A Ferrari owner was in deep financial trouble. Business difficulties had left him pretty well broke. Worst of all, he owed the IRS more than $3 million, and an IRS agent was hot on his heels to collect.
In need of cash, the owner approached his bank for a loan. Since the IRS had filed liens for the unpaid taxes, the bank required collateral to secure a line of credit. All that was available was the 2005 Ferrari, so the bank took a security interest in it to secure a $200,000 line of credit. The bank also took possession of the certificate of title to perfect its lien.
Soon afterward, the owner and the IRS agent had a very unpleasant conversation — the Ferrari had to go. They recognized that seizing the Ferrari and selling it at a government auction wouldn’t bring anything near top dollar. So they hatched a plot to consign it to the local Ferrari dealer to maximize the sale proceeds.
The agent and the dealer talked about the deal. The dealer would sell the Ferrari, keep an agreed-upon commission and remit the remaining proceeds to the IRS. The bank was just out of luck, as the IRS had priority to the proceeds. The dealer insisted that he needed a title to complete the sale, and the agent said that would not be a problem. The agent also spoke to the bank, but the two did not reach an agreement on who was entitled to the money.
Dates are key
The plan went awry right away. The parties had agreed that the Ferrari would be delivered to the dealer on July 2. To protect the IRS’s interest, the agent that day served a Notice of Levy on the dealer. That is much like an attachment — the Ferrari, or its sale proceeds, had to be turned over to the IRS.
Late that day, the dealer called the agent to inform him that the owner did not deliver the Ferrari as promised. The agent called the owner. After a no doubt heated conversation, the owner agreed to deliver the Ferrari the next day, which he did. The agent contacted the dealer, confirmed the Ferrari was there and that the deal was still on.
On July 25, the dealer sold the Ferrari for $210,454. The dealer immediately contacted the agent to explain the status and to address the need for the title, but the agent was away on vacation. However, the deal couldn’t wait long enough for the agent to return.
The buyer’s bank would not loan the purchased funds unless it had clear title to the Ferrari. Since the bank had the title, the sale was imperiled. On August 7, while the agent was still on vacation, the dealer completed the sale, with the title going to the buyer, the commission going to the dealer, $194,982 going to the bank to pay off the line of credit, and the remaining funds going to the IRS.
Litigation, of course
Upon his return from vacation, the IRS agent demanded full payment from the dealer, who no longer had the money. On August 28, he served a levy on the bank, which claimed it was not liable because it only received money that was owed to it. Soon, the IRS sued the dealer and the bank in federal court on two counts — conversion (wrongfully taking the sales proceeds) and failure to honor an IRS levy.
The IRS won at trial, and the dealer and the bank appealed. The appeal was heard by a three-judge panel of the Fifth Circuit Court of Appeals. The IRS won again, and the bank appealed to the U.S. Supreme Court, which declined to consider the appeal. The reasoning of the appellate decision illustrates how complicated the legal issues can be when you have competing claims to collateral, especially when the IRS is one of the claimants.
State law applies
Even though the case was tried in federal court and the IRS was one of the parties, the substantive law analysis of the claims is generally made under state law, which was Texas in this case, and not federal law. Federal law will determine the procedural aspects of the collection efforts made by the IRS, but the general rights and priorities between the parties will be determined under state law.
The court had no trouble with the concept that the IRS lien took priority over the bank’s lien. But that wasn’t because of any inherent superiority afforded to the IRS. In this case, it was determined that the bank knew about the IRS lien when it made the loan, and that fact gave the IRS a prior claim.
In contrast, the buyer of the Ferrari had no way of knowing about the IRS lien — it did not appear on the title and he was not obligated to search deed recordings in case a tax lien might have been filed somewhere. Thus, the buyer took the Ferrari free of the IRS lien.
Timing is everything
The court determined that, under Texas law, a conversion did not occur because the IRS never had an immediate right to possession of the Ferrari or the sale proceeds.
An IRS lien is not “self-executing.” To enforce it, the IRS must do something more to collect on the lien. That usually means actually seizing the asset or serving a levy. But here is where timing gets critical. Although the IRS did serve a levy on the dealer, that happened on July 2, and the dealer did not have the Ferrari on that day. And a levy is good only on the day that it is served, so it had essentially expired when the dealer received the Ferrari on July 3. Similarly, when the bank received the sale proceeds, it did not convert them, as the IRS still had not yet acquired an immediate right to possess them.
The dealer was also absolved of liability for failing to honor the IRS levy. Since it had been served on the dealer the day before he took possession of the Ferrari, there was nothing to honor on the day the levy was served. The next day, when the dealer took possession of the Ferrari, no levy was in effect, and no additional levy was received before the Ferrari was sold and its proceeds distributed.
How the bank lost
The bank’s situation was more complex. It hinged on the effectiveness of the levy served on the bank on August 28. The bank argued that, by then, the money was gone — it had been applied against the owner’s debt on August 7. After that, the owner had no interest in the sales proceeds, and the levy had nothing left to reach.
The Court of Appeals reasoned that, while that much was true, a levy could also reach property that was subject to an IRS lien. When an asset subject to a tax lien (the Ferrari) is sold, the lien transfers to the proceeds. When the proceeds are reinvested, the lien transfers to the new asset. The IRS can “follow the money” as long as it can be distinctly traced. When the bank applied the funds to the owner’s debt, all that meant was that the bank kept the cash. The bank still had the funds, and the levy could reach them. Thus, the bank failed to honor a valid IRS levy.
Observations and takeaways
Clearly, the IRS agent botched this deal. He served the levy on the wrong day, didn’t serve another one the next day, didn’t clarify how title was going to be handled, didn’t communicate properly with the bank, and didn’t make arrangements for someone else to cover for him when he was on vacation. That was not lost on the court — as the opinion makes quite clear — but the IRS still won.
In the end, the bank was the only one liable and had to give back the money that it had improperly received. The dealer got off lucky, and got to keep the sales commission.
Readers might ask why the dealer was not liable for violating their clear agreement. The answer is that, although the agent and the dealer did agree upon what was to happen, their agreement did not rise to the level of a legally enforceable contract, which would have otherwise been a pretty easy analysis.
This “Legal File” gives readers one important point to remember. If you find yourself in a position where you are getting a good deal on a collector car from a seller who needs to raise cash for past-due income taxes, be careful. A clean certificate of title may not be enough to fully protect you.
If you have reason to know that a tax lien has been filed against the seller, the IRS might still be able to seize your newly purchased car, leaving you with only an unsecured legal claim against a financially weak seller. ?
John Draneas is an attorney in Oregon. His comments are general in nature and are not intended to substitute for consultation with an attorney.