Unclaimed Property: Current Issues and Trends

Editor: Sarah McGahan, J.D., LL.M.

Even as the economy is slowly crawling back from its recent downturn, states continue to scramble for dollars. In the face of tight budgets, states increasingly are turning to their abandoned or unclaimed property (AUP) laws to generate revenue. Compliance with AUP reporting requirements has become a critical issue for many businesses in recent years, particularly as states have enforced their laws through far-reaching audits resulting in costly liability assessments. Delaware, the state of incorporation for thousands of U.S. companies, has been particularly aggressive in its pursuit of AUP assessments. To reduce the odds of an unwelcome surprise in the form of a hefty AUP assessment, companies need to stay on top of the latest AUP issues, including court challenges and legislative developments.

What Is AUP?

Unclaimed (or abandoned) property generally is defined as property held or owing in the ordinary course of business that the owner has not claimed for a certain period of time (the dormancy period). AUP can include uncashed payroll and vendor checks, unapplied accounts receivable credit balances, dormant bank and brokerage accounts, unredeemed gift certificates and gift cards, life insurance policies, publicly traded securities with “lost” owners, customer refunds and rebates, benefit plan payments, and the contents of safe deposit boxes.

The AUP Laws

All 50 states, the District of Columbia, Puerto Rico, the U.S. Virgin Islands, Guam, and a few foreign countries have AUP laws. Under the laws, businesses holding AUP (holders) must turn the property over to the state after the dormancy period expires. States typically hold AUP in a custodial capacity until the rightful owner claims it.

The U.S. Supreme Court has established jurisdictional rules for states’ claims to AUP. Under the primary-priority rule, the holder must report AUP to the state of the rightful owner’s last known address as reflected in the holder’s books and records. If the owner is unknown or the holder lacks the owner’s address records (no-address property), the holder must remit the AUP to the state of the holder’s legal domicile (state of incorporation) under the second-priority rule.1 The Court also established that the state of incorporation can claim property held by entities legally domiciled in the state and not subject to custodial taking in the state of the owner’s last known address.

Most of the AUP laws—including state AUP laws based on the Uniform Unclaimed Property Act of 1981 or the Uniform Unclaimed Property Act of 19952—have provisions that generally allow a state to estimate a liability for AUP that the holder failed to report if the holder has not complied with statutory recordkeeping requirements.

AUP vs. Taxation

AUP has its own lexicon that might be unfamiliar to many CPAs. Unique terms include:

• Escheat. To report and remit AUP to the state. Technically, it is the process by which the state takes legal ownership of presumed abandoned property. However, as commonly used, the term refers to a state’s custodial taking and holding of AUP.
• Holder. The obligor or party that holds AUP.
• Owner or apparent owner. The party that has a legal claim of ownership to an item of AUP.
• Dormancy period. The period of time that must lapse before an item becomes AUP. The dormancy period varies by state and property type.
• Due diligence. The procedures by which a holder attempts to contact an AUP owner before property is reported to the state. Virtually every state requires due diligence.3
• Aggregation limit. A holder can combine and report AUP items under the aggregation limit to the state as a single amount. (Because there is no owner name or other identification, AUP reported on an aggregated basis cannot be returned to the property owner. Although it is “free money” to the state, it obviously defeats the primary purpose of unclaimed property laws, which is to reunite lost property with owners.)
• Reciprocity. An informal agreement under which one state will accept AUP otherwise reportable to another state.

Collecting AUP is not technically taxation—but a tax by any other name is still a tax. AUP essentially gives state governments a politically neutral way of raising revenues from corporations and other holders without using the dreaded “T” word. As with taxes, though, state revenue departments usually enforce the AUP rules, and the funds received eventually are treated as revenue in state budgets (even though the states themselves do not own the collected AUP). In Delaware, in fact, collected AUP goes directly into the general fund and is removed only when an owner makes a claim. But there are some differences between AUP laws and taxation that can make the former the more troublesome to deal with.

The use of contract auditors is one such difference. States typically use their own employees to conduct tax audits, but third-party auditors conduct the majority of AUP audits. These auditors often make no money unless they find AUP, and then they are paid a percentage of revenues the states would not otherwise reap. From the states’ perspective, there’s little downside in AUP audits. After all, it does not cost them anything if no AUP is found.

Most AUP laws also are not restricted by statutes of limitation. The IRS generally is prohibited from going back more than three years in an audit (in the absence of a material misstatement or fraud), but few states limit the period that an AUP audit can reach back.

Finally, AUP laws are not subject to the equitable apportionment rules that apply to state taxes. Under federal law, state taxes must be fairly apportioned.4 In other words, a state generally cannot subject a company to taxation out of proportion to the company’s activity in the state. Because AUP technically is not a tax, these rules do not apply to AUP assessments.5 In fact, Delaware will claim 100% of estimated AUP liability for any company incorporated there, regardless of whether the company had any employees, customers, vendors, or property in the state (see example in next section).

AUP as a Revenue Generator

Certain states view AUP as a significant source of revenue. In Delaware, for example, “abandoned property” represented the third-largest source of revenue in fiscal year 2013, bringing $566.5 million into state coffers.6 That figure is more than three times the state’s corporate income tax receipts for the year.

Delaware’s AUP laws allow the state and its contract auditors (virtually all Delaware AUP audits are conducted by third-party auditors) to estimate a holder’s liability for AUP, and assessments can go back more than 30 years.7 Without authoritative guidance, the contract audit firms that the state employs essentially are left to their own devices when it comes to determining an audited company’s unreported estimated liability. Additionally, the state compensates the audit firms on a contingent fee basis, creating a clear conflict with the statutory objective of an audit, which is to determine compliance with state unclaimed property reporting rules.8

Moreover, Delaware exploits jurisdictional rules for collecting AUP, such as the last-known address rule, whereby a holder’s state of incorporation can claim no-address property. Delaware claims the entire amount of an estimated liability even when a holder has virtually no business contact with the state other than—perhaps unluckily—happening to be incorporated in the state. The contract audit firm estimates a holder’s liability for the years where records are no longer available, and Delaware claims the entire amount. The state assumes that the entire estimated liability represents “no-address property,” which Delaware, as the holder’s state of incorporation, is entitled to claim.

Example: Company XYZ is incorporated in Delaware but conducts all of its business activity in Florida. Because it never had AUP in Delaware, it appropriately has not filed any AUP reports with the state. (Delaware does not require so-called negative reports.) A contract auditor audits the company back to 1981 and finds that it does not have accounting records dating that far back. The contract auditor uses existing records to estimate a liability back to 1981, and Delaware claims the entire estimate, ignoring the fact that Company XYZ never actually conducted any business activity in the state and that there was no requirement for the company to file AUP reports in prior years.

New Jersey has recently been aggressive in pursuit of AUP, too. In 2010, it amended its AUP laws to treat stored-value cards (SVCs) not used in two years as AUP. The amendment applied retroactively to cards issued before the revision was enacted and required issuers to submit the entire value of SVCs in cash to the state—even though the SVCs were not redeemable for cash under the issuer’s contract with the customer.

The Third Circuit, however, found that the amendment improperly impaired SVC issuers’ contractual relationship with their purchasers by imposing unexpected obligations on issuers.9 Because the value of an SVC includes the expected profit for the issuer, requiring issuers to turn over the entire value effectively transferred their benefits from the contractual relationship to state custody. The court concluded that the amendment did not reasonably accommodate the rights of the contracting parties in light of the state’s public purpose (reuniting abandoned property with its rightful owners) because it did not allow issuers to collect their bargained-for profits or merchant fees.

The Third Circuit also addressed New Jersey’s place-of-purchase presumption. Under the rule, if an SVC issuer did not have the name and address of the purchaser or owner of the card, the address of the purchaser or owner would be presumed to be the address where the card was purchased. But under the Supreme Court’s secondary priority rule, the Third Circuit pointed out, the issuer’s state of incorporation is entitled to claim the AUP when the purchaser’s address is unknown. If the issuer was not incorporated in New Jersey, New Jersey could not claim the SVC simply because it was purchased in the state.10

It seems that the AUP efforts of Delaware and New Jersey have drawn the attention of other states, as the number engaging contract audit firms has increased dramatically over the past year. Previously, only a handful of states had engaged the leading contract audit firm, Kelmar Associates LLC, but more than 20 states now are doing so.

Opposition to Contract Auditors

The expanded use of contract auditors to recover AUP has prompted responses from both business and professional organizations.

In April 2014, the U.S. Chamber of Commerce released a white paper addressing the use of private auditors.11 The paper particularly criticized contingent fee arrangements, which inject a private profit motive into the enforcement of state laws and therefore carry a significant risk of abuse. It noted that private auditors have taken an increasingly aggressive approach to how they interpret and enforce AUP laws. According to the paper, some audit firms are going so far as to require insurers to cross-reference company records with the Social Security Administration’s death master file (DMF) to identify dead policyholders who had not yet been reported to the insurer, a requirement that in most states historically has not been supported by law.

The chamber fears that the experience of the insurance industry represents a cautionary tale of the risks of delegating enforcement of AUP laws to profit-motivated private auditors. To combat these risks, the white paper recommends:

• Transparency reforms that require state administrators to post contracts with private audit firms online and to allow an open, competitive process for audits;
• Fee arrangements where private audit firms are compensated on an hourly basis or an agreed-upon fixed amount under a written contract;
• Contract reforms; and
• Voluntary disclosure programs that properly incentivize companies to come forward voluntarily, including a route to amnesty for companies that might be out of compliance with AUP laws.

The AICPA also has weighed in on contingent fee audit arrangements, staking out a position in opposition to the practice in 2013.12 The Institute acknowledged the attractiveness of the arrangements as an avenue for augmenting revenues, but it concluded that the financial benefit is not worth “the many negatives arising from such arrangements, including primarily that they likely will compromise the integrity of the tax system.” Thus, the AICPA encourages state CPA societies to suggest that governments at all levels reject the use of contingent fee audit arrangements.

Relevant Litigation

Not surprisingly, given Delaware’s reliance on unclaimed property as a revenue source as well as the state’s excessively aggressive stance on enforcement, several AUP-related disputes have made their way to the courts. The most recent cases are discussed here.

Select Medical Corp. v. Cook¹³

Select Medical sued Delaware (represented by Thomas Cook, its secretary of finance, and David Gregor, the state escheator) in April 2013, seeking injunctive relief to prevent the state from enforcing a request for payment of an unclaimed property assessment of about $300,000. Among other arguments, the company challenged the state’s estimation method.

Before the federal district court could address the issue, though, the defendants filed a motion to dismiss in November 2013, indicating they had received sufficient information from the company after its request for payment such that no estimation was needed. Delaware agreed to withdraw the request for payment, the parties filed a stipulation of dismissal of all claims with prejudice on Jan. 21, 2014, and the court approved a settlement on Jan. 23.

Delaware ex. rel. Higgins v. SourceGas, LLC¹⁴

AUP also has been subject to claims under state false claims laws (also known as qui tam or whistleblower laws). These laws allow third-party, private citizens to act on behalf of the government to sue persons who knowingly make or use a false statement material to an obligation to pay money to the government. The potential financial consequences of a successful qui tam action are significant. Under the Delaware False Claims and Reporting Act (DFCRA),15 for example, a violator is liable to the government for a civil penalty of at least $5,500, but not more than $11,000, for each violation, plus three times the amount of damages the government sustains because of the violations.16 Treble damages are typical of false claims awards.

The private citizen in this case was the defendant’s former tax manager. He alleged that after the company acquired an oil and gas pipeline company that had various accounts containing uncashed utility deposits and other payments owed to the customers, it reclassified and renamed a liability account originally named “Unclaimed Property Liability” to “Converted Balance from Dec. 2004.” He claimed this was done to conceal the true nature of the funds and avoid the obligation to report AUP liabilities to Delaware. In May 2012, the state trial court found that the citizen’s allegations regarding that account established a valid claim under the DFCRA and denied the defendant’s motion to dismiss the claim. The court also held, however, that a factual question existed as to whether AUP was in fact owed to Delaware.

This case, too, ultimately failed to reach trial, as the parties agreed to dismiss the action in November 2013. Delaware decided to pursue, and SourceGas agreed to submit to, an administrative examination.

Delaware ex. rel. French v. Card Compliant, LLC¹⁷

Another qui tam case brought under the DFCRA was filed under seal in a Delaware state court in 2013. The complaint alleges that dozens of major retailers and chains have engaged in improper schemes to avoid being classified as holders of unclaimed gift card liabilities under the state’s AUP law. Specifically, it asserts that the companies, along with the plaintiff’s former employer, Card Compliant, created “sham” contracts portraying Card Compliant as the holder of unredeemed gift cards in exchange for an annual fee. The complaint alleges that funds associated with sold gift cards were always in the possession and control of the issuers. In April 2014, the Delaware attorney general filed a motion to intervene in the case.

Temple-Inland, Inc. v. Cook¹⁸

On May 21, 2014, Temple-Inland filed a lawsuit against Delaware’s secretary of finance, Cook, and other state officials as well as Delaware’s principal contract auditing firm, Kelmar Associates, in federal district court. The complaint challenges the state’s estimation methods and the state’s purported claim to a company’s entire estimated liability. The outcome of this case could significantly affect the potential liability of any company currently under audit in Delaware and in other states.

Legislative Developments

The AUP arena also is seeing action from state legislatures.

Proposed Delaware Amendments

Delaware recently considered two bills dealing with AUP collections. Senate Bill (S.B.) 228 was enacted and changed from June 30, 2014, to Sept. 30, 2014, the date by which an AUP holder must submit, and the secretary of state could accept, a letter of intent to enter an AUP voluntary self-disclosure agreement. It would also extend the sunset of the secretary of state’s voluntary self-disclosure program by one year, to July 1, 2016, to allow for the processing of all voluntary self-disclosure agreements.19

More notably, S.B. 215 would have prohibited the state from paying contract auditors by commission or a percentage of the property recovered. It would also require the rebidding of auditing contracts at least every three years. Interestingly, the bill notes that Delaware law already prohibits state employees from representing or assisting any private enterprise on any matter involving the state for a period of two years after leaving state employment. In the recent past, a former lawyer with the state’s attorney general’s office and a former Delaware state escheator have gone to work for Kelmar Associates after retiring from the state. Perhaps not surprisingly, the Senate Banking Committee elected not to advance S.B. 215.

Michigan’s Audit Reforms

In 2013, Michigan adopted a law setting forth specific changes regarding AUP audits. House Bill (H.B.) 4289 requires that audits be conducted in accordance with GAAS.

In addition, the law mandates that an entity that has undergone an AUP audit must receive a complete copy of the audit report. The report should identify in detail the work performed, property types reviewed, any estimation techniques employed, calculations showing the potential amount of property due, and a statement of findings as well as copies of all correspondence and documentation that formed a basis for the findings.

The law also prohibits the estimation of liability if an entity has maintained “substantially accurate records,” which is defined as at least 90% of the records necessary for AUP examination purposes under the principles of internal controls. The determination of whether records are substantially complete is not made solely as a percentage of the total overall individual records to be examined but also considers the materiality of the records. The law makes clear that where a holder’s records for one particular property class are insufficient, the contract auditor does not have authority to estimate liability for other property classes for which the entity has filed all the required reports and maintained sufficient records.

Lowering Aggregate Reporting Thresholds

Several states are proposing or have enacted a decrease in the aggregate reporting threshold for AUP. Most states permit a holder to aggregate property under a certain dollar amount (usually $25 or $50), forgo due diligence, and report that property as a single line amount. For example, last year the Illinois Legislature lowered the aggregation threshold from $25 to $5 (S.B. 1988).20 This trend runs counter to the revenue-generating focus of many states, and, while laudable, it increases the cost of compliance for holders.

Life Insurance Company Due-Diligence and Research Requirements

Many states are adopting statutes mandating how life insurance companies must use the Social Security DMF to identify potential unclaimed property associated with life insurance and annuity contracts. The following are some examples:

• Alabama H.B. 192 changes the life insurance DMF-matching requirements enacted in 2012 by limiting the matching requirements to life insurance policies, annuity contracts, and retained asset accounts issued and delivered in Alabama, and that are issued or entered into on or after Jan. 1, 2016. It also requires the first of the matches to be completed by Jan. 1, 2019, and then performed every three years thereafter.
• Maryland S.B. 77 requires semi-annual DMF comparisons of in-force policies and retained asset accounts and, if benefits are due, locating and notifying beneficiaries.
• Montana S.B. 34 requires semiannual DMF comparisons of in-force policies, annuity contracts, and retained asset accounts and, if benefits are due, locating and notifying beneficiaries.
• North Dakota H.B. 1171 requires life insurers to perform DMF matches before Nov. 1, 2014, and then semiannually of in-force policies and retained asset accounts and, if benefits are due, locating and notifying beneficiaries. The bill also reduces the dormancy period from three years to one year for funds held or owing under a life or endowment insurance policy that matured or terminated.
• New Mexico S.B. 312 requires semiannual matches of in-force policies and retained asset accounts against the DMF and, if benefits are due, locating and notifying beneficiaries.
• Nevada Assembly Bill 226 (effective July 1, 2014) requires at least semiannual comparison by a life insurer of its in-force life insurance policies, annuities, benefit contracts, and retained asset accounts against the DMF and, if benefits are due, locating and notifying beneficiaries.
• Vermont H.B. 95 requires semiannual DMF comparisons of in-force policies, annuity contracts, and retained asset accounts and, if benefits are due, locating and notifying beneficiaries. The bill applies to all in-force life insurance policies, annuity contracts, and retained asset accounts in force on or after July 1, 2013.

What Is Coming

Litigation over AUP audits is likely to continue, particularly in Delaware, where companies subject to audit have been emboldened by the settlement of Select Medical and the cogent arguments presented in Temple-Inland. Until some appellate decisions on the matters are issued, though, holders also can expect states to ramp up their auditing activities, often using contract audit firms.

On the legislative front, some changes will favor AUP holders, while others tilt toward the states. For example, as with Delaware’s S.B. 215, some legislation will at least propose restrictions on the use of a contingent fee arrangement with contract auditors. In addition, more states will be considering bills that provide business-to-business and other exemptions for certain categories of property.21 In April 2014, the Missouri House voted to enact an unclaimed property business-to-business exemption (H.B. 1075). H.B. 1075 would also establish a three-year statute of limitation for audits. On the other hand, states probably will try to accelerate collections by reducing dormancy periods, a trend over the past few years. In July 2014, for example, the Pennsylvania General Assembly reduced the dormancy period from five years to three years for several types of property (H.B. 278). Some states also might follow Illinois’s lead by adopting lower aggregation thresholds, which will trigger additional reporting and due-diligence obligations for holders and make compliance more costly.

It is possible, too, that the meaning of the term “unclaimed property” could expand to capture new types of property. States might claim that AUP encompasses virtual currency, such as bitcoin, or property associated with affinity programs, such as frequent-flier points.

Conclusion

Holders need to determine their risks related to AUP in light of their histories of compliance and their current policies and procedures, and they must take proactive steps to address any weaknesses and exposure areas. Doing so can include adopting more robust compliance practices and considering entering voluntary self-disclosure agreements with implicated states to address historical liabilities. Finally, tax practitioners and advisers should evaluate the AUP statutes and enforcement practices when choosing a jurisdiction for incorporation or noncorporate organization formation. A corporation formed in Delaware unknowingly could be subject to millions of dollars of AUP audit exposure, but a company with identical operations incorporated in Ohio, an “escheat-friendly” state, likely would have little or no liability.

Footnotes

¹ Texas v. New Jersey, 379 U.S. 674 (1965); Delaware v. New York, 507 U.S. 490 (1993).

² National Conference of Commissioners on Uniform State Laws (NCCUSL) Model Act of 1981 and NCCUSL Model Act of 1995.

³ Delaware is a notable exception.

⁴ Complete Auto Transit, Inc. v. Brady, 430 U.S. 274 (1977).

⁵ However, as described in this column, the distinction is challenged by the manner in which certain states treat AUP collections.

⁶ Del. Dep’t of Fin., “State General Fund Revenue by Category,” Delaware Fiscal Notebook (2013 ed.), available at finance.delaware.gov.

⁷ However, Delaware’s ability to estimate a liability prior to 2010 is being challenged in a complaint filed in U.S. District Court (Temple-Inland v. Cook, No. 1:14-cv-00654-SLR (D. Del. 5/21/14) (complaint filed)).

⁸ See, e.g., Delaware’s examination of records statute, Del. Code tit. 12, §1155.

⁹ New Jersey Retail Merchants Ass’n v. Sidamon-Eristoff, 669 F.3d 374 (3d Cir. 2012).

¹⁰ Beginning in July 2016, New Jersey is requiring retailers to obtain purchaser ZIP code information when an SVC is sold. N.J. Stat. §46:30B-42.1(c). Whether a ZIP code is sufficient documentation for a state’s claim to AUP under the first-priority rule is subject to debate.

¹¹ U.S. Chamber of Commerce, Institute for Legal Reform, Unclaimed Property: Best Practices for State Administrators and the Use of Private Audit Firms (April 2014), available at www.instituteforlegalreform.com.

¹² AICPA statement, “Contingent Fee Audit Arrangements,” www.aicpa.org.

¹³ Select Medical Corp. v. Cook, No. 1:13-CV-00694-LPS (D. Del. 1/23/14) (settlement approved).

¹⁴ Delaware ex rel. Higgins v. SourceGas, LLC, No. N11C-07-193-MMJ-CCLD (Del. Super. Ct. 5/15/12).

¹⁵ Del. Code tit. 6, ch. 12.

¹⁶ Del. Code tit. 6, §1201.

¹⁷ Delaware ex rel. French v. Card Compliant, LLC, No. N13C-06-289-FSS (Del. Super. Ct. 6/28/13).

¹⁸ Temple-Inland, Inc. v. Cook, 1:14-cv-00654-SLR (D. Del. 5/21/14) (complaint filed).

¹⁹ Fearing the state’s reputation as “business friendly” was being sullied by the Division of Revenue’s hyperaggressive AUP revenue collection activities, in 2012 the Delaware legislature enacted a statute permitting the Delaware secretary of state to administer all unclaimed property voluntary disclosure agreements for a limited period of time (Del. Code tit. 12, §1177).

²⁰ 765 Ill. Comp. Stat. 1025/11(b)(1).

²¹ Fourteen states have some type of exemption from their unclaimed property reporting requirements for transactions with businesses. See, e.g., Ohio Rev. Code §§169.01(B)(2)(b) and (c). In addition, many states allow at least a partial exemption for unredeemed gift certificates or gift cards often subject to certain limitations or restrictions, such as when the gift certificate or gift card does not include an expiration date or dormancy charge. See, e.g., 72 Pa. Cons. Stat. §§1301.1 and 1301.6.1.