When you’re buying a business, you should make sure that the business’s assets aren’t encumbered by liens. As I mentioned in Don’t Let the Seller’s Liens and Taxes Stalk You, even if you structure a business acquisition 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’re buying a business whose assets are encumbered by a lien, someone else will have an interest in your property. If that someone is the seller’s creditor, that’s bad news for you if the lien is still intact after closing.
Although you can protect yourself contractually by negotiating protections in the purchase agreement, your first — and often best — line of defense is appropriate due diligence. In the case of liens, that means searching public records.
A common type of lien is a security interest granted to secure the seller’s debt. Such liens can arise in the case of bank financing, trade credit for equipment, and a whole host of other situations.
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 of the debtor’s state of incorporation or organization. The system is similar to the recording system for real estate in county land records. And the purpose is to give potential buyers of personal property notice that the property is encumbered by a lien.
A lienholder perfects its security interest by filing a financing statement, also called a UCC-1. It’s a simple form that includes information such as the legal names and addresses of the debtor and creditor and a description of the collateral. Here’s a screenshot of a UCC-1:
Tax liens and judgment liens, which I discuss below, can also be recorded using a UCC-1. Financing statements are effective for five years and can be continued for another five years. Note that recorders of deeds (i.e., local county offices) will accept UCC filings for fixtures, so they can be found by searching the county real estate records.
To search the state UCC records for liens, you can either file an Information Request (Form UCC-11) or perform an on-line search. In Missouri, online searches can be performed at the Missouri Business Access Center.
When performing a UCC search, it’s essential to search for the seller’s exact legal name. In Missouri, you can find the exact legal name by using the Secretary of State’s business entity search tool. I explain how to use the tool in my post Missouri Business Entity Search — Resource of the Week.
I usually use a third-party search company to perform UCC searches. They are affordable and since I generally also need them to perform tax and judgment lien searches on the same seller, it’s usually more practical for me to throw UCC searches into the order.
If your UCC search uncovers lien filings, you can determine whether the filings 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 filing a financing statement, the creditor must file a termination statement to record the release of the lien.
If you find an active financing statement that hasn’t been terminated, you’ll need to work with the seller to ensure the security interest is released on or before closing. Otherwise, the creditor will have a security interest in your business assets after closing to secure an obligation of the seller. That’s not a good situation.
When a business doesn’t 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 assets acquired in the future while the lien is in effect. When the IRS asserts a lien, 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 business, that means the company’s executive offices and where executive decisions are made. For small businesses, this is usually the principal place of business. (Note that this is different from UCC liens, which are filed in the state of incorporation or organization.)
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.
You can search public databases for tax liens, or go to the circuit court in person, but as with UCC searches, I prefer to use a third-party search company.
A judgment lien is created after someone loses a case in court and has a judgment entered against them. Judgment liens can attach to real estate located in the county where the lien is recorded or the judgment is entered. They also attach to personal property, vehicles, and after-acquired property (i.e., property the debtor acquires after the lien arises). As with other types of liens, requirements for imposing judgment liens vary from state to state.
Michael Sankey wrote an in-depth article about various liens and places to search for them, Searching Recorded Documents, Judgments, and Liens. It’s well worth the read.
As you can see, liens pose a significant risk for a buyer of a business. A prudent buyer will do appropriate due diligence by performing UCC, tax, and judgment lien searches.