Federal Tax Lien Overview
In general, a lien is a charge or encumbrance that a creditor has on the property of a debtor as security for a debt or obligation. If a debtor does not repay the creditor that holds the lien, the creditor can take action to collect the debt by taking the property that is subject to the lien. A federal tax lien is no different as it arises in favor of the IRS to secure unpaid tax debts. When a federal tax lien arises, the IRS has a claim against all property on which it has a lien. While this sounds simple, various issues arise related to federal tax liens and require a deeper analysis to understand how a tax lien impacts a debtor.
A federal tax lien is a statutory lien that arises by operation of law upon the occurrence of three events. The IRS must first assess a tax liability against a taxpayer. Next, the IRS must provide notice of this assessment and demand payment. Third, the taxpayer must fail to pay the assessed tax, whether by willfully refusing to pay or negligently ignores the demand. Once all three events occur a lien arises in favor of the IRS as of the date of assessment. This lien may arise for income taxes, but other taxes as well including estate and gift taxes. The IRS is not required to file a notice of federal tax lien (NFTL) for the lien to be effective against the taxpayer. As discussed later, the IRS must file a NFTL in certain cases to have priority over other creditors of the taxpayer that try to collect debts from the same taxpayer property as the IRS.
The federal tax lien is a very broad lien and secures the collection rights of the IRS in all types of property, including both real and personal property. While many people may think of IRS actions specific to certain types of property like levies covering bank accounts or garnishment covering wages, the federal tax lien is the federal government’s security interest or property rights in all of the taxpayer’s property, both existing at the time the lien arises and future property as well that the taxpayer owns whether directly or held by a third party, to pay the IRS the unpaid assessed taxes.
A federal tax lien continues to exist until the related tax liability is either paid or the collection expiration statute runs, which is ten years from the date of the assessment. In certain cases the applicable tax lien period may be extended, including for certain installment agreements and releases of levies. State statutes of limitations do not affect the duration of a federal tax lien. A federal tax lien continues to attach to property until the lien has expired, is released, or the property has been discharged from the lien. If a taxpayer sells the property, the lien attaches to the proceeds from the sale and the transfer subsequent to attachment does not affect the lien.
The federal tax lien arises by operation of law, meaning that no filing by the IRS is required for the IRS to have a property or security interest in the taxpayer’s property. State law determines the rights of a creditor in a debtor’s property, but federal law determines whether that state law has created a property right in the property at issue for purposes of applying the federal tax lien rules. But the existence of a lien against all property should not be confused with the concept of the IRS having priority over every other creditor of the taxpayer in the taxpayer’s property.
The rights of creditors is often determined by the “first in time, first in right” rule of priority where the first creditor to get a security interest in a debtor’s property or perfect a security interest, will ultimately get the property when a debtor’s creditors both seek to use the same property to satisfy a debt. The IRS, as a creditor and lien holder, would like to be paid first before a tax debtor’s other creditors, so ensuring first priority is important upon assessing tax against a taxpayer. To protect its interests in a debtor’s property, the IRS may file a notice of federal tax lien that creates a security interest in the debtor’s property and provides priority rights over certain other creditors of the debtor. Against certain creditors, the IRS must file a notice of federal tax lien to have priority. While a federal tax lien arises automatically as an operation of law, the determination to file a notice of federal tax lien is subject to certain internal IRS guidelines and is not automatic. The IRS takes into account the amount owed, the type of property, the taxpayer’s compliance history, and the impact of filing the notice of federal tax lien on the ability of the IRS to collect the debt. Among competing creditors, the general categories of creditors that must be provided NFTL for the IRS to have priority rights include a purchase, mechanics lienor, a holder of a security interest and a judgment lien creditor.
A NFTL must be filed with the state authority where property interests are generally located. For real property, this generally is the recorder of deeds in the county where the property is located. For personal property (e.g., cars, boats, etc.), the NFTL against individuals is filed with the county clerk where the taxpayer resides at the time the federal tax lien is filed. For corporations or partnerships with the principal office in Michigan, the NFTL is filed with the secretary of state. A NFTL filed in the wrong state office is ineffective at preserving priority for the IRS against later creditors. The contents of the NFTL filing generally include the taxpayer’s name, the tax liability giving rise to the tax lien and the date of assessment. In certain cases, the IRS may have to refile a NFTL to preserve its rights.
Once a NFTL is filed, the types of property the IRS tax lien attaches to is very broad. The property may not even be currently in the taxpayer’s possession but could be a future or contingent interest in property. The property may also be tangible or intangible. For future interests, this means future distributions or disbursements of property from a source regardless of when the distributions are made. A contingent interest in property includes a right that may or may not occur based on the occurrence of another event. Executory contracts include the right to property based on future agreed performance. Importantly, the federal tax lien attaches to all property acquired after the lien arises, so any property acquired after the assessment date is fair game for the IRS tax lien once the lien arises. As mentioned above, state law determines if a taxpayer has an interest in property, so the IRS will look to state law to understand ownership interests like joint tenancies, partnership rules, etc, but look to federal law to determine when such an interest qualifies as property.
Interests in Real Property
Federal tax liens can attach to real property and may include a personal residence home, cottage or vacation home, office buildings, rental real estate, etc. Lien issues arise when the delinquent taxpayer is a co-owner of the property and vary depending on the type of co-ownership. Common ownership issues relate to joint tenancy, tenancy in common, tenancy by the entirety, and community property. Federal tax liens may prevent the sale of real estate and raise subordination issues with other creditors who also have liens a
In general, where only one co-owner is a tax debtor, the IRS may the debtor’s property to satisfy a tax debt. Other creditors may have an interest in the property as well, but the IRS may attempt to sell the property if its interest would result in full or partial satisfaction of the debt. A joint tenant who is not unrelated to the tax lien may not stop the sale, but would be entitled to compensation or may continue as a tenant in common where state law allows. Where a state allows for general survivorship rights for joint tenants, where the joint tenant who has the tax lien attached to its interest in the property dies prior to other joint tenants, the federal tax lien is extinguished. If the joint tenant with the tax lien is the last surviving joint tenant, the entire property is subject to the federal tax lien.
A tenancy by the entirety applies in certain states to property held solely by spouses. A tenancy by the entirety is similar to a joint tenancy except the property interests may not be separated or transferred without the other spouse’s consent. The U.S. Supreme Court has held that a federal tax lien still attaches to one spouse’s interest in the property even if the other spouse does not have a tax debt or consents. The general rule is that the lien gives the IRS rights in half the property held by the tenancy by the entirety.
Tenancy in common property is more straightforward. Because the ownership interests are held separately without survivorship rights or consent rights, and may generally be transferred unless subject to a side contractual agreement. As a result, if property subject to a lien is transferred, the lien survives. The lien also survives even if the taxpayer dies. The IRS may sell the entire property held by tenants in common, but must compensate the non-debtor owners.
Interests in Personal Property
Personal property is defined generally as everything that can be owned that is not real property. Tangible property is defined generally as personal property that has physical form and is moveable.
The Service takes collection action against a variety of types of personal property, including automobiles, trucks, boats, goods, bank accounts, wages and benefits, interests in trusts, and partnership interests.
Common issues related to liens on personal property include liens on the taxpayers money. Deposits in banks are subject to the lien and full seizure by the IRS even if deposited in a joint account. A joint owner may lay claim to later deposits that the joint owner included, but the IRS may attempt to seize these as well. Additionally wages that are earned are subject to the lien and garnishment even though held by a third party. A portion of wages may be exempt from garnishment, but this amount is small and generally will not allow the taxpayer to cover basic living expenses. Wage garnishment, once started, generally continues until the tax assessment is paid in full.
For business owners operating as a partnership, the federal tax lien attaches to the taxpayer’s partnership interest, but not the partnership’s underlying assets. The lien value is generally limited to the equity in the partnership, not the entire partnership. The IRS would commonly look to the taxpayer’s draws or distributions from the partnership to satisfy the tax debt and the lien attaches to these automatically.
For property related to a trust, various issues arise including for the grantor of the trust and the beneficiary. A grantor, the person who sets up the trust and contributes property to the trust, may retain control over the trust to be considered the owner of the trust property. In such cases, a federal tax lien attaches to the grantor’s interest in the trust and the trust property. These types of trusts are commonly referred to as “grantor trusts” or “living trusts”. Another variation of these trusts related to the grantor retaining control is a family trust where the family members use trust property while ignoring the rights and rules of the trust. The IRS also then ignores the trust as a separate entity and will take the property subject to the lien.
For beneficiaries of a trust, the IRS will look to the trust instrument to determine what rights the beneficiaries have in the trust. As mentioned above, state law is used to determine what rights the trust beneficiaries have in the trust property. A beneficiary may have rights to the income of the trust, the property of the trust, or both.
Certain trusts may also provide the trustee with the right to redirect trust distributions to other beneficiaries and so the beneficiary who is the subject of a tax lien would not receive distributions that they IRS could take. Another type of trust commonly referred to as a “spendthrift” trust seeks to limit creditors’ right in trust property. Spendthrift trusts under state law generally have specific requirements related to the rights of trustees to distribute property, but limit creditors’ rights to access the trust property or distributions to debtor beneficiaries. Federal tax liens can still reach the trust property and distributions despite the state law restrictions.
There are other property types that are subject to federal tax liens. The same general principles generally will apply to those property types as the ones described above. Federal tax liens will apply once a property right is determined to exist under state law. Taxpayers may not transfer property without receiving compensation, which the Service may view as a fraudulent conveyance in an attempt to avoid or defeat the federal tax lien.
In general, federal tax liens arise automatically when the IRS assesses tax, demands payment and the taxpayer fails to pay tax. This lien will reach all of a taxpayer’s current and future property, unless an exemption applies and then the IRS may levy or seize property subject to its rights under applicable federal law. Taxpayers can take steps, aside from paying the tax assessment amount, to stop or delay IRS collection efforts and avoid financial or other disruptions in their lives. If you are currently subject to IRS collection efforts or a federal tax lien, give me a call for a free consultation to discuss your tax situation.