Anticipation v. Reality – A Refresher on IRS Basics After ERC Letdown
Written by: Rachel Libowitz and Jason Peckham, Tax Guard
In the icy grips of January, one might daydream of sun-soaked beaches and plan the ultimate escape. Researchers claim the excitement of planning a vacation surpasses the destination itself, asserting that the joy lies in the anticipation. However, the idyllic vision of curling one’s toes in warm sand clashes with the reality of crowded shores, sunburns, and disputes over coveted beach chairs.
Back in 2020, Congress had an idea to help businesses struggling during the COVID-19 pandemic – a plan akin to plotting a dream vacation – and enacted legislation deferring taxes and creating refundable credits. Owners and lenders dreamed of reduced or eliminated tax bills with the Internal Revenue Service (IRS). Unfortunately, for many businesses, the idea of relief or a vacation from taxes differs substantially from the reality, and the bill is about to come due.
The CARES Act of 2020 allowed employers to defer payment of the employer’s share of Social Security taxes for the last three quarters of 2020. The first half of the deferred amount was to be paid by December 31, 2021, and the second half by December 31, 2022. The key word is deferred. Many business owners either misunderstood the rules or were unable to repay the deferred amounts when they came due. The IRS was slow to assess liabilities in 2023 resulting from the unpaid deferrals, with new assessments slowly trickling out in Q4. Tax Guard expects those assessments to continue into 2024, creating new exposure for lenders.
The CARES Act also created the Employee Retention Tax Credit program. Employee Retention Credits (ERCs), when properly claimed, are refundable tax credits for eligible businesses that continued paying employees during the pandemic. At a high level, businesses are eligible for ERCs if (a) operations were fully or partially suspended due to a government order or (b) gross receipts declined significantly during the required periods.
Unfortunately, widespread fraud turned the ERC process into a hot mess (imagine any Florida beach during Spring Break). On September 14, 2023, the IRS announced a moratorium, indicating it would cease processing any existing claims and/or accepting any new claims until it could address the fraud problem. As of the writing of this article, the IRS has not announced a date to resume processing, but it appears the plan is to address the issue in stages.
Initially, the IRS relied on voluntary efforts, asking businesses to voluntarily withdraw or disclose problematic claims, beginning with a voluntary withdrawal program unveiled on October 19, 2023. By withdrawing ineligible claims voluntarily, businesses can avoid substantial fraud penalties. According to Bloomberg Law, as of January 10, 2024, businesses have withdrawn approximately $140 million of ineligible claims, which seems significant until one considers the IRS has already paid out $200+ billion in ERCs. Later, on December 21, 2023, the IRS publicized the voluntary disclosure program, allowing businesses that received improper credits to repay them at a discount.
After creating the voluntary programs, the IRS moved on to obvious cases of fraud. On December 6, 2023, the IRS issued 20,000 “disallowance” letters rejecting claimed ERCs because (a) the entity was not in existence and/or (b) there were no paid employees during the period(s) of eligibility. The number of ineligible claims based on non-existent businesses and/or employees illustrates the magnitude of the fraud problem.
The substantial gap between the anticipated relief and the harsh reality of deferred taxes and ERCs affects all parties involved. The IRS, struggling with the inundation of dubious claims, seems to be tightening its grip on acceptance criteria for pending (and previously accepted) ERCs. Businesses find themselves in an uncomfortable limbo, with many still waiting for a response to claims that were submitted not just months but, unbelievably, years ago. Lenders’ long-held expectations that ERCs will erase their customers’ existing liabilities may not materialize, and new liabilities will likely be assessed.
Refresher - Levies and Liens
Between the IRS resuming enforced collection, assessing liabilities for unpaid CARES Act deferrals, and rejecting ineligible ERCs, the number of business liabilities will increase in 2024. Lenders will have some additional exposure within their portfolios. As such, this is a perfect opportunity to review the basic elements of a lender’s exposure to federal tax liabilities – levies and liens.
When lenders lose assets (money) to the IRS, it is almost always due to a levy on receivables. A levy is essentially the same as a seizure in that it takes an asset. The most common levies attach to bank accounts or accounts receivable, but the IRS can also seize inventory, equipment, real property, and more. For factors and asset-based lenders, levies attaching to receivables are particularly problematic.
In a typical transaction, a lender (a) advances funds using a business’s accounts receivable as collateral for a line of credit or (b) purchases the invoice(s). Generally, the debtor will pay the invoiced amount directly to the lender according to the terms of the invoice (net 30 days, for example). Assuming there is no IRS levy, the lender recoups its advance. However, when the IRS levies receivables, it sends a letter to the debtor with instructions to send any outstanding funds owed to the business directly to the IRS, instead of the business (or lender). The IRS intercepts the funds, and the lender does not recoup its advances, resulting in financial losses.
Fortunately, the IRS cannot issue a levy indiscriminately. Before the IRS can levy, it must issue a Final Notice of Intent to Levy. Once assessed, the IRS can issue the final notice on a period of liability at any time, typically in the form of Letter 1058 or LT11. Upon receipt of the final notice, the taxpayer has 30 days to either file a Collection Due Process appeal or pay the balance in full. Failure to do either allows the IRS to proceed with enforced collection (levies).
A common misconception is that the IRS must file a federal tax lien before it can levy bank accounts or receivables, but there is no such requirement. However, if there is no federal tax lien and the IRS levies receivables used as collateral in a factoring and/or ABL transaction, the levy would be considered “wrongful” (not because the IRS cannot levy but because the IRS does not have priority on the collateral it seized). It should come as no surprise that it is much easier to be proactive and prevent a levy than to try to get money back from the IRS.
In contrast to a levy, a federal tax lien does not take or seize anything. Instead, the federal tax lien (a) provides notice to third parties of the government’s secured interest in the property and (b) establishes priority relative to other secured interests. A properly filed federal tax lien, as determined by state law, attaches to all the taxpayer’s property as of the date of recording as well as to after-acquired property during the life of the lien, e.g., receivables. The lien remains in effect until the liability is paid in full or it becomes unenforceable, by the lapse of time, for example (the statute of limitations is ten years from the date of recording, unless extended).
A federal tax lien affects the priority of a lender’s secured interest in the receivables. The general rule of priority is “first in time, first in right.” The party that secures its interest first has a right to the taxpayer’s property over subsequently secured interests. Unfortunately, the IRS has what some refer to as a “super-priority” in matters regarding revolving assets, e.g., receivables. The IRS’s federal tax lien moves into first position relative to other secured parties, but, importantly, the “jump” does not occur as soon as the lien is recorded.
According to federal statute, lenders with secured interests maintain priority over the federal tax lien to the extent that the loan or purchase is made (a) within 45 days of the recording of the lien (the “45-day rule”) or (b) before the lender or purchaser had actual knowledge of the filing, if earlier. In practice, the IRS generally follows the 45-day rule. When a lender purchases or uses receivables as collateral on or after the 46th day, the lender funds in second position behind the IRS, exposing it to tortious conversion of assets (also known as “clawback” or “disgorgement”). Although instances of clawback are much less frequent than levies on receivables, lenders should not fund in second position behind the IRS.
Avoid Exposure, Preserve Funding
Generally, the risks associated with IRS levies and liens can be addressed through a three-step process, which protects the business, protects the lender, and preserves the funding relationship:
Pending installment agreement,
An installment agreement reduced to writing, and
Subordination of federal tax lien.
Levies on receivables represent the greatest risk to a lender. An installment agreement protects the business and lender from IRS levy throughout the life of the agreement. Unless a taxpayer submits a proposal “solely to delay” collections, the IRS’s Internal Revenue Manual (IRM) dictates that no levies can be served while the proposal is pending, for 30 days after rejecting a proposed installment agreement, while the rejection is being appealed, while an agreement is in effect and good standing, for 30 days after an agreement is terminated, and while termination (or proposed termination) of an agreement is being appealed.
Not only does an installment agreement protect the business and lender from levy, but it is also a requirement for a subordination of federal tax lien. Per the IRM, a subordination “elevates another creditor’s lien to the Service’s priority position making the Service’s lien junior to that creditor’s lien.” The subordination addresses the threat of clawback by putting the lender’s secured interest back into first position ahead of the IRS. Even if the installment agreement and subordination ultimately terminate, the lender still has priority on receivables funded while the subordination was in effect (there’s no race to collect out before the IRS issues a levy).
As the dreams of deferred taxes and ERCs fade in 2024, lenders will be exposed to the uncomfortable heat of IRS collections for more of their business customers. Fortunately, lenders can rely on the usual forms of protection, installment agreements and subordinations of federal tax lien, to mitigate the risks associated with IRS levies and liens and preserve funding.