal tax lien registration act since the 1920s. More recent versions also cover other federal liens (such as employer liability liens under the Federal Pension Reform Act). It is advisable to check applicable state statutes to confirm where to search for federal liens.

Vicki R Harding, Esq.

About BankruptcyRealEstateInsights

Vicki R. Harding was a partner in the Detroit office of Pepper Hamilton LLP who moved to Arizona seeking warmer weather. Ms. Harding continues to handle commercial transactions with an emphasis on real estate and bankruptcy issues (but no longer owns a snow shovel).
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