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Publication

February 21, 2006Client Alert

Preserving Lender's Rights to Federal Income Tax Refunds

From time to time, a borrower is entitled to a federal income tax refund. A borrower can grant its lender a security interest in the income tax refund since the pending refund constitutes a general intangible and, once the refund check is received, constitutes an instrument. For a number of reasons, a lender would prefer to take possession of the tax refund check, rather than having it delivered to the borrower.

The IRS has procedures to assist the lender in obtaining the borrower's tax refund check and endorsing the same. The procedures are as follows:

  1. For any size tax refund, the lender and borrower should complete IRS Form 2848 (Power of Attorney and Declaration of Representative) to obtain the federal tax refund check from the IRS. Under the IRS rules, the borrower's representative must be an attorney or public accountant. Consequently, in-house or outside counsel for the lender could be designated by the borrower as its authorized representative. Under Treasury Procedural Rule ยง601.506(b), the IRS is not obligated to honor a power of attorney, but the IRS does acknowledge a general policy to honor such powers of attorney. In addition, beware that the borrower can subsequently revoke its power of attorney.
  2. In addition, for federal tax refunds in excess of $1,000,000, IRS Form 8302 (Application For Electronic Funds Transfer Of Tax Refund Of $1 Million Or More) can be used by the lender. This form is completed by the borrower and the lender, and attached to the borrower's federal income tax return or filed with the IRS office issuing the tax refund check. The lender can require the borrower to wire transfer proceeds of the federal tax refund to a restricted account in the name of the lender for the account of the borrower. This form should be used in conjunction with, and not in lieu of, IRS Form 2848. Beware, however, that the borrower can subsequently revoke this application.
  3. IRS Forms 2848 or 8302 do not give the lender authority to endorse the borrower's federal income tax refund check. To authorize the lender to endorse the federal tax refund check, U.S. Treasury Form 234 (Power of Attorney for Corporation for the Collection of Checks Drawn on the Treasurer of the United States) must be completed by the borrower. This form does not have to be filed with the IRS.
  4. The Federal Assignment of Claims Act can be utilized by the lender as an additional method to obtain the borrower's federal tax refund check, but it has two substantial drawbacks. First, the borrower's assignment of its federal tax refund is not enforceable against the Department of Treasury until the tax refund claim has been allowed and certified. Second, the notice of assignment must be delivered to the Department of the Treasury by the lender only after allowance of the refund. Consequently, the notice of assignment might not be processed in time for the borrower's tax refund check to be mailed to the lender. Consequently, use of the Federal Assignment of Claims Act is less desirable than use of the IRS Forms described above.

The Department of the Treasury may offset the amount of a borrower's federal tax refund against its unpaid federal taxes, payroll withholdings, excise taxes, etc. Consequently, if the borrower is a financially troubled company and is delinquent on any federal tax payments or other obligations to the federal government, the lender might expect the potential tax refund to be offset by liabilities of the borrower to the federal government.

Because of borrower's revocation rights, the government's offset rights and timing challenges with these procedures, payment of a tax refund by the IRS to a lender is not "guaranteed." The risk the lender faces on recovering a federal tax refund is similar to the risk of non-receipt of any payment on an account receieable. Unless the borrower's mail is delivered to the lender, the borrower may receive the original refund check and use it for purposed other than repayment of the loans due the lender.

Readers who desire more information about this topic may email Ann Ustad Smith at ausmith@michaelbest.com or Alec P. Fraser at apfraser@michaelbest.com.

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