The IRS May Have Priority Over Secured Lenders in Tax Lien and Levy Cases
Lenders must exercise extreme caution when lending to borrowers who have delinquent tax obligations in order to minimize the risk of federal tax liens taking priority over the lenders' security interests.
A tax levy is the means by which the Internal Revenue Service can collect on its tax lien on a debtor’s property that is in possession of a third party, such as a secured lender. The most common types of IRS levies include wage levies, bank account levies, and levies on a taxpayer’s securities and accounts receivables. If a taxpayer does not have financial assets sufficient to satisfy a delinquent tax liability, the IRS also can attempt to seize physical property directly from the taxpayer.
It is accepted practice that once a lender receives notice of a levy, the lender cannot dispose of the debtor’s property in the lender’s possession without being liable to the IRS. However, if that same lender disposed of the debtor’s property and applied the proceeds the lender received from the sale of the property to an indebtedness to the lender prior to receipt of notice of the tax levy, then the lender would not be liable to the IRS for the tax lien.
Courts, however, are narrowing the ability of a secured lender to take any pre-notice action. If a lender sells collateral and receives proceeds from the sale, the lien attaches to the proceeds. It the lender takes the proceeds and applies them against the debtor’s debt to the lender, some courts have held that those proceeds, although no longer in the debtor’s account at the bank, are still in the possession of the bank and therefore subject to the levy.
Such was the case in U.S. v. Boardwalk Motor Sports, Ltd., in which Plains Capital Corp. accepted a Ferrari as collateral for a $200,000 line of credit to a borrower, even though the IRS already had filed $3 million in federal tax liens against the borrower’s property. Although Plains Capital was aware of the federal tax liens at the time it extended the line of credit, it also was aware that the IRS had not attempted to levy its lien at that time.
The borrower defaulted on the line of credit and the IRS and Plains Capital entered into discussions to sell the Ferrari and divvy up the proceeds. The Ferrari was delivered to a dealer to sell, and in a misstep, the IRS sent the notice of levy to the dealer a day before the dealer received the car. Because the law requires that the taxpayer’s property be in the possession of the party who receives the notice of levy on the date the notice is received, that levy was ineffective. No possession--no levy. The dealer then sold the car and gave the proceeds to Plains Capital. Because the IRS had not yet served a notice of levy on Plains Capital, Plains Capital applied the sale proceeds to the outstanding balance on the line of credit and released its lien on the car. Twelve days later, the IRS sent a notice of levy to Plains Capital and tried to obtain the proceeds from the sale of the Ferrari. Plains Capital claims it no longer possessed any of the proceeds– they were applied against the borrower’s debt.
The Fifth Circuit Court of Appeals did not agree with Plains Capital. The court ruled that even though Plains Capital applied the sale proceeds to the line of credit before its receipt of the tax levy, the application of the funds was a mere bookkeeping entry and Plains Capital still had possession of the funds at the time it received the tax levy “because the money can still be traced to the bank’s account.” As a result, the court held that the tax levy issued almost two weeks after the sale proceeds were applied against the borrower’s debt was effective against those proceeds and that Plains Capital was liable for failure to honor a tax levy.
While the court’s decision has been criticized heavily, the holding highlights the need for vigilance from lenders when making loans to borrowers who have incurred federal tax liens against them.
The case above illustrates the need for banks to be very cautious when handling the property of a debtor subject to an IRS lien whether or not the bank has received a notice of levy.
Michael Smith is a commercial lending attorney at Lerch, Early & Brewer in Bethesda, Maryland whose practice is focused on the structuring, negotiation, documentation, due diligence and closing of commercial lending transactions. For more information about working with debtors subject to IRS liens, contact Mike at (301) 657-0166 or email@example.com.