Bloomfield State Bank v. IRS

Filing

Filed opinion of the court by Judge Posner. The judgement is REVERSED and the case REMANDED with directions to enter judgment for the bank. Richard A. Posner, Circuit Judge; Diane P. Wood, Circuit Judge and John Daniel Tinder, Circuit Judge. [6307317-3] [6307317] [10-3939]

Case: 10-3939

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In the

United States Court of Appeals
For the Seventh Circuit
No. 10-3939
B LOOMFIELD S TATE B ANK,
Plaintiff-Appellant,
v.
U NITED S TATES OF A MERICA,
Defendant-Appellee.
Appeal from the United States District Court
for the Southern District of Indiana, Terre Haute Division.
No. 2:10-cv-00131-LJM-WGH—Larry J. McKinney, Judge.

A RGUED A PRIL 13, 2011—D ECIDED M AY 11, 2011

Before P OSNER, W OOD , and T INDER, Circuit Judges.
P OSNER, Circuit Judge.
The question presented is
whether a mortgage that assigns future rental income
to the mortgagee creates a security interest that takes
priority over a federal tax lien. The answer depends on
whether such an assignment constitutes an “interest in
property acquired by contract for the purpose of
securing payment or performance of an obligation” and
whether when the interest is acquired “the property is in

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existence and the interest has become protected under
local law against a subsequent judgment lien arising out
of an unsecured obligation.” 26 U.S.C. § 6323(h)(1).
Only the application of the clause that we have
italicized is at issue.
In 2004 the plaintiff bank made a mortgage loan in
Indiana secured by the borrower’s real estate plus (so far
as relates to this case) “all rents . . . derived or owned by
the Mortgagor directly or indirectly from the Real Estate
or the Improvements” on it. Three years later the mortgagor defaulted. The Internal Revenue Service filed a tax
lien against the real estate. At the bank’s request a state
court appointed a receiver to administer the debtor’s
real estate, and he rented some of the property the following year, collecting $82,675 in rents for the bank’s
account. The IRS conceded that on rentals received before
the tax lien was filed (had there been any such rentals—there weren’t), the bank’s lien would take priority
over its own lien. But it claimed that the tax lien took
priority over the bank’s lien on rentals received after
the tax lien was filed, thus including the $82,675. The
bank sued in federal district court for declaratory relief. The court granted summary judgment in favor of
the IRS and the bank has appealed.
The rentals provision in the mortgage created a perfected security interest in rentals received at any time.
Ind. Code § 32-21-4-2(c); Chase Commercial Corp. v. Brandt ex
rel. Creditors of AnaMag, Inc., 1999 WL 965843, at *1-2 (N.D.
Ill. Oct. 14, 1999); see also Uniform Assignment of Rents
Act, § 5 and comment 2 (2005) (“roughly one-third of the

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states[, including Indiana,] have enacted statutes making
clear that an assignment of rents is ‘perfected,’ without
regard to whether the mortgagee has taken any steps to
‘activate’ or ‘enforce’ that assignment”). But the provision
of the federal tax code that we quoted gives such an
interest priority over a federal tax lien only if the property
secured by the mortgage was “in existence” when the
federal tax lien was filed. The government argues and the
district court ruled that the relevant property was the
rentals, which did not exist—the receiver had not yet
rented the debtor’s real estate—when the federal tax
lien attached. The bank argues that the relevant property was the real estate.
Oddly, there is no reported appellate decision on
point. (At the district court or bankruptcy court level we
find divergent rulings. Compare Bank One, West Virginia,
N.A. v. United States, 1996 WL 303276, at *3-4 (S.D. W. Va.
Mar. 29, 1996), with First National Bank of Ohio v. United
States, 1994 WL 481357, at *1 (N.D. Ohio Mar. 28, 1994), and
In re Whyte, 164 B.R. 976, 988-89 (Bankr. N.D. Ind. 1993).)
The district judge based his decision primarily on the
analogy of rents to accounts receivable; accounts
receivable that come into being after a federal tax lien
attaches to the assets that generate them have been held
not to trump the tax lien. J.D. Court, Inc. v. United States,
712 F.2d 258, 261-64 (7th Cir. 1983); Sgro v. United States,
609 F.2d 1259, 1263-65 (7th Cir. 1979); Texas Oil & Gas
Corp. v. United States, 466 F.2d 1040, 1049-52 (5th Cir. 1972).
The “existence” condition for a creditor’s lien to trump
a federal tax lien is known in tax-speak (and to a lesser

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extent in bankruptcy when priority between two
security interests is disputed) as “choateness.” The word
“choate,” used as it is in law to mean “in existence” (its
usage outside of law is essentially nonexistent), is a
barbarism, albeit a venerable one. Its earliest known
appearance is in 2 R.S. Donnison Roper & Henry Hopley
White, A Treatise on the Law of Legacies 358 (3d ed. 1829);
it first appeared in a U.S. Supreme Court opinion in
United States v. City of New Britain, 347 U.S. 81, 84 (1954).
“Choate, a back-formation from inchoate, is a misbegotten
word, for the prefix in inchoate is intensive and not
negative . . . . The word derives from the Latin verb inchoare
‘to hitch with; to begin.’ Yet, because it was misunderstood as being a negative (meaning ‘incomplete’),
someone invented a positive form for it, namely choate
(meaning ‘complete’).” Bryan Garner, A Dictionary of
Modern Legal Usage 152 (2d ed. 1995); see also Ben
Zimmer, “On Language—Choate,” N.Y. Times, Jan. 3, 2010,
p. MM16. The “in” in “inchoate” is no more a negative
than the “in” in “incipient” or “into” or “ingress” or
“inflammable.” Imagine thinking that because “inflammable” means “catches fire,” “flammable” must mean fireproof. “Inchoate” means vague, unformed, or undeveloped. If there were a word “choate,” it would mean
approximately the same thing.
Garner adds that “although the word is etymologically
misbegotten, it is now fairly well ensconced in the
legal vocabulary . . . [and] is used even by those who
deprecate its origins.” Garner, supra, at 152-53. Not used
by us! For the law’s use of “choate” is not only a sign of
ignorance but also a source of confusion. The require-

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ment of being in existence does not apply to the lien;
no one doubts that the lien exists—if it didn’t the taxpayer couldn’t get to first base. Yet beginning with City
of New Britain the cases invariably state the question
as whether the lien is “choate.” What must exist is the
property that the lien is on. The statute could not be clearer.
The government misreads not only the statute but also
the Supreme Court’s statement in United States ex rel.
IRS v. McDermott, 507 U.S. 447, 449-50 (1993), that “our
cases deem a competing state lien to be in existence
for ‘first in time’ purposes only when it has been ‘perfected’ in the sense that ‘the identity of the lienor, the
property subject to the lien, and the amount of the lien are
established’ ” (emphasis added). The government thinks
this means that the amount of money that enforcement
of a lien will yield must be known. We do not read the
passage so. The mortgage agreement in this case established a lien on the real estate and all the rents it
might yield, up to the amount of the loan, which of
course is stated in the agreement. The Justices in
McDermott were thinking of cases like United States v.
Pioneer American Ins. Co., 374 U.S. 84, 89-91 (1963), where,
because the lien was on fees for attorneys’ services not
yet provided, the amount of the lien was unanchored.
It was similar to a lien on accounts receivable, the
amount of which cannot be known until a good is sold
and generates a receivable.
The “property” that must be in existence for a lender’s
lien to take priority over a federal tax lien is the property
that, by virtue of a perfected security interest in it, is a

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source of value for repaying a loan in the event of a
default; it is not the money the lender realizes by
enforcing his security interest. This proposition is clearly
stated in PPG Industries, Inc. v. Hartford Fire Ins. Co., 531
F.2d 58, 61-62 (2d Cir. 1976); Plymouth Savings Bank v.
IRS, 187 F.3d 203, 207-09 (1st Cir. 1999); MLQ Investors,
L.P. v. Pacific Quadracasting, Inc., 146 F.3d 746, 749 and n. 1
(9th Cir. 1998), and Jefferson Bank & Trust v. United States,
894 F.2d 1241, 1244-45 (10th Cir. 1990).
No one would dispute the proposition in a case in which
a mortgaged property was sold in a foreclosure sale
rather than rented. Suppose that after the tax lien in
this case attached in 2007, the receiver had sold the mortgagor’s property for $1 million. Would the IRS argue
that its tax lien was prior to the bank’s interest in the
$1 million? Of course not; the mortgage had been
issued years earlier, secured by real estate then existing.
Whether the proceeds from the enforcement of a
lender’s lien take the form of sale income or rental
income is a detail of no significance. To say that a parcel
of land is “sold” rather than “rented” just means that
the owner sells the use of the land forever rather than
for a limited period. Sale income and rental income are
just two forms of proceeds from land (or from improvements on it).
That would have been obvious in this case had not
the mortgage contained a provision stating that rental
income generated by the borrower’s real estate was
additional collateral securing the mortgage. That makes
it seem as if the rental income is a distinct form of

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property rather than merely proceeds of owning a
rented property. Actually the rental-income provision in
the mortgage is a superfluity. The receiver appointed
to conserve the mortgagor’s assets for the benefit of
creditors was empowered without regard to that
provision to manage the real estate in whatever way
would generate the maximum amount of money to
satisfy the debt, secured by the mortgage, that was owed
to the bank. The rental-income provision would be in
play if the mortgagor, when it defaulted, had deposited
rental income from its property in a bank account;
the mortgagee could have seized the income in the
account on the authority of its lien on rental income.
That is not this case.
The only effect of the rule adopted by the district court
would be to deflect the receiver from renting rather than
selling real estate secured by the mortgage, in order
to avoid the tax lien. Who would benefit from such a
curtailment of a receiver’s authority to maximize the
value of receivership assets? Not the bank, not the
Internal Revenue Service, and not mortgagors.
The concern behind the “existence” requirement in the
tax code (as in the judge-made doctrine denying priority
to tax liens for liens deemed “inchoate,” before the
Federal Tax Lien Act was passed in 1966) appears to
have been concern about allowing liens in certain types
of after-acquired property to trump a federal tax lien. See
United States ex rel. IRS v. McDermott, supra, 507 U.S. at 45053; Glass City Bank v. United States, 326 U.S. 265, 268-69
(1945); UNI Imports, Inc. v. Aparacor, Inc., 978 F.2d 984, 987

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(7th Cir. 1992); In re Avis, 178 F.3d 718, 722 (4th Cir. 1999);
S. Rep. No. 89-1708, 1966 U.S.C.C.A.N. 3722, 3723-24; David
A. Schmudde, Federal Tax Liens § 7.02(i), pp. 151-53 (4th ed.
2001); Peter F. Coogan, “The Effect of the Federal Tax
Lien Act of 1966 Upon Security Interests Created Under
the Uniform Commercial Code,” 81 Harv. L. Rev. 1369,
1375-77, 1381 (1968). Suppose the mortgage in this case
had created a lien not only in the mortgagor’s existing
real estate but also in any property of any kind that the
mortgagor might ever acquire. Then the IRS would
never be able to enforce a tax lien against the mortgagor
were it not for the requirement that property subject to
a lien be existing property of the borrower when the
lien attaches. The real estate that generated the rental
income at issue in this case existed when the mortgage
was issued and thus before the tax lien attached; the
rental income was proceeds of that property, which preexisted the tax lien.
The government relies primarily, as did the district
court, on cases which hold that a security interest in
accounts receivable does not come into existence and
thus trump a subsequently filed federal tax lien until
the accounts receivable come into existence, that is, until
a buyer of goods or services from the grantor of
the security interest becomes indebted to the grantor.
Suppose company A assigns its accounts receivable to
bank B at time t, before A has sold anything. At time t + 1
the IRS obtains a lien on A’s assets. At time t + 2 A sells
goods to C on credit. C now has a debt to A, and, by virtue
of B’s security interest, B has a lien on the money C owes
A. C’s debt to A is an account receivable of A, assigned

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to B. But B’s lien was on accounts receivable, and A had
no accounts receivable, and B therefore no lien, when
the federal tax lien attached. That would be just like
the Pioneer case.
This case would be similar had the plaintiff bank
not had a mortgage on its borrower’s property, but just
a lien in rentals. Then until rentals were received, the
property on which the bank had a lien would not have
come into existence. But because the bank had a lien on
the real estate, the rentals were proceeds. By virtue of
the rental-income provision in the mortgage, the bank
had a separate lien on the rents, but that is not the lien
on which it is relying to trump the tax lien. The lien on
which it is relying is the lien on the real estate. If an
asset that secures a loan is sold and a receivable generated, the receivable becomes the security, substituting
for the original asset. The sort of receivable to which
the statute denies priority over a federal tax lien is one
that does not match an existing asset; a month’s rent is
a receivable that matches the value of the real property
for that month.
The judgment is reversed and the case remanded
with directions to enter judgment for the bank.
R EVERSED AND R EMANDED.

5-11-11