When someone owes the IRS money, chances are good that they have other creditors who are also owed money. This raises questions as to who gets paid first–the third parties or the IRS.
The answer is usually the IRS–if the IRS even bothers to attempt to collect. In many cases, the IRS does not ever attempt to collect. But when it does, the tax laws generally give the IRS priority over other third-party creditors. This is particularly true for direct transfers between family members.
This does not mean that the parties cannot make arrangements between themselves to avoid this result. The recent United States v. Allahyari, No. 18-35956 (9th Cir. 2020), case provides an opportunity to consider this situation. The case involves a father who was owed money by his son and he recorded a deed of trust against the son’s property to get paid back before the IRS could collect on tax liens.
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Facts & Procedural History
The defendants in this case were a father and his son. The father learned that his son owed over $1.7 million in back taxes to the IRS. The son also owed his father money from past loans.
Fearing the IRS would seize the son’s home to collect the tax debt, the father and son executed a deed of trust against the son’s property in 2005. The deed purportedly secured $471,000 the son owed the father from prior debts. The father recorded the deed in the local real estate records before the IRS filed notice of the tax liens.
When the IRS sued to foreclose its tax liens against the son’s home years later, the father argued his security interest took priority. The district court disagreed with the father on two grounds: 1) the deed of trust wasn’t a “security interest” under federal law since the father knew of the tax debts, and 2) the deed was an invalid fraudulent transfer under state law to avoid creditors.
The father appealed. The IRS cross-appealed, arguing the amount of the father’s prior mortgage interest should be reduced based on the statute of limitations.
About IRS Tax Liens
A federal tax lien is just a notice to the public that the IRS has an interest in the taxpayer’s property. It is intended to put the public on notice that they have to be careful in transacting business with the taxpayer.
The lien attaches to all of the taxpayer’s property and rights to property, including real estate.
A federal tax lien arises when a taxpayer fails or refuses to pay taxes owed after the IRS makes a demand for payment. This is why it is often referred to as a “secret lien,” as it does not necessarily have to be made public to be enforceable.
To establish priority of its lien against other creditors, the IRS must file a Notice of Federal Tax Lien (“NFTL”) in the public records. The IRS files the NFTL using a Form 668(Y) and filing it with the appropriate state or local government office where the taxpayer’s property is located, such as the county recorder’s office for real estate.
The NFTL puts third parties on notice of the IRS’s claim. This prevents third parties, even those who do not search the public records, from claiming an interest in the taxpayer’s property over that of the IRS.
Taxpayers are to be given notice of the lien filing and they can challenge an NFTL filing through a Collection Due Process hearing or by bringing a civil action in federal district court.
Priority of Federal Tax Liens
Section 6323(a) governs the priority of federal tax liens against competing interests. A federal tax lien is not valid against certain third parties, like purchasers and holders of security interests, until the IRS files a proper NFTL.
A “security interest” includes any interest in property acquired by contract for the purpose of securing payment or performance of an obligation, such as a mortgage or deed of trust.
As the court held in this case, a deed of trust can qualify as a “security interest” under Section 6323(a) if it meets certain requirements and is properly recorded before the IRS files its NFTL.
That is what we had in this case. The father recorded his deed of trust against the son’s property prior to the time the IRS filed its NFTL. Thus, the father had priority over the IRS’s lien.
Fraudulent Transfers
Just because the father had priority does not necessarily mean that he prevails. There are other tools the IRS can use in this situation. The state fraudulent transfer laws are one such tool.
State fraudulent transfer laws allow creditors, including the IRS, to void certain transfers made by a debtor if the transfer was made with actual intent to hinder, delay, or defraud creditors or for less than reasonably equivalent value when the debtor was insolvent.
The elements of a fraudulent transfer generally are: (1) a transfer of an asset; (2) made with actual intent to hinder, delay, or defraud creditors; or (3) for less than reasonably equivalent value; (4) when the debtor was insolvent. Badges of fraud that indicate intent can include transfers to insiders or family members, concealment of the transfer, transfer of substantially all the debtor’s assets, or the debtor’s insolvency at the time of transfer.
If a court finds a fraudulent transfer occurred, it can void the transfer and allow the creditor to seize the asset from the transferee to satisfy the creditor’s claim. This is a frequent type of tax case the courts consider.
In the current case, the court explained that proving fraud requires “clear and satisfactory evidence,” which is a heightened standard of proof. The appellate court sent the case back to the trial court to determine if the deed of trust was a fraudulent transfer, even though the father recorded it before the IRS filed its tax lien notices. The father’s knowledge of his son’s tax debts was a relevant factor according to the appellate court.
Statute of Limitations on Prior Debts
The IRS can also raise other defenses. In this case, the IRS raised the defense as to the statute of limitations. Specifically, the IRS also argued that a 6-year statute of limitations should reduce the amount of the father’s secured claim on the property.
When the IRS forecloses a tax lien under Section 7403, the IRS “steps into the shoes” of the taxpayer and acquires whatever rights the taxpayer would have had. This includes asserting any defenses the taxpayer could have raised.
Here, the father’s claim was based on a prior mortgage his son owed. The IRS argued that Washington’s 6-year statute of limitations on actions to enforce written contracts should partially bar the father’s claim. The appellate court agreed the IRS could assert this statute of limitations defense to reduce the father’s priority claim, since some of the mortgage payments were allegedly due more than six years before the suit. This is yet another hurdle the father would have to overcome to be able to get paid first, before the IRS.
The Takeaway
This case shows it may be possible for family members to use a deed of trust to secure repayment of past debts and gain priority over later-filed IRS tax liens. However, there are several potential obstacles. For example, the deed of trust must be properly recorded before the IRS files notice of the tax lien and one has to comply with the state fraudulent transfer rules and contend with the state statute of limitation rules. These rules are not necessarily insurmountable if the parties act sooner rather than later.
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