And on the 46th Day, Who Wins?

On June 15, 2006, Company, a manufacturer, gives Lender a security interest in its account receivables and inventory for a loan of $20,000, and Lender files it security interest on that date. The Internal Revenue Service (“IRS”) files a notice of federal tax lien on July 6, 2006. On that date, Lender's security interest would have priority over a judgment lien arising on July 6, 2006. On Aug. 3, 2006, without knowledge of the notice of federal tax lien, Lender loans $15,000 to Company. On Aug. 4, 2006, Lender learns of the notice of federal tax lien, but still loans Company $3,000. On Oct. 31, 2006, Lender loans Company $2,000.

Scenario 2

On Jan. 2, 1969, Company, an appliance dealer, in order to finance the acquisition from Seller of a large inventory of appliances, enters into a written agreement with Lender. Under the terms of the agreement, in return for a security interest in all of Company's inventory, presently owned and subsequently acquired, Lender issues an irrevocable letter of credit to allow Company to make the purchase. On Dec. 31, 1968 and January 10, 1969, separate notices of federal tax lien are filed by the IRS with respect to Company's delinquent tax liabilities. On March 31, 1969, Lender honors the letter of credit. Under local law, Lender's security interest in the inventory purchased under the letter of credit qualifies as a purchase money security interest and is valid against persons acquiring security interests in or liens upon such inventory at any time.

Scenario 3

On Dec. 1, 1997, the IRS assesses delinquent taxes against Taxpayer. On Jan. 2, 1998, Taxpayer enters into a written agreement with Lender whereby Lender agrees to lend Taxpayer $10,000 in return for a security interest in certain property owned by Taxpayer. On Jan. 10, 1998, the notice of tax lien against Taxpayer is filed. On Feb. 1, 1998, Lender, without actual notice or knowledge of the notice of tax lien filing, disburses the loan to Taxpayer. Under local law, the security interest arising from the disbursement is entitled to priority as of the date of tax lien filing over a judgment lien arising out of an unsecured obligation.

• In Scenario 1, does Lender have priority over the federal tax lien with respect to the $15,000, the $3,000, and the $2,000 advances?
• In Scenario 2, does Lender have priority over the federal tax liens with respect to its purchase money interest in Company's inventory?
• In Scenario 3, does Lender have priority over the federal tax lien with respect to its disbursement made after the notice of tax lien filing?

The answers are largely found in the provisions governing the interaction of federal tax liens under the Code with Article 9 secured interests, and, in particular, the provisions pertaining to the “45-day rule” safe harbor for future advances based on a prior secured interest. A brief review of pertinent parts of such laws follows.

Article 9 Security Interests And Future Advances

As a general rule, if a creditor makes a loan or extends credit to a debtor that is secured, up to the amount of the loan or letter of credit by assets or property of the debtor, the creditor has a security interest in the debtor's property or assets. If a creditor extends an unsecured loan or credit to a debtor and the debtor defaults on his payment to the creditor, the creditor must obtain a judgment and must execute the judgment via a sheriff's levy to collect the payment. Having a security interest is critical. A security interest is a right held by a secured creditor, which can force the sale of debtor's property (collateral) to satisfy the debt owed to the creditor. In order to obtain a security interest, the loan or credit extension must be perfected. Under Article 9-203(b), three things must be satisfied in order to create an enforceable security interest against a creditor: 1) the secured party must give value; 2) the debtor must have rights in the collateral or the power to transfer rights in the collateral; and 3) the debtor must authenticate a security agreement. UCC ' 9-203(b). Under UCC ' 9-302, a financing statement must be filed to perfect all security interests unless the secured party is already in possession of the collateral. Once a filing statement is filed in the correct office of the Secretary of State, the secured party has perfected. Secured interests rank according to priority in time of filing or perfection. UCC ' 9-322 (A)(1).

With respect to future advances, a security interest will not have priority over the rights of a person that becomes a lien creditor if the security interest secures an advance made more than 45 days after the person becomes a lien creditor unless the advance is made without actual knowledge of the lien or pursuant to a commitment entered into without actual knowledge of the lien. UCC
' 9-323(b).

The Federal Tax Lien

Once an Article 9 security interest is determined to exist, the issue becomes the priority of that interest as against the federal tax lien (the “tax lien”). With certain exceptions, the rules governing priority of a tax lien over other interests in the same property follow the “first in time, first in right” common law rule.

The Code establishes a hierarchy with respect to the tax lien's priority over and subordination to other Article 9 creditors. At the bottom are those creditors over which the tax lien has priority as of the date of tax assessment regardless of when the notice of tax lien is recorded. With respect to these creditors, the priority of the tax lien follows the first-in-time, first-in-right rule as of the date of assessment. In the middle are those statutorily excepted secured creditors over which the tax lien has priority only if the notice of tax lien is recorded before the creditors' interests are secured pursuant to the applicable state law. With respect to these exceptions, the tax lien follows the first-in-time, first-in-right rule as of the date the notice of tax lien is recorded. At the top are certain statutorily identified super-priority creditors to which the tax lien is subordinate regardless of when the taxes have been assessed or notice of lien has been recorded against the debtor. In essence, for policy reasons, these latter creditors have been granted a form of immunity from the tax lien.

The tax lien arises by operation of law at the time an assessment of outstanding taxes is made against a debtor. An “assessment” is simply the statutorily required recording in the IRS's internal books and records of a debtor's tax liability. An assessment may be the result of a debtor's voluntary self-declared assessed tax (i.e., via the filing of a tax return showing amounts due) or of an investigative audit of a debtor where the IRS has determined that a debtor owes additional tax. In the latter case, the debtor may file an administrative appeal or initiate judicial action to contest the audit findings before any additional taxes, if necessary, are required to be assessed against the debtor.

Within 60 days of an assessment, the IRS must send to the debtor a notice of the tax assessed (plus interest and penalties, if any) and a demand for payment. If the debtor does not pay the tax within the 10-day period set forth in the demand for payment, then a notice of tax lien will be filed. Thus, for all creditors except those specifically enumerated as exceptions in the Code, there are two important components to a tax lien: when it arises (at the time of assessment, for purposes of determining priority), and when it becomes enforceable (after the notice and demand for payment is refused and the IRS files a notice of lien). Once the notice of tax lien is recorded for enforcement purposes, the tax lien relates back to the date of assessment for purposes of priority against such other creditors.

Thus, the tax lien is perfected as to all creditors, except those specifically enumerated as exceptions in the Code, at the time of assessment, attaching to “all property and rights to property, whether real or personal,” belonging to the debtor, including after-acquired property, and continues in force until the outstanding taxes are paid or the statute of limitations on collection is exhausted. As to these creditors, the lien has been referred to as a “secret lien” because it attaches to the debtor's property automatically at the time of assessment even though the notice of tax lien for the benefit of such creditors is not filed until sometime later (after the IRS issues the notice and demand for payment against the debtor, and the debtor has neglected or refused to pay such tax within the 10-day period prescribed for responding to the demand for payment). In this sense, the tax lien effectively “lurks” within a debtor's property for the period of time between assessment and enforcement. For these creditors, unless a specific statutory exception is available, a tax lien's priority is set at the time of assessment and, once the notice of tax lien is filed, is enforceable against such creditors from that date.

Next month, we discuss exceptions for purchasers, holders of security interests, and certain others.

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.

Lenders, financiers, and other creditors are often aware of the ever-present danger of a federal tax lien lurking within a debtor's assets. It is one of many risks that typically must be taken into account in performing due diligence for any financing arrangement. Protecting an interest from a federal tax lien involves both careful legal planning and extensive due diligence with respect to a debtor's assets. In many respects, the federal tax lien represents the worst of both worlds. It is the intersection of complex and multi-layered legal framework involving the federal tax laws, the state and local law adaptations of the Uniform Commercial Code (the “UCC”), and the state common laws of property and contract rights, among others. At the same time, it is a highly fact-determinative inquiry, with questions of priority often turning on the who, what, when, where, and how of the parties' secured or unsecured interests. The end result is large body of continuously evolving and often conflicting case law that can be a headache for anyone attempting to sort through the issues.

This article provides a review of the basic principles of federal tax liens and secured transactions under Article 9 of the UCC (“Article 9″) and discusses certain issues that arise with respect to the priority of federal tax liens against certain interest holders under the “45-day rule” of the Internal Revenue Code of 1986, as amended (the “Code”), explained in more detail below. To guide the discussion, consider the following hypothetical scenarios:

Scenario 1

On June 15, 2006, Company, a manufacturer, gives Lender a security interest in its account receivables and inventory for a loan of $20,000, and Lender files it security interest on that date. The Internal Revenue Service (“IRS”) files a notice of federal tax lien on July 6, 2006. On that date, Lender's security interest would have priority over a judgment lien arising on July 6, 2006. On Aug. 3, 2006, without knowledge of the notice of federal tax lien, Lender loans $15,000 to Company. On Aug. 4, 2006, Lender learns of the notice of federal tax lien, but still loans Company $3,000. On Oct. 31, 2006, Lender loans Company $2,000.

Scenario 2

On Jan. 2, 1969, Company, an appliance dealer, in order to finance the acquisition from Seller of a large inventory of appliances, enters into a written agreement with Lender. Under the terms of the agreement, in return for a security interest in all of Company's inventory, presently owned and subsequently acquired, Lender issues an irrevocable letter of credit to allow Company to make the purchase. On Dec. 31, 1968 and January 10, 1969, separate notices of federal tax lien are filed by the IRS with respect to Company's delinquent tax liabilities. On March 31, 1969, Lender honors the letter of credit. Under local law, Lender's security interest in the inventory purchased under the letter of credit qualifies as a purchase money security interest and is valid against persons acquiring security interests in or liens upon such inventory at any time.

Scenario 3

On Dec. 1, 1997, the IRS assesses delinquent taxes against Taxpayer. On Jan. 2, 1998, Taxpayer enters into a written agreement with Lender whereby Lender agrees to lend Taxpayer $10,000 in return for a security interest in certain property owned by Taxpayer. On Jan. 10, 1998, the notice of tax lien against Taxpayer is filed. On Feb. 1, 1998, Lender, without actual notice or knowledge of the notice of tax lien filing, disburses the loan to Taxpayer. Under local law, the security interest arising from the disbursement is entitled to priority as of the date of tax lien filing over a judgment lien arising out of an unsecured obligation.

• In Scenario 1, does Lender have priority over the federal tax lien with respect to the $15,000, the $3,000, and the $2,000 advances?
• In Scenario 2, does Lender have priority over the federal tax liens with respect to its purchase money interest in Company's inventory?
• In Scenario 3, does Lender have priority over the federal tax lien with respect to its disbursement made after the notice of tax lien filing?

The answers are largely found in the provisions governing the interaction of federal tax liens under the Code with Article 9 secured interests, and, in particular, the provisions pertaining to the “45-day rule” safe harbor for future advances based on a prior secured interest. A brief review of pertinent parts of such laws follows.

Article 9 Security Interests And Future Advances

As a general rule, if a creditor makes a loan or extends credit to a debtor that is secured, up to the amount of the loan or letter of credit by assets or property of the debtor, the creditor has a security interest in the debtor's property or assets. If a creditor extends an unsecured loan or credit to a debtor and the debtor defaults on his payment to the creditor, the creditor must obtain a judgment and must execute the judgment via a sheriff's levy to collect the payment. Having a security interest is critical. A security interest is a right held by a secured creditor, which can force the sale of debtor's property (collateral) to satisfy the debt owed to the creditor. In order to obtain a security interest, the loan or credit extension must be perfected. Under Article 9-203(b), three things must be satisfied in order to create an enforceable security interest against a creditor: 1) the secured party must give value; 2) the debtor must have rights in the collateral or the power to transfer rights in the collateral; and 3) the debtor must authenticate a security agreement. UCC ' 9-203(b). Under UCC ' 9-302, a financing statement must be filed to perfect all security interests unless the secured party is already in possession of the collateral. Once a filing statement is filed in the correct office of the Secretary of State, the secured party has perfected. Secured interests rank according to priority in time of filing or perfection. UCC ' 9-322 (A)(1).

With respect to future advances, a security interest will not have priority over the rights of a person that becomes a lien creditor if the security interest secures an advance made more than 45 days after the person becomes a lien creditor unless the advance is made without actual knowledge of the lien or pursuant to a commitment entered into without actual knowledge of the lien. UCC
' 9-323(b).

The Federal Tax Lien

Once an Article 9 security interest is determined to exist, the issue becomes the priority of that interest as against the federal tax lien (the “tax lien”). With certain exceptions, the rules governing priority of a tax lien over other interests in the same property follow the “first in time, first in right” common law rule.

The Code establishes a hierarchy with respect to the tax lien's priority over and subordination to other Article 9 creditors. At the bottom are those creditors over which the tax lien has priority as of the date of tax assessment regardless of when the notice of tax lien is recorded. With respect to these creditors, the priority of the tax lien follows the first-in-time, first-in-right rule as of the date of assessment. In the middle are those statutorily excepted secured creditors over which the tax lien has priority only if the notice of tax lien is recorded before the creditors' interests are secured pursuant to the applicable state law. With respect to these exceptions, the tax lien follows the first-in-time, first-in-right rule as of the date the notice of tax lien is recorded. At the top are certain statutorily identified super-priority creditors to which the tax lien is subordinate regardless of when the taxes have been assessed or notice of lien has been recorded against the debtor. In essence, for policy reasons, these latter creditors have been granted a form of immunity from the tax lien.

The tax lien arises by operation of law at the time an assessment of outstanding taxes is made against a debtor. An “assessment” is simply the statutorily required recording in the IRS's internal books and records of a debtor's tax liability. An assessment may be the result of a debtor's voluntary self-declared assessed tax (i.e., via the filing of a tax return showing amounts due) or of an investigative audit of a debtor where the IRS has determined that a debtor owes additional tax. In the latter case, the debtor may file an administrative appeal or initiate judicial action to contest the audit findings before any additional taxes, if necessary, are required to be assessed against the debtor.

Within 60 days of an assessment, the IRS must send to the debtor a notice of the tax assessed (plus interest and penalties, if any) and a demand for payment. If the debtor does not pay the tax within the 10-day period set forth in the demand for payment, then a notice of tax lien will be filed. Thus, for all creditors except those specifically enumerated as exceptions in the Code, there are two important components to a tax lien: when it arises (at the time of assessment, for purposes of determining priority), and when it becomes enforceable (after the notice and demand for payment is refused and the IRS files a notice of lien). Once the notice of tax lien is recorded for enforcement purposes, the tax lien relates back to the date of assessment for purposes of priority against such other creditors.

Thus, the tax lien is perfected as to all creditors, except those specifically enumerated as exceptions in the Code, at the time of assessment, attaching to “all property and rights to property, whether real or personal,” belonging to the debtor, including after-acquired property, and continues in force until the outstanding taxes are paid or the statute of limitations on collection is exhausted. As to these creditors, the lien has been referred to as a “secret lien” because it attaches to the debtor's property automatically at the time of assessment even though the notice of tax lien for the benefit of such creditors is not filed until sometime later (after the IRS issues the notice and demand for payment against the debtor, and the debtor has neglected or refused to pay such tax within the 10-day period prescribed for responding to the demand for payment). In this sense, the tax lien effectively “lurks” within a debtor's property for the period of time between assessment and enforcement. For these creditors, unless a specific statutory exception is available, a tax lien's priority is set at the time of assessment and, once the notice of tax lien is filed, is enforceable against such creditors from that date.

Next month, we discuss exceptions for purchasers, holders of security interests, and certain others.

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.