M & T Electrical Contractors, a second-tier subcontractor, went into bankruptcy while owing money to third-tier supplier Capital Lighting. The surety (bonding company) tried to use setoff rights to reduce what it owed M & T by claiming M & T owed it money. The court ruled that federal tax liens filed by the IRS take priority over the surety's setoff rights, even though the surety had a legal duty to pay under the payment bond. This means the IRS gets paid first, and the surety cannot use setoff as a workaround.
Federal tax liens beat surety setoff rights—the IRS gets priority in payment disputes, so don't count on setoff to reduce your obligations
Payment bonds don't protect you from federal tax claims—if your general contractor or upstream sub owes taxes, it affects the whole payment chain
Get paid directly and quickly—don't rely on setoff or indemnity agreements to cover your costs if the project involves tax-delinquent parties