Understanding the IRS 45 Day Rule for a Federal Tax Lien

Many businesses rely on the use of their accounts receivable or inventory as collateral for loans or for factoring. However, in my experience, few business owners fully grasp how devastating the consequences can be if they engage in this type of financing and fall behind with federal taxes. Unfortunately, fully grasping this concept often does not occur until they receive notification from their factor or lender informing them that their agreement is in default and that funding will cease immediately. For businesses without sufficient cash flow or cash reserves, such a default can easily mean the demise of the business.

The reason why failing to pay federal taxes coupled with the use of receivables or inventory-based financing can often equal disaster has to do with a law that is informally referred to as “the 45-day rule.” This article will explore the basics of the 45-day rule, and will provide guidance on what one should do in order to avoid or mitigate the type of disaster described above.

When a taxpayer becomes delinquent and accrues a tax liability, a statutory federal tax lien comes into existence. This tax lien attaches to all property or rights to property of the taxpayer. At this point it is a statutory tax lien because nothing has yet to be filed with the county or Secretary of State’s office in which the taxpayer’s property is held and, thus, no outside parties are privy to the lien. Generally speaking, in order for an IRS tax lien to be valid against other creditors, the IRS must perfect its security interest by filing a Notice of Federal Tax Lien with the correct authority (usually the office of the secretary of the state or the office of the county recorder).

Once a tax liability is assessed, it is only a matter of time before the IRS officially files a federal tax lien in order to perfect it. This is done to alert all outside creditors of their interest in the taxpayer’s property. Once a lien is perfected, the general rule is that “first in time is first in right.” This simply means that the party who filed a lien first is the party that has priority over those who file liens subsequently. Additionally, once perfected, a federal tax lien attaches to all current property as well as all future acquired property.

The 45 Day Rule of a Notice of Federal Tax Lien

For the most part, federal tax law recognizes “first in time, first in right” for lenders for loans made when there is no actual knowledge of a federal tax lien being filed within 45 days of the tax lien being filed. This is referred to as the 45-day rule.

While “first in time, first in right” is the general rule, there are limited exceptions with regards to an IRS tax lien. One exception is that the IRS’s perfected federal tax lien will have priority over the lender’s previously filed lien if the IRS tax lien was filed within 45 days of the creation of the loan and the funds are not disbursed until more than 45 days after the IRS files a lien. This is true even if the lender was unaware of the filing of the federal tax lien because the burden is on the lender to conduct due diligence to determine if a lien exists prior the completion of the loan. This is why a lender will often do periodic lien checks prior to approving and disbursing a loan.

Another exception is discussed in Internal Revenue Code Section 6323(d), which states that “even though notice of a lien imposed by section 6321 has been filed, such lien shall not be valid with respect to a security interest which came into existence after the tax lien filing by reason of disbursements made before the 46th day after the date of tax lien filing, or (if earlier) before the person making such disbursements had actual notice or knowledge of tax lien filing, but only if such security interest (1) is in property (A) subject, at the time of tax lien filing, to the lien imposed by section 6321, and (B) covered by the terms of a written agreement entered into before tax lien filing, and (2) is protected under local law against a judgment lien arising, as of the time of tax lien filing, out of an unsecured obligation.”

If that last sentence has you scratching your head, you’re not alone. The Internal Revenue Code is very convoluted and seemingly purposely confusing. This is precisely why it may be beneficial to have a tax professional, such as a tax attorney, assist with these complicated tax matters. Translated, this law basically states that a lender will receive priority over the IRS with regards to collateral used by a borrower to secure a loan from the lender only if: 

1. The loan agreement predates the filing of the federal tax lien.
2. The lender disburses the funds no more than 45 days after the tax lien is filed.
3. The collateral of the loan is acquired within the 45 days.
4. When the funds are disbursed the lender did not have actual knowledge or notice of the federal tax lien.

Many businesses with limited borrowing power attempt to secure a business loan by using existing and future accounts receivable or inventory as collateral. Another common situation for a business to attempt to obtain financing is to use a factoring company. A factoring agreement is where the business assigns their current and future accounts receivable to the factoring company in exchange for cash advances. The factoring company typically charges interest on the advance, commission, and/or service fees.

It is important to note that the IRS 45-day rules also applies to accounts receivable and inventory (#3 above puts the lender behind the IRS if the collateral is acquired more than 45 days after the tax lien filing; the business may very well acquire new receivables or inventory after this 45 day period). This is significant, and also highly unusual in the law, because in certain circumstances an IRS tax lien can take precedence over a previously filed lien from a lender.

Internal Revenue Code Section 6323 gives the IRS priority over a lender’s security interest in receivables and inventory provided that the receivable or inventory came into existence at least 46 days after the filing of the IRS federal tax lien. Since many businesses pledge all future accounts receivable or inventory as collateral for a loan or factoring, the tax lien can be a major problem, as the private lender’s secured interest will lose its priority over the IRS’s secured interest. For this reason, lenders and factoring companies who use future accounts receivable or inventory as collateral almost always include a provision in their contracts that calls for the default of the loan (or factoring agreement) in the event that the borrower fails to pay taxes or if a tax lien is filed.

Disaster Example:  Acme Construction has plenty of work lined up, but cannot meet its existing cash flow needs for payroll, supplies, materials, vendors, rent, etc. Acme needs money now, or it will have to close its doors. Acme pledges its current and future accounts receivable to ABC Factoring Company in exchange for an immediate cash advance. ABC advances additional funds to Acme as new jobs and future receivables are created. Acme becomes completely reliant on ABC’s cash advances in order to finance the work that must be done now, but for which payment will not be due for many weeks or months into the future.

Although the cash advances are sufficient to cover almost all of Acme’s necessary expenses, Acme is still short on cash. Acme must postpone some kind of expense, so it decides not to pay its 941 payroll taxes for the time being, with the intention that it will get caught up with the IRS in the near future. The IRS, then, files a Notice of Federal Tax Lien. In the course of conducting regular lien searches of its borrowers, ABC learns that the IRS has filed a lien against Acme.

ABC is rightly terrified that the IRS will seize Acme’s receivables, leaving ABC with no viable method to be repaid for the cash advances that it has made to Acme. Therefore, ABC immediately calls a default, and stops funding Acme. Whereas all of Acme’s existing accounts receivable have been assigned to ABC, Acme cannot seek any short-term cash flow from its customers. On top of this, ABC will no longer make cash advances to Acme. Without the cash advances that Acme relies on, Acme cannot pay its necessary expenses such as payroll, materials, rent, vendors, etc. Acme is forced to go out of business, and Acme’s principals face financial ruin.

Avoiding Disaster:  For businesses that rely on accounts receivable or inventory-based financing, the most obvious way to avoid this type of disaster is to make absolutely certain that all taxes are paid in full and on time. If, for whatever reason, such a business gets behind with taxes, the business may be able to pay off the tax delinquency (plus penalties and interest) before the tax lien is filed. Doing so will prevent a tax lien from being filed and should avert the disaster. However, this method is fraught with peril due to the fact that the IRS is only required to give the taxpayer notification ten days before it files its lien. Ten days isn’t a lot of time for a struggling business to come up with a significant sum of cash, and it certainly isn’t a lot of time for the business to find a tax attorney while still providing the attorney with a meaningful amount of time to try to prevent the filing of the tax lien.

For this reason, I strongly encourage businesses in this situation to seek professional assistance immediately if they begin to get behind on taxes. It may be possible to convince the IRS not to file the federal tax lien even though the business needs time to repay the tax liability, and the sooner a tax pro is brought on board, the better the chances of avoiding the disaster. Of course, the business could attempt to convince the IRS not to file a lien without the aid of an attorney. However, with the stakes being so high, a wise business owner or executive would seek professional help.

Mitigating Disaster:  So, what if a business that relies on inventory or accounts receivable based financing fails to take the above actions and the IRS proceeds with filing a tax lien? Although this is very bad news, and should be avoided at all costs, it may still be possible to salvage the relationship with the lender/factor, and to avoid default. Some lenders/factors will call a default no matter what. However, others can be convinced to continue funding or to refrain from seizing the collateral. The key is to convince the lender/factor that the IRS will not commence enforcement action against the collateral (receivables or inventory). This is primarily done by securing resolution of the outstanding tax liability through an Installment Agreement or an Offer in Compromise.

Again, due to the magnitude of the stakes in play, I would strongly urge any business owner or executive in this situation to seek help from a tax attorney who has extensive experience dealing with the Collection Division of the IRS.  My firm, Fortress Financial Services, Inc., as well as other tax resolution firms, offer free consultations for people or businesses facing unresolved tax liabilities.