When considering buying a business, you should make sure that the business’s assets are not encumbered by liens, even if the transaction is structured as an asset sale, the seller’s liens are your problem.
A lien is a legal right or interest that a creditor has in another’s property. If you are buying a business and the business’s assets are encumbered by a lien, a third party will have an interest in the business or assets you are purchasing. If that third party is a creditor of the seller, if the lien is still intact after closing that is bad news for you as the buyer.
You can protect yourself contractually by negotiating protections in the purchase and agreement, your first — and often best — line of defense is appropriate due diligence. For liens, this means searching public records. There are three main type of liens which are the subject to this post – (1) UCC liens; (2) tax liens; and (3) judgment liens.
A common lien is a security interest granted to secure the seller’s debt or financing. These liens typically arise in the case bank financing or trade credit for equipment.
In the case of a lien encumbering personal property, the creditor will often record the lien in the public records of the Secretary of State in the state in which the debtor is incorporated and organized and can also be filed in the state in which the debtor maintains is corporate offices, which in certain instances can be different that the state the debtor is incorporated or organized in. The system is similar to the recording system for real estate in county land records.
The purpose of filing the lien in the public records is to give potential buyers of personal property notice that the personal property is encumbered by a lien.
A lienholder perfects its security interest by filing a UCC-1 or financing statement. It’s a simple form that includes information such as the legal names and addresses of the debtor and creditor and a description of collateral. Financing statements are effective for five years and can be continued for another five years.
When performing a UCC search, it’s essential to search for the seller’s exact legal name. We use a third-party search company to perform UCC searches. They are affordable and since we generally also conduct tax and judgment lien searches on the same party at the same time, it is usually more practical to conduct all three searches at the same time.
If the UCC search uncovers lien filings, you are able to determine whether a filing have been terminated by looking through the records for a termination statement. When a debtor pays off a debt secured by a lien and perfected by the filing of a financing statement, the creditor must file a termination statement to record the release of the lien. If the UCC search reveals an active financing statement that has not been terminated, you will need to work with the seller to ensure the security interest is released on or prior to closing. If the lien is not released on or prior to closing, the creditor will have a security interest in the purchased business assets after closing to secure an obligation of the seller. This is not a situation you want to deal with after closing on the purchase.
When a business fails to pay its federal taxes in full and on time, the IRS can assert a lien on all of the business’s property, including accounts receivable and future assets acquired after the lien comes into effect. When a tax lien is asserted by the IRS, it files a Notice of Federal Tax Lien to alert creditors that the government has a legal right to the business’s property.
Federal tax liens are filed at the place of residence of the taxpayer. In the case of a company, that would be where the company’s executive offices and where executive decisions are made. For small businesses, this is usually the principal place of business.
Similarly, state and local taxing authorities may place a lien on the business’s property for unpaid state and local taxes. State tax liens are filed with the recorder of deeds and the circuit court where an individual resides or a business is located. As with UCC liens, a buyer of a business or a business’s assets would want these liens paid off and released on or prior to closing.
A judgment lien is a lien created after a party loses a case in court and a judgment is entered against them. Judgment liens can attach to real estate located in the county where the lien is recorded or the judgment is entered. Judgment liens can also attach to personal property, vehicles and after-acquired property - property the debtor acquires after the lien arises. As with UCC liens and tax liens, a buyer of a business or a business’s assets would want these liens paid off and released on or prior to closing.