By Jeffrey M. Wong
Greene & Markley, PC

Last issue's article on tax administration discussed the similarities between the general federal tax lien and the state tax lien for income and withholding taxes. They arise under similar circumstances, and are perfected and enforced in similar manners. The state and federal tax liens diverge when it comes to lien priority. The state tax lien is treated like a judgment lien against real property or a UCC interest against personal property. If you understand the priority rules for judgment liens and UCC security interests, you understand the priority rules for a state income or employment tax lien. The federal tax lien is, in contrast, a super lien. The Internal Revenue Code gives the federal tax lien very special priority rights, under a very complex set of rules. Federal tax lien priorities are one of the most complex areas of our complex tax laws. This article focuses on the priority granted to the general federal tax lien, which comes into existence with every tax assessed under the Internal Revenue Code. There are a handful of other liens established by the IRC for estate, gift, and certain excise tax liabilities, but the general tax lien serves as the workhorse for the collection of federal taxes in most cases.

The lien's priorities are defined by a combination of principles from federal common law and statutes. All of the statutory provisions regarding lien priority are contained in one place: 26 USC §6323. This single statute, however, consists of eight pages of fine print drafted by the same wordsmiths who drafted the rest of the Internal Revenue Code. The statute is a sea of special definitions, exceptions, and exceptions to exceptions, providing many opportunities for improvident assumptions and oversights. The fundamental concepts of federal tax lien priority can be broken into seven categories. Tax Lien Priority Concept 1 - Supremacy The first important concept concerning the federal tax lien's priority is supremacy. Federal law is the supreme law of the land, and a federal tax lien preempts state priority rules. The most frequently cited case on the federal tax lien is the Supreme Court decision in United States v. City of New Britain, Connecticut, 347 US 81 (1954), which holds that while state law dictates the rights to property that a taxpayer owns, federal law, and exclusively federal law, dictates the rights of the IRS against property and any competing interests.

This simple principle takes many lenders and attorneys by surprise. Never assume that a priority or exemption arising from state law holds water against a federal tax lien. "First in time, first in right" is the cardinal principle of priority with the federal tax lien, and thus, encumbrances with priority over other state encumbrances often prevail over a federal tax lien. They prevail in such instances, however, only because the federal laws generally provide similar priority rules. There are many instances where first in time is not first in right with a federal tax lien.

Consider, for example, the statutory liens held by agricultural suppliers in most states. The agricultural vendor who supplies seed and fertilizer on credit can obtain a statutory lien against the subsequent crops that is entitled to superpriority over other state law encumbrances. The vendor rarely worries about being trumped by another encumbrance under the superpriority. If, however, the IRS assessed a tax against the farmer (and thus, the tax lien came into existence) before the crops were harvested, the agricultural supplier would lose priority to the tax lien. The priority of the tax lien is exclusively controlled by federal law, which doesn't recognize a superpriority for agricultural supplier liens unless the supplier is in possession of the collateral. The crops would arguably constitute "after-acquired property" upon which the IRS would prevail (discussed below). Forget about state superpriorities and perfection rules when competing with a federal tax lien: "Obviously, the State cannot . . . impair the standing of the federal lien, without the consent of Congress." City of New Britain, 347 US at 84.

Tax Lien Priority Concept 2 - Two Sets of Rules

Federal tax lien priorities are regulated by two distinct sets of rules. The first and most complex set is in IRC §6323, which establishes priority rules for four common types of competing interests: consensual security interests, judgment liens, mechanics' liens, and purchasers' interests. The statutes also establish ten superpriorities, i.e., interests that always prevail over a federal tax lien.

The second set of rules, commonly referred to as the choateness principles, are derived from federal common law. These rules control the lien's priority against all other interests besides the four horsemen (discussed below). These other interests include statutory liens and the ownership interests of transferees who receive property encumbered for less than fair market value. Determining whether priority is controlled by statute or by the choateness principles is the first step in unravelling any priority dispute with a federal tax lien.

Tax Lien Priority Concept 3 - The Four Horsemen of IRC §6323(a)

The general rule of priority is set forth in IRC §6323(a). This statute states that a notice of federal tax lien must have been filed for a federal tax lien to prevail against: (1) a security interest holder, (2) a purchaser, (3) a mechanic's lienor, or (4) a judgment lien creditor. IRS employees refer to these four competing interest holders as the four horsemen of IRC §6323.

IRC §6323(a) was intended to bring the tax lien priority rules into better harmony with state law priority rules and common commercial practices, by requiring the IRS to give public notice of its liens just as private creditors must under the UCC and other state laws. Under the general rule of §6323(a), perfected interests beat unperfected interests, and the first interest to be perfected generally wins.

This general rule, however, is riddled with an elaborate system of exceptions, special rules and definitions under IRC §§6323(c)(d), and (h). There are, for example, special definitions for the terms "security interest" and "purchaser," that are materially different from UCC and state real property law definitions. A "security interest" under §6323(a) will prevail over an unperfected tax lien only if it meets the definition of "security interest" provided by federal statute. Whether the encumbrance qualifies as a security interest under state law, and the rights afforded to state law security interests, are irrelevant.

The IRS's filing of its perfection document, the Notice of Federal Tax Lien, is regulated by a combination of federal and state law. IRC §6323(f) grants authority to states to designate where federal tax lien notices are to be filed. Oregon, like most other states, requires tax lien notices to be filed in the same places where state security interests and deeds for personal and real property are filed. ORS 87.806. With realty, the IRS must file its lien notice in the county where the real property is located. The IRS files with the Secretary of State to perfect its lien on personal property.

A handful of lenders and purchasers are surprised every year by the fact that the IRS does not need to file a lien notice with DMV, the Marine Board, the Coast Guard, or the Federal Aviation Administration to perfect liens on cars, boats, and airplanes. The federal statute only requires the IRS to file one lien notice in "one office" within each state to perfect the lien on all of a taxpayer's personal property. The IRS relies upon this one-office rule, and never files lien notices with other the state and federal agencies. Lenders and purchasers of vehicles must check the Secretary of State's office to determine whether self-propelled vehicles they are dealing with are encumbered by tax liens.

Tax Lien Priority Concept 4 - The Choateness Principles

By its terms, the tax lien perfection requirement of §6323(a) applies only to the four horsemen. If a competing interest is not one of these four, the federal tax lien need not be perfected to prevail. The two biggest classes of interests for which perfection of the tax lien is irrelevant are statutory liens and non-purchase transfers. State statutory liens include state tax liens, agricultural, timber, and wood product liens, landlord's liens, and many others. Gifts and bequests are common forms of non-purchase transfers. Recipients of fraudulently transferred property are not "purchasers" under the federal statutes, and thus are also vulnerable to unperfected tax liens.

"First in time, first in right" is the fundamental principle of priority between tax liens and non-horseman interests. Priority is determined according to the dates the tax lien and competing lien came into existence. In the federal vernacular, an interest is deemed to exist for purposes of priority competition when it is "choate." Under City of New Britain, 347 US at 84, a tax lien or other interest becomes choate when: (1) the identity of the lienor; (2) the property subject to the lien; and (3) and the amount of the lien, have been established. For federal tax liens, elements 1 and 2 are established by statute: the US government is always the holder of the federal tax lien, and the property subject to lien is always "all property and rights to property belonging to the taxpayer."

Thus, federal tax liens become choate when the tax is assessed and third element (amount of the lien) is established. The date a competing interest becomes choate is determined by the statutes or principles of common law that create the interest. The provisions of the ORS that establish the state income tax lien are similar to the federal statutes that create the federal tax lien, and state income tax liens become choate on the date of tax assessment. Other Oregon statutes condition establishment of statutory liens upon the lienholder's recordation of a notice of claim or lien or other document. In those instances, the lien will not be choate until the required document is filed.

Title companies and attorneys often fail to realize that, for many tax lien priority conflicts, perfection dates are irrelevant. Assume, for example, that: (1) the IRS assesses a tax and establishes its lien against Taxpayer on Day 1; (2) the Oregon Department of Revenue assesses a tax and establishes its lien against Taxpayer on Day 2; and (3) the ODR perfects its lien against Taxpayer on Day 3 by filing a state tax warrant. The IRS never "perfects" by filing a notice of lien against Taxpayer. Who wins? The IRS. Why? Because a state tax lien is not a "security interest" for purposes of §6323(a), and thus, the federal tax lien need not be perfected to prevail. Statutory liens, as a class, are denied "security interest" status under the federal statute definition for security interests: IRC §6323(h)(1) specifically limits this term to interests acquired by contract.

The choateness principles similarly apply to non-purchase transferees. For example, on Day 1, the IRS assesses a tax against Testator. On Day 2, Testator dies and Beneficiary inherits his home. On Day 3, the IRS seizes Testator's home without having filed a notice of lien. Who wins? The IRS. Why? Because Beneficiary was not a "purchaser" against whom the IRS needed to perfect to prevail. The federal tax lien became choate on Day 1, before Beneficiary acquired his interest. Since the tax lien was "first in time" under the choateness principle, the lien is a valid encumbrance against the property inherited by Beneficiary, and the property is subject to seizure.

Tax Lien Priority Concept 5 - After-Acquired Property

The after-acquired property rules also often surprise attorneys and competing creditors. They apply with both the statutory rules of §6323 and the choateness test, and can be described as follows: 1. The federal tax lien prevails against a horseman interest with respect to all items of property a taxpayer acquires after the federal tax lien has been perfected, unless some provision of §6323 provides otherwise; and 2. The federal tax lien prevails against a non-horseman interest with respect to all items of property the taxpayer acquires after the federal tax lien has arisen through assessment, unless some provision of §6323 provides otherwise.

These rules, in conjunction, with the money or money's worth requirement described below, give the federal tax lien its most suffocating effects. They turn taxpayers with large tax liabilities into what Judge Hess of the Oregon Bankruptcy Court called "credit pariahs," to whom no lender will extend further credit. In substance, once the IRS has perfected a tax lien or a tax lien has become choate, the federal tax lien attaches, as a first priority encumbrance, to all property the taxpayer subsequently acquires. Lenders cannot rely upon any after-acquired property items for collateral. The rule is rooted in principles of sovereignty under English law: the tax lien is the king's lien, and once a debt to the king has become due, no other interest can prevail.

The Supreme Court settled any doubts about the continued viability of the after-acquired property rules in a 1993 decision involving a tax lien and a judgment lien. United States v. McDermott, 507 US 447 (1993). On Day 1, a Private Creditor obtained a judgment against the Debtor and recorded it in County X. On Day 2, the IRS recorded a notice of tax lien against the Debtor in County X. On Day 3, Taxpayer acquired real property in County X. Both the Private Creditor and the IRS claimed priority. Private Creditor claimed that it was in first position because it was the first to record. In the alternative, Private Creditor claimed that under common law principles of equity, the proceeds should be distributed pro rata, since both encumbrances attached at the point the property was acquired. The IRS claimed priority on the basis of the after-acquired property rule and won. After a careful analysis of §6323, the Court concluded: "the federal tax lien is ordinarily dated, for purposes of 'first in time' priority against §6323(a) competing interests, from the time of its filing, regardless of when it attaches to the subject property." 507 US at 454. The operation of the after-acquired property rule with a competing statutory lien, i.e., a non-horseman interest, is demonstrated in an old decision, US v. Graham, 96 F Supp 318 (SD Calif 1951), aff'd sub nom California v. United States, 195 F2d 530 (9th Cir), cert. denied, 344 US 831 (1952). On Day 1, the State of California assessed a tax and obtained a lien against Taxpayer. On Day 2, the IRS assessed a tax and obtained a lien against Taxpayer. On Day 3, the Taxpayer acquired a piece of property subject to both liens. Held: the IRS prevailed.

Much of the complexity within §6323 arises from narrow exceptions carved out from the after-acquired property rules. One of the famous "45 day rules" of §6323 (of which there are three) grants certain creditors priority over property acquired during the 45-day period after a notice of tax lien has been filed. Other types of creditors are granted priority over specific items of property acquired after a notice of tax lien has been filed. Revenue Ruling 68-57, 1968-1 CB 553, grants a priority to purchase money security interests that parallels the priority granted to such interests under the UCC. The after-acquired property rules are still quite broad in scope, and should not be forgotten in any circumstance when a lawyer discovers that his client's debtor owes a federal tax debt.

Tax Lien Priority Concept 6 - Money or Money's Worth

The money or money's worth rule is a companion to the after-acquired property rules. Once a federal tax lien notice has been filed, creditors generally cannot advance further credit to the taxpayer with protection from the federal tax lien. For example: (1) on Day 1, Harry agrees to lend Joe up to $2,000, perfects, and advances half of it; (2) on Day 2, a notice of tax lien is filed against Joe; and (3) on Day 3, Harry discovers the federal tax lien, but advances Joe the remaining $1,000, assuming that the UCC relation-back rule will protect the second advance. Harry loses. The definition of "security interest" in IRC §6323(h) limits the value of a "security interest" to the "money or money's worth" the holder advanced before the tax lien notice filing. Unless an exception to the rule applies, a lender has no "security interest" (for purposes of competition with the tax lien) in any subsequent advances of money or other property.

"Credit pariah" standing is thus assured to a recalcitrant taxpayer: the federal tax lien both usurps priority over after-acquired property items and cuts off lenders and vendors from extending further credit. Lenders and vendors are granted limited opportunities for further advances of money or money's worth by §6323(c). There are two 45-day rules that allow certain lenders to make additional advances for 45 days after lien notice filing, and other lenders are allowed to make advances indefinitely as long as they are made under a pre-lien-filing contract. The lawyer advising the lender or vendor who wishes to make post-lien-filing advances to a taxpayer must examine the statute and insure an exception applies.

Tax Lien Priority Concept 7 - The Superpriorities

The ten superpriorities established by §6323(b) complete the list of relief provisions from the powerful grasp of the federal tax lien. An interest entitled to one of the superpriorities primes a federal tax lien regardless of when the tax lien and the interest arose. Real property taxes are granted a superpriority that subordinates the federal tax lien to real property tax liens in all instances. Purchasers of motor vehicles (but not boats or airplanes) who buy a car from a taxpayer without actual knowledge of a tax lien are granted a superpriority allowing them to take the car free and clear. The same holds true for purchasers of securities or money. A superpriority protects the right of an attorney to recover under a state law attorney's lien from a judgment or settlement fund that the attorney's labor produced.

Six other superpriorities cover tangible personal property sold at retail, personal property subject to a possessory lien, de minimis purchases of household goods, de minimis liens for the repair or improvement of real property, certain insurance contracts, and passbook loans.

Conclusion

The foregoing summary should help lawyers determine the potential risks federal tax liens can create for their clients. Attorneys should also be aware of the special liens provided by IRC §6324 for unpaid estate and gift taxes. The lien that arises for unpaid estate taxes under IRC §6324(a) is one of the most powerful collection devices ever established by federal law. It is a "secret lien" that does not need to be perfected, and can attach without notice on the date of death to both property of the decedent's estate and other property the decedent previously owned or financed.

Feel free to direct questions regarding federal tax liens to Jeff Wong at (503) 295-2668.

This article is intended to inform the reader of general legal principles applicable to the subject area. It is not intended to provide legal advice regarding specific problems or circumstances. Readers should not act upon this information without seeking competent legal counsel for their specific situation.