Be Alert. Accidents Hurt. Don’t Forget the Subordination Published January 1, 2014
This article was originally published in the January/February edition of Commercial Factor and focuses on subordinations of federal tax liens and if they are necessary.
Seat belts save lives – but you have to use them. I have a bad habit of waiting until after I back out of the driveway and put the car in “drive” before I buckle up. My five-year-old daughter “reminds” me to put my seat belt on halfway down the drive. I (usually) resist the urge to say, “Don’t tell daddy what to do!” Instead, I take a deep breath. Just as I’m about to say something sarcastic, the teenager from down the street with a new car comes around the corner going way too fast. It’s nice to have someone looking out for you.
Subordinations of federal tax lien (subordinations) are similar to seat belts – they will protect your collateral so long as you use them. Moreover, it’s important that they not be taken for granted – subordinations are not absolute or indefinite. Rather, subordinations are tied to Installment Agreements and usually have expiration dates.
Is a Subordination Necessary?
Lenders frequently ask whether they are protected from the IRS when their clients (a) have a federal tax liability, (b) a federal tax lien has been filed, (c) there is an Installment Agreement in place, but (d) there is no subordination. Per the Internal Revenue Manual, the IRS’s procedures based on the Internal Revenue Code, the IRS cannot levy bank accounts or receivables while an Installment Agreement is in effect. The existence of an Installment Agreement in good standing should also protect the lender from disgorgement (tortious conversion of assets).
A lender can fund with an Installment Agreement in place while waiting for the subordination to be accepted and reduced to writing by the IRS. In that sense, the Installment Agreement (Step One) is essentially a bridge to the formal subordination (Step Two). Lenders can fund with an Installment Agreement in place, but they really want and should obtain the subordination as well. If lenders are going to fund with just an Installment Agreement in place, it should be for a short period to allow the IRS time to process the subordination paperwork.
A number of lenders forget or ignore Step Two – the subordination. Without the subordination, the lender’s protection is based solely on the Installment Agreement. Assuming the Installment Agreement is and remains in good standing, there should be no problems. However, 95 percent of all Installment Agreements with the IRS fail – typically because they were set up to fail in the first place because of a large down payment or an unaffordable monthly installment payment.
If the lender is funding with the protection of an Installment Agreement only, the protection disappears when the Installment Agreement is terminated. Once the “Notice of Intent to Terminate the Installment Agreement” is issued by the IRS, the clock begins to run and the “race” with the IRS to collect out begins. The lender will have 30 to 45 days to collect out before the IRS can levy the receivables (it is possible that the lender will have longer before the IRS actually issues a levy). The clock begins to run whether the lender is aware of the “Notice of Intent to Terminate the Installment Agreement” or not.
Benefits of a Subordination
The subordination provides additional and important protections to the lender. Most importantly, the subordination clearly defines the rights of the lender and allows the lender to avoid the “race” to collect out with the IRS entirely. The subordination puts the lender in the first secured position relative to the IRS for receivables funded and used as collateral while the subordination is in effect (there should be no risk of disgorgement). If an Installment Agreement terminates and the subordination is no longer in effect as a result, the lender maintains the first secured position relative to the receivables so long as the funding occurred while the subordination was in effect. As such, the lender can take as long as necessary to collect out. There is no “race” with the IRS – the lender does not have to collect out before the IRS begins levying receivables since the lender has priority.
The existence of a formal subordination certificate – IRS Form 669-D Certificate of Subordination of Property From Federal Tax Lien – increases the likelihood the IRS will actually send to the lender the “Notice of Intent to Terminate the Installment Agreement” and/or notification the subordination is no longer in effect. When the IRS issues the subordination, there is usually an attachment – the “SUBORDINATION AND FORBEARANCE AGREEMENT” (“Subordination Attachment”). Paragraph 15 of the Subordination Attachment indicates in the event of default, “[The IRS] will notify the parties…in writing by certified mail that a default has occurred.”
Additionally, the subordination provides a window for the client to fix any problems and get the Installment Agreement back into good standing. Paragraph 15 of the Subordination Attachment indicates, “The Taxpayer has Thirty (30) days to cure either the default in the Subordination Agreement or the default in the accompanying Installment Agreement.” If the client can fix the problem, the lender can continue to fund. If the client cannot fix the problem, the lender has thirty days to begin planning an exit strategy (cease funding).
Compare the subordination’s notice provisions to a situation where there is an Installment Agreement only. Once the IRS issues the “Notice of Intent to Terminate the Installment Agreement,” the lender must stop funding and begin collecting out immediately. There is insufficient time to fix the problem and put the Installment Agreement back into good standing since the IRS may be in a position to levy in 30 days. The client may lose its business and the lender will likely lose the client.
Once a subordination is obtained, the lender cannot fall asleep (even with a seat belt, it’s important to watch the road). There are two important items to monitor – the underlying Installment Agreement and the expiration date of the subordination.
The Installment Agreement
A prerequisite for a subordination is an Installment Agreement in good standing. If there is no Installment Agreement in place, the IRS will not agree to a subordination. Moreover, once the subordination is obtained, if the underlying Installment Agreement terminates, it will take the subordination with it. When one considers that 95 percent of all Installment Agreements with the IRS fail, it is important to monitor the underlying agreement to ensure it remains in good standing.
For an Installment Agreement to remain in good standing, there are three requirements. First, there can be no periods of liability outside the agreement (the business must be current and compliant with its federal tax deposits). Second, there can be no “missing” returns. Finally, the taxpayer must make the periodic (almost always monthly) installment payments in full and on time.
The consequences of a client failing to make a federal tax deposit, file a federal tax return, or make a monthly installment payment can be severe – the Installment Agreement and subordination can be terminated. Although the IRS is supposed to notify the lender in the event of default and termination, there is no absolute requirement to do so. In fact, paragraph 17 of the Subordination Attachment indicates, “The failure of [the IRS] to notify the parties of any default will not constitute a waiver of either the default of the Installment Agreement or this Subordination Agreement.” Since the lender cannot count on notice from the IRS, it is important for the lender to monitor all three requirements for keeping an Installment Agreement in good standing (not just the monthly installment payments).
Generally, subordinations are not indefinite. On occasion, the IRS will fail to include an expiration date, but typically a specific date or timeframe (three to twelve months) is included in the subordination documentation. The IRS’s Internal Revenue Manual finally updated the section relating to subordinations and factors in October 2013. Section 22.214.171.124.1.1(4) indicates, “The subordination must be for a period no longer than one year.”
To determine the expiration date, the lender must look at the documentation itself. Some IRS Form 669-D subordination certificates provide specific dates, for example, “[F]or all receivables coming into existence between January 1, 2013 and January 1, 2014.” Other subordinations rely on the Subordination Attachment to provide the expiration date. Paragraph 21 of the Subordination Attachment provides, “The period of this subordination shall be One (1) year [for example] from the date the Service approves the subordination, as evidenced on the Form 669-D, Certification of Subordination of Federal Tax Lien.”
During the course of monitoring, we have come across a number of situations where Installment Agreements have defaulted and/or terminated. When we bring these issues to the attention of the lender, a common response is, “That’s okay, we have a subordination in place.” Not so fast.
If the Installment Agreement is no longer in effect, the subordination will likely no longer be in effect either, regardless of whether the IRS provided notice. The lender will be protected on receivables funded while the subordination was in effect, but not those funded after the subordination terminated (or expired). Unfortunately, in a number of these instances, the subordination in question expired long ago (well before the Installment Agreement terminated).
Lenders must pay attention to the Installment Agreement and the expiration date of the subordination, otherwise the “protection” provided by the subordination is non-existent. In keeping with the seat belt theme – trust your captain, but keep your seat belt securely fastened. Don’t forget the subordination. Just as important – once you have it in place, keep an eye on it (and the underlying Installment Agreement). Trust, but verify.
This article can be read inside the January/February 2014 edition of Commercial Factor, an International Factoring Association publication.
Jason S. Peckham, Esq., is vice president of Resolutions for Tax Guard, Inc. Tax Guard monitors federal tax compliance, identifies risks before federal tax liens are filed and resolves federal and state tax liabilities. He can be reached at firstname.lastname@example.org or 303-953-6325.