Notification of IRS as a Junior Creditor

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Two recent lien decisions demonstrate the power of the federal tax lien and the specific steps that parties must take when trying to address that lien. Today, I will discuss the Mendoza v. Cisneros.  This case involves the special notice requirements of section 7425.  Here, the federal tax lien remains on property even where the IRS received notice of the sale because the notice did not meet the statutory requirements.  Between and innocent party who had nothing to do with the notice and the IRS which did receive some notice of the sale of the property although not to the right location, the Court finds that the IRS must win even though this creates a very harsh result for the innocent purchaser.  The case also provides a cautionary tale for those interested in purchasing property at a bargain price at certain sales.

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As always in these cases we start with someone who did not pay their taxes and someone, in this case, whose only part in the litigation involves lending his name to the case caption. Mr. Cisneros purchased the subject property in 2003.  He basically ran up federal tax liabilities for the years 2000-2008 which he neglected or refused to pay.  After the federal tax liens arose for these liabilities, the IRS took the further step of filing notices of federal tax lien on January 23, 2006, June 22, 2006 and April 4, 2011.  The notices were properly filed in Weld County where the property was located.

Consistent with his federal tax situation, Mr. Cisneros failed to pay his property taxes on this property. Weld County sold a tax deed to someone who assigned the deed to the plaintiff in this case.  Prior to 1966 the federal tax lien would have defeated the real property lien in this case because the federal tax lien came first.  The general rule for lien priority is first in time first in right.  The problem with that rule when applied to the real property lien was that it constantly caused circular priority issues.  Local laws provide that the real property taxes come ahead of prior recorded mortgages.  That is why mortgage holders require parties to make escrow payments to insure the timely payment of real property taxes.  In the world before the Federal Tax Lien Act of 1966 a person would have a mortgage, then a federal tax lien and then a real property lien.  The mortgage would defeat the federal tax lien because that contest was fought on a first in time basis (and also because for policy reasons the IRS defers to purchase money mortgages even if they arise after the federal tax lien), the federal tax lien would defeat the later file local real estate lien and the local real estate lien would defeat the mortgage.  Judges would get splitting headaches trying to decide where to send the proceeds.

To resolve this problem, in 1966 Congress created subsection 6323(b) by which 10 superpriority parties defeat the federal tax lien even if notice is filed. Local real estate taxes are on the superpriority list at subsection 6323(b)(6).  So, the Weld County lien comes ahead of the federal tax lien even though it came into existence after the perfection of the federal tax lien through the recording of the notice of federal tax lien.  As a junior creditor, the IRS would normally have its lien cut off from property sold by a senior lien holder.  This case addresses the law concerning the impact of a senior lien foreclosure because the IRS argued that its lien remained on the property after Weld County’s tax sale.  The purchaser of the property, or here the assignor of the purchaser, paid a price for the property that assumed the federal tax lien no longer existed.  If the IRS prevails, the assignor ends up with property that has little or no value to him rather than property purchased at a bargain.

The IRS takes the position that the sale by Weld County did not destroy its lien on the property through the sale because Weld County as the senior lienholder did not take the proper steps to notify the IRS as it sold the property. In the end, the district court very reluctantly agrees with the IRS even though it swallowed hard to do so.  The case provides a lesson in the application of section 7425 and a caution to senior lienholders and purchasers when selling property subject to the federal tax lien.  The case began as a suit against the IRS seeking a declaration its liens no longer attached to the property.  The IRS counterclaimed seeking foreclosure of its liens.  The parties filed cross motions for summary judgment and the opinion addresses those motions.

Section 7425 sets out the circumstances in which senior lienholders must notify the IRS of a sale pursuant to their lien and the method of notification. Congress assumes in the statute that the IRS needs extraordinary notification because it does not have the capability to watch newspapers and other ordinary places where notice of given of such sales and match generic notice to circumstances in which it has a lien interest.  While other issues exist in the case, I will focus solely on the notification issue because that is where the parties engaged in a real contest and that issue provides the most instruction.  On this issue the Court looks at two issues: (1) did the notice of federal tax lien get filed more than 30 days before the sale and (2) did the senior lienholder give the IRS proper notice.  The first issue required little effort by the Court.  The notices of federal tax lien for two of the three notices were filed several years before the sale in the proper courthouse and properly identified the taxpayer thereby reaching all of his real property in the county.  The third notice of federal tax lien was filed after the date of the sale to the initial purchaser but well prior to the date of assignment.  So, the Court looked at the statute and the regulations to determine the date of sale for purposes of the federal tax lien notification.

Under Colorado law the owner of the property has three years to redeem the property after a tax sale. Only after that three year period ends does the county issue the purchaser a Treasurer’s deed.  During the three year period the taxpayer still has an interest in the property and the junior lienholder’s liens remain in place awaiting the possibility that the owner will redeem.  So, the date of the sale in this case is the later date meaning that the third federal tax lien also met the recording deadline of thirty days prior to the sale.  Since the notice to the IRS goes to the same place whether it has one lien or twenty, the time of sale does not impact the notice issue in the case but does determine the amount of the IRS lien interest still remaining on the property.

Section 7425(c) requires that the senior lienholder must give the IRS notice in the manner prescribed in the regulations at least 25 days before the sale. The regulation, section 301.7425-3(a) specifies that the notice must be sent to the IRS office and address specified in IRS Publication 786 or any successor publication.  The publication requires that the notice be sent to the regional Collection Advisory Group Manager.  IRS Publication 4235, which is referenced in Publication 786, provides the actual address.  In 2013, the time of the deemed sale, this address was 1999 Broadway, MS 5021DEN Denver, CO 80202-2490.  Weld County sent only one notice of the sale to the IRS and that notice was sent to 301 S. Howes St., Room 302, Fort Collins, CO 80521.  The county representative of the Treasurer’s office stated that this is the IRS office she was instructed to send the notice by an IRS representative.

The outcome of the case turns on whether the IRS having actual knowledge of the sale allows its lien to be cut off even though the notice itself went to the wrong IRS office. The 10th Circuit had addressed almost the identical issue 25 years previously and determined that the regulation must be followed despite the fact that the IRS might have actual knowledge.  So, bound by Circuit precedent – which lines up with the precedent in other circuits, the district court held for the IRS.  The IRS fights for this result vigorously because it does not want to assume the burden of getting information about a sale into the hands of the right persons by whoever in the IRS happens to come into possession of knowledge about a sale.  The time frames are very tight in these cases for the IRS to act to preserve its lien and it fears that if notice to anyone at the IRS can serve to meet the 7425 notice requirement, it will fail to act in time in circumstances where it might do so.  This creates a tough result for someone purchasing property when it looks like all of the proper steps were taken.  How many purchasers read this regulation?

 

Comments

  1. The regulation at the centre of this case raises a potentially interesting issue of incorporation by reference. The Administrative Procedure Act provides that “[e]ach agency shall … publish in the Federal Register … rules of procedure … [and] substantive rules of general applicability adopted as authorized by law”. 5 USC § 552(a)(1)(C), (D).

    The regulation specifying the notice of sale requirements (codified at 26 CFR 301.7425-3) was indeed published in the Federal Register, at 73 FR 38915 (July 8, 2008). However, the regulation does not actually specify where the notice is to be sent; it merely refers readers to an IRS publication. As far as I can tell, IRS Publication 786 has not been published in the Federal Register. As the decision in Mendoza illustrates, the exact location where the notice is to be sent is critically important so as to make it either a “rule of procedure” or a “substantive rule[]”, either of which needs to be published in the Federal Register.

    If a person has “actual and timely notice” of material that should have been published in the Federal Register but was not so published, then the material is still fully effective against that person. 5 USC § 552(a)(1) flush language. However, the purchaser and assignee in Mendoza presumably did not have “actual … notice” of the specific address requirement, or they would have ensured that it was complied with. In the absence of such “actual and timely notice”, “a person may not in any manner be required to resort to, or be adversely affected by, a matter required to be published in the Federal Register and not so published”. Id. The only exception to this rule is that material does not need to be published in the Federal Register if it is, among other things, “incorporated by reference … with the approval of the Director of the Federal Register”. Id.

    The Electronic Code of Federal Regulations (“c-CFR”) provides a list of codified regulations that incorporate material by reference with the approval of the Director of the Federal Register (http://www.ecfr.gov/cgi-bin/text-idx?tpl=ibr.tpl). No regulations codified under 26 CFR appear in the list.

    The Director of the Federal Register has promulgated regulations, codified at 1 CFR Part 51, describing the circumstances under which the Director will approve an incorporation by reference. At least one court has relied on these regulations in finding that an incorporation by reference was invalid. Appalachian Power Co. v. Train, 566 F2d 451, 456-57 (4th Cir 1977). The regulations provide that “[p]ublication in the Federal Register of a document containing an incorporation by reference does not of itself constitute an approval of the incorporation by reference by the Director”. 1 CFR 51.1(e). The regulations further provide that, when making an incorporation by reference, “the agency must” include language in the preamble to the regulation indicating that the incorporation by reference was approved by the Director. 1 CFR 51.9(c)(1). No such language appears in 73 FR 38915-17.

    These defects in the regulation, if they had been raised, may have created an obstacle to an IRS victory in Mendoza and related cases.

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