Court Rejects IRS Claim to Taxpayer’s Property – Houston Tax Attorneys

If a bank loans money to a business to buy equipment when the business owes back taxes, can the bank foreclose on and repossess the equipment? Does the bank or the IRS have a superior interest in the equipment?

This gets into questions of state and federal law. Generally, state law defines property rights and what rights parties have to property. Then, with respect to unpaid federal taxes, federal tax law is applied to the state-created property rights and interests.

This can result in situations where the IRS asserts an interest in a taxpayer’s property, even though the bank has a superior right to the property. The court recently addressed this in United States v. Dunn, Case No. 22-CV-1152-JAR (D. Kan. 2023)–denying the IRS’s claim that it had a superior right to property.

Facts & Procedural History

This case involves a trucking company that got behind on its payroll taxes. The IRS assessed the payroll taxes and eventually filed notices of federal tax liens in the public records.

After this, the trucking company purchased trucks and financed them with a bank. The bank repossessed on the trucks and sold them at auction.

The federal government brought an action against a trucking company to enforce tax liens for unpaid payroll taxes. It also included a claim against the bank for allegedly converting the IRS’s interest in the trucks by auctioning them off. The key question was whether the IRS’s earlier-filed tax liens took priority over the bank’s later-attached security interests.

About IRS Tax Liens

Once a tax is assessed and unpaid, the IRS has a lien against all of the taxpayer’s property. This helps protect the IRS’s interest and is supposed to help the IRS collect unpaid taxes, but there are times when an IRS lien can hinder the IRS’s ability to collect.

The IRS lien is often referred to as a secret lien, as the lien is not public and the lien relates back to the date of the assessment. Until the lien notice is filed, the secret lien is not valid against third-party purchasers who pay fair market value for the taxpayer’s property. This can even prevent transfers of property to spouses and is why many wealthy clients hold their assets in trust.

This changes when the IRS files its notice of federal tax lien. The lien is then public and, generally, even a bona fide purchaser for fair market value cannot take the property free of the lien.

These are the general rules, but there are exceptions. And the IRS tax lien rules have changed over time. For example, as relevant here, there is an exception for purchase-money security interests.

Exception for Purchase Money Security Interests

The term “purchase money security interest” or “PMSI” essentially refers to the interest a lender has in property that it loans money against. In this case, it refers to the security interest the bank has in the trucks at issue in this case.

In commercial transactions, PMSIs play a major role in enabling businesses or consumers to afford big purchases they otherwise could not make. Common examples, beyond equipment loans, include vehicle purchase loans and home mortgages.

Under the UCC and other state commercial laws, properly perfected PMSIs receive special priority status over other security interests in the same collateral. Proper perfection procedures are defined under applicable state law.

State commercial laws, like the Kansas Uniform Commercial Code (UCC) at issue in this case, govern the validity of security interests, including PMSIs. Under the UCC, one has to take steps to “perfect” security interests to make them valid against third parties. Perfection procedures often include filing a UCC statement or noting the security interest on the title document. State laws set out the rules for perfecting security interests.

This brings us to the PMSI exception to IRS liens. Where a PMSI is properly perfected under the applicable state UCC rules, it takes priority over the IRS lien. This is based on the idea that the lender has a superior right to the taxpayer owner in this property as the owner takes “subject to” the security interest, so the lender also has a superior right over the IRS in the property.

How Long to Perfect a Security Interest

This now brings us to the question in this case. How long does a lender have to perfect their PMSI when there is a pre-existing IRS lien and the IRS has already filed a notice of its lien in the public records?

The bank in this case did not take the steps under state law to perfect its interest. The bank could probably have avoided this dispute if it updated certificates noting its security interests before repossessing and selling the trucks. It should have completed the registration procedures, but it did not do so.

Importantly, Kansas law provides a perfection grace period allowing security interests to relate back to the time of the loan. This gave the bank’s PMSIs priority over the earlier IRS tax liens notwithstanding the gap between financing the trucks and completing registration procedures.

The court held for the bank in this case, holding that the bank’s PMSI in the trucks, though perfected later in time, took priority over the IRS tax liens under federal law.

The Takeaway

It is surprising to see a bank lend money when there are existing IRS tax liens filed. It is also surprising to see a situation where a bank did not timely perfect its security interest. But as this case shows, the bank that makes a loan to a business that has tax liens filed may still be able to perfect its security interest if state law allows for late perfection.