Unclaimed property audit fallacies and myths

Editor: Catherine Stanton

Despite the strong economy and their fuller coffers, states across the nation continue to take an aggressive approach in administering their unclaimed property statutes. Illinois, for example, has eliminated its business-to-business exemption. And Delaware, the domicile for many U.S. companies and unquestionably the most aggressive state in this area, has once again begun issuing audit notices.

Every U.S. state, the District of Columbia, Puerto Rico, the U.S. Virgin Islands, Guam, and some foreign countries have unclaimed property laws. Companies that find themselves in the crosshairs of an audit often discover that some of their assumptions about the examination process are incorrect. The following seven misconceptions, in particular, are prevalent and can leave businesses exposed to costly and protracted audits.

Myth 1: States are primarily concerned with reuniting property with owners

This idea has not always been a myth. The original intent of unclaimed property laws — which generally require businesses (holders) to turn over unclaimed property to the state after the dormancy period expires — was to reunite individual owners with their lost property. However, in some states, that goal largely has fallen by the wayside. In today’s climate, a number of states zealously enforce their unclaimed property rules, generating significant revenue in the process.

In Delaware, for example, unclaimed property is the third-largest source of revenue.¹ Indeed, rather than recording proceeds as a liability as most states do, Delaware deposits unclaimed property takings directly into its general fund, where they remain until an owner makes a claim. In fiscal year 2018, unclaimed property accounted for $506.2 million — or 11.5% of general fund revenues — a 12.7% increase over 2017.² By contrast, the state returns only a fraction of this amount to owners. In 2018, for example, it returned less than 10% of the amount collected.³

Delaware is not the only example in which a state’s goal of unclaimed property enforcement has shifted over time. In 2007, a federal district court issued a preliminary injunction prohibiting the California State Controller’s Office from accepting or taking possession of any property under the state’s unclaimed property statutes until the controller promulgated regulations providing for fair notice to potential owners and the public.⁴ The court observed that “[i]f the purpose of the law is . . . to reunite owners with their lost or forgotten property, its ultimate goal should be to generate little or no revenue at all for the state.”⁵

Before it retroactively eliminated its business-to-business exemption, Illinois had been one of the more holder-friendly states, appropriately exempting transactions between businesses.⁶ (Unclaimed property, at its crux, is about consumer protection, not settling transactions between businesses.) Now, however, the state, which has had a reputation for fiscal irresponsibility, appears to be using unclaimed property in an attempt to fulfill its pension obligations. Recently enacted legislation provides that the Illinois unclaimed property administrator “may deposit any amount in the Unclaimed Property Trust Fund into the State Pensions Fund during the fiscal year at his or her discretion.”⁷

Even more troubling, Illinois drafted legislation in 2018 authorizing the state treasurer to purchase an office building using money from the unclaimed property fund. Former Gov. Bruce Rauner vetoed the bill and commented, “The business community should not be subjected to a hidden tax and the Treasurer should not be spending funds improperly diverted from Illinois businesses to purchase and renovate a building.”⁸

Some courts, however, have de-emphasized the primary purpose of states’ unclaimed property laws. The Sixth Circuit, for example, found that a revision to Kentucky’s unclaimed property law that reduced the presumptive abandonment period for traveler’s checks from 15 years to seven did not violate the Due Process Clause of the Fourteenth Amendment.⁹ The lower court had ruled against the change, noting “it is clear that the state’s objective [in passing the 2008 amendment] was to raise revenue rather than to reunite citizens with lost property.”¹⁰ In vacating that court’s ruling, the appeals court noted that “the mere fact that [Kentucky] generates revenue by escheating abandoned property does not run afoul of any substantive due process safeguards.”¹¹

Myth 2: Unclaimed property audits are similar to state tax audits

Corporations’ tax departments often become aware of the concept of unclaimed property when they receive an audit notice. But unclaimed property obligations are not a tax; rather, they represent a property right. The lack of understanding can lead to the tax, legal, and accounting functions playing a game of intracompany “hot potato” about unclaimed property compliance. Unclaimed property audits often land in the tax department because that department traditionally handles tax audits.

However, unclaimed property audits differ dramatically from state tax audits. Contract audit firms — rather than a state’s tax agency — routinely conduct unclaimed property examinations. And unlike state agents, contract auditors generally are compensated on a contingency basis. This compensation structure provides a strong incentive to conclude that anything remotely resembling unclaimed property must, from the auditor’s perspective, be unclaimed property.

State tax audits typically involve only one state. A contract audit firm, on the other hand, might represent more than 30 states, so the target business can be audited by multiple jurisdictions simultaneously.

Unclaimed property audits typically are broader in scope than state tax audits. A sales-and-use-tax audit, for example, is limited to a handful of specific accounts such as sales, purchases, and capital expenditures. Unclaimed property contract auditors review a company’s entire chart of accounts hunting for unclaimed property, and all related entities within an organization are fair game. They scrutinize general ledger detail of balance sheet and income statement accounts such as cash, accounts receivable, suspense accounts, accounts payable, bad debt-related accounts, miscellaneous income, and expense accounts, making for a much more intrusive experience.

State tax audits generally are subject to a statute of limitation of three or four years. The statute of limitation for unclaimed property is not always as clear. In some states, such as Illinois, the statute of limitation applies only to property specifically identified on an unclaimed property report.¹² Any property not reported could be subject to review, which effectively renders the statute of limitation meaningless. This is one reason auditors can, and frequently do, audit businesses for transactions going back as far as 15 years.¹³

Another significant disparity stems from the treatment of information that companies provide auditors. In most states, taxpayer information is considered confidential and cannot be disclosed. Because unclaimed property is not a tax, some states might disclose information on companies under audit in response to Freedom of Information Act requests. Delaware currently is facing a lawsuit that alleges, among other things, that its use of a contract auditor in a multistate audit violates the holder’s due process rights “because it not only exposes the confidential and proprietary records of a holder of unclaimed property to public inspection due to the conflicting public records laws of the multiple participating states but also violates the unclaimed property laws of the participating states as they apply to the confidentiality of unclaimed property records produced during an examination.”¹⁴

Myth 3: Specific guidelines apply to how audits are conducted

In contrast to state tax audits that typically have well-defined examination procedures and methodologies, unclaimed property audits have few rules of engagement. According to the unclaimed property statutes of virtually every state, the purpose of an unclaimed property audit is to determine a holder’s compliance with unclaimed property reporting rules — nothing more.¹⁵ The reality is that contingent fee auditors typically lead the charge and set out to find transactions that cannot be reconciled, treating them as unclaimed property. In fact, audit firms sometimes recommend companies for audit.

As such, many unclaimed property audits are far from objective and unbiased. Although a few states have regulations addressing unclaimed property audits (for example, Ohio¹⁶), states often defer to contract auditors and provide little auditor oversight. Michigan, Ohio, and Tennessee ostensibly mandate that auditors comply with generally accepted auditing standards, but the states rarely enforce the requirement in practice.¹⁷ Typically, states only intercede in an audit when the auditor claims the holder is not cooperating, the holder requests the state’s involvement, or the auditor has issued its audit findings. As a result, contract auditors devise their own standards and audit methodologies, which vary, sometimes significantly, by audit firm.

Myth 4: Unclaimed property audits typically are completed in less than two years

While companies under audit can expect unclaimed property auditors to request a wide range of information, they do not necessarily need to provide it all. However, disputes over information production can prolong the audit process. A survey conducted by the Council on State Taxation’s (COST’s) Unclaimed Property Task Force in 2014 found that half of the respondents undergoing a Delaware unclaimed property examination had been under audit for three to eight years.¹⁸ Of the respondents that had completed Delaware audits, 37.5% reported that their audits lasted between seven and eight years.

The sheer volume of information requests slows the examination process. To quantify an accounts payable exposure, an auditor will typically review all cash accounts on the general ledger to identify accounts that disburse check payments. It then creates voluminous schedules consisting of checks voided and outstanding more than 30, 60, or 90 days (depending on the audit firm) after issuance, going back as long as 15 years, and requests that the holder remediate or prove — to the auditor’s satisfaction — each item does not represent unclaimed property. In one case, a contract auditor identified more than 50,000 transactions, some going back more than 10 years, and expected the holder to remediate the transactions within 90 days. Rebutting an auditor’s presumption of abandonment often becomes a tedious forensic accounting exercise rather than an evaluation of the holder’s compliance with state reporting rules.

Ironically, a previous Delaware regulation posited that “the time to complete a typical examination should not exceed twelve (12) months.”¹⁹ The authors are not aware of any Delaware audit being completed in less than four years, let alone one year. Perhaps the source of the two-year myth is that contract auditors often tell holders that an unclaimed property audit should be completed within two years.²⁰

Myth 5: Maintaining extensive historical records is a good audit defense strategy

State unclaimed property laws are ambiguous when it comes to record retention rules. The Revised Uniform Unclaimed Property Act of 2016 states:

A holder required to file a report under Section 401 shall retain records for 10 years after the later of the date the report was filed or the last date a timely report was due to be filed, unless a shorter period is provided by rule of the administrator. The holder may satisfy the requirement to retain records under this section through an agent. The records must contain:

(1) the information required to be included in the report;

(2) the date, place, and nature of the circumstances that gave rise to the property right;

(3) the amount or value of the property;

(4) the last address of the apparent owner, if known to the holder; and

(5) if the holder sells, issues, or provides to others for sale or issue in this state traveler’s checks, money orders, or similar instruments, other than third-party bank checks, on which the holder is directly liable, a record of the instruments while they remain outstanding indicating the state and date of issue.²¹

Does this provision mean that only details relating to reported unclaimed property should be maintained, as the model statute suggests, or does it require a holder to retain all records that hypothetically could give rise to unclaimed property? Delaware regulations seem to imply the latter.²²

Some companies have been advised that they can reduce the pain of an unclaimed property audit by keeping comprehensive records indefinitely. While such an approach in theory could limit certain states, such as Delaware, from estimating a liability for prior years, it might not reduce the amount of time and expense associated with completing an unclaimed property examination.²³

Many holders operate under the false assumption that having a wealth of records will reduce the rebuttal burden. This assumption simply is not true unless a holder details the resolution of every transaction that could give rise to an unclaimed property liability. Even worse, holding on to a surplus of information can backfire by giving auditors a vast quantity of records to comb through. Maintaining 15 years of records does not mean an auditor will not attempt to find unclaimed property in those records. Trying to prove that hundreds or even thousands of transactions are not unclaimed property can be an onerous and expensive task.

Perhaps a more practical and strategic approach is to establish a well-defined record retention policy and take steps to ensure that retained records are clean — that is, reconcilable. For example, a company can retain documentation showing how stale-dated checks were resolved — whether a check was issued in error, voided and reissued, voided because the obligation was never truly owed, or reported to the state as unclaimed property — but only for the predetermined record retention period. To prove an accounts receivable credit is not unclaimed property, the company should document in writing a conversation with the customer that concluded the credit was not owed. Contemporaneously prepared internal notes and other documentation will help to rebut the presumption of abandonment. While no accounting practice can guarantee a pain-free unclaimed property audit, adhering to a record retention policy and the early reconciliation of open transactions can go a long way toward expediting the examination process.

Myth 6: Unclaimed property audit assessments represent a holder’s actual unclaimed property liability

Given the contingency nature of contract auditor fee arrangements, it would be naive to expect an auditor’s finding to be fair and unbiased. Contract audits are fundamentally designed to identify large numbers of questionable (in the auditor’s view) transactions spanning multiple years that typically are challenging or not possible for the company under audit to reconcile or remediate.

The treatment of some transactions between businesses also raises concerns about contract auditor tactics. In a recent examination that one of the authors was involved in, an auditor identified approximately $75 million of alleged unreconciled payments to businesses. The auditor failed to notice that 75% of the flagged payments were made to a wholly owned subsidiary of the entity under audit and obviously were not unclaimed property. In another instance, a contract auditor requested the remediation of hundreds of debit entries made to accounts receivable, believing the transactions were customer credits inappropriately taken into income. In fact, the transactions were entries to record actual sales to customers.

Fundamentally, treating any transaction between sophisticated businesses as unclaimed property is bad public policy and an impediment to commerce. According to the Unclaimed Property Professionals Organization (UPPO):

Most credits, overpayments, uncashed checks and rebates listed in the records of a business typically are not obligations actually owed to other businesses. Often, such amounts represent bookkeeping or systems errors that are automatically reconciled by electronic systems when future transactions are recorded, offset intentionally in the next transaction as is industry custom, or settled at some future date by some other means.²⁴

Myth 7: An estimated liability is unclaimed property

One of the most contentious aspects of unclaimed property audits is the use of estimation methodologies to compute purported liabilities for prior years. As a threshold matter, the authors question whether an estimated liability even is unclaimed property. The U.S. Supreme Court has held that the first step in ascertaining a state’s jurisdiction over unclaimed property is to determine the “precise debtor creditor relationship as defined by the law that creates the property at issue.”²⁵ With an estimate, there is no creditor (and arguably no debtor), and, consequently, no precise debtor-creditor relationship can exist.

A state’s rights to unclaimed property derive from, and generally can be no greater than, the rights of the owner.²⁶ Reported funds are held by the state in a custodial capacity until the owner or the owner’s heirs can claim them. With an estimated liability, there is no owner and, therefore, in the authors’ view, no basis for the state’s asserting custodial jurisdiction. Apparently aware of this incongruity, Illinois positioned its estimation statute as a penalty in its 2017 unclaimed property statute revisions.²⁷

The contingent fee arrangements that give contract auditors an incentive to find unclaimed property understandably call their estimates into question. An auditor’s typical approach makes clear the arbitrary and skewed nature of liability estimations:

1. The auditor identifies a “base period” — a multiyear period starting with the earliest year for which the auditor received transaction-level records;
2. The auditor compiles a population of potential unclaimed items, such as stale and voided checks;
3. The holder attempts to reconcile the identified items to prove they are not unclaimed property, a difficult proposition given the typical age and volume of transactions;
4. Items that cannot be remediated to the satisfaction of the auditor are included in the numerator of an error rate — the denominator of the error rate typically is total sales during the base period; and
5. The error rate is applied to annual sales for years prior to the base period to determine the total amount of unclaimed property owed.

In 1965, the U.S. Supreme Court established priority rules for states’ claims to unclaimed property:

• The jurisdiction of the owner’s last known address as reflected in the holder’s records is entitled to custody of the unclaimed property;
• If the owner’s last address is unknown, the jurisdiction in which the holder is legally domiciled (incorporated) is entitled to claim the unclaimed property.²⁸

For years, Delaware, the state of formation for many corporate and noncorporate entities, has grossly distorted these rules when estimating liabilities. Delaware has applied the theory that, because there are no owner addresses (as there are no owners), the estimated liability can be claimed only by the state of incorporation or organization of the entity (often Delaware) under the Court’s second priority rule. The fact that a holder might have little or even no business activity in the state is ignored. In fact, no statutes or case law decisions prevent any state from estimating a liability for any holder.

In a pivotal June 2016 decision, a federal district court held that Delaware’s method of estimating unclaimed property liabilities violated the substantive due process requirements of the U.S. Constitution.²⁹ The court noted that Delaware had “engaged in a game of ‘gotcha’ that shocks the conscience.”³⁰ It highlighted several problems with the estimation approach used by Delaware’s contract audit firm, Kelmar Associates:

Most notably, Kelmar’s estimation methodology relies heavily on property escheatable only to other states to increase the amount of unclaimed property owed to Delaware. . . . A larger base period liability leads to a larger ratio estimator, which leads to a larger amount of estimated unclaimed property in the reach back years owed to Delaware.³¹

The court added that Kelmar “employed a method of estimation where characteristics that favored liability were replicated across the whole, but characteristics that reduced liability were ignored.”³²

The court deferred its decision regarding an appropriate remedy, leaving it to Delaware to propose a remedy or appeal the decision. Less than a month after the ruling, the parties settled the dispute outside of court and filed a joint motion to dismiss the case. Figuratively thumbing its nose at the federal court, Delaware in 2017 adopted regulations that include the same estimation methodology the court criticized and found unconstitutional.³³

Be prepared

While a number of fallacies and myths exist concerning unclaimed property audits, one thing is certain: These examinations are complex, time-consuming, and challenging to manage. Holders of potentially reportable property should recognize that many states are using unclaimed property audits as a means to generate revenue, with no indication that this trend will end.  

Footnotes

¹Del. Dep’t of Fin., Delaware Fiscal Notebook, 2018 Edition, p. 31 (Dec. 1, 2018), available at finance.delaware.gov.

²Id., p. 31.

³Id., pp. 31 and 175.

⁴Taylor v. Chiang, No. S-01-2407 WBS GGH (E.D. Cal. 6/1/07), vacated on other grounds (E.D. Cal. 10/18/07), aff’d in part, rev’d in part sub nom. Taylor v. Westly, 525 F.3d 1288 (9th Cir. 2008).

⁵Id., slip op. at 4.

⁶More recently, Colorado eliminated a decades-old, holder-friendly unclaimed property deduction when it revised its unclaimed property statutes in S.B. 19-088, enacted April 16, 2019, and effective July 1, 2020 (Colo. Rev. Stat. §§38-13-101 through 38-13-1505).

⁷765 Ill. Comp. Stat. 1026/15-801(a).

⁸Thorp, “Treasurer: Rauner Veto Will Hamper Recovery of Unclaimed Property,” Chicago Sun-Times (Aug. 29, 2018), available at chicago.suntimes.com.

⁹American Express Travel Related Servs. Co. v. Kentucky,No. 09-5898 (6th Cir. 5/5/11).

¹⁰American Express Travel Related Servs. Co. v. Hollenbach, 630 F. Supp. 2d 757, 760-64 (E.D. Ky. 2009).

¹¹American Express Travel Related Servs. Co. v. Kentucky,No. 09-5898 (6th Cir. 5/5/11), slip op. at 11, quoting American Express Travel Related Servs. Co. v. Sidamon-Erestoff, No. 10-4890 (D.N.J. 11/13/10), slip op. at 36.

¹²765 Ill. Comp. Stat. 1026/15-610(b).

¹³See, e.g., 12 Del Code, tit. 12, §1172(h) (10-year limitation period plus a five-year dormancy period). Prior to a 2016 federal district court decision, a Delaware unclaimed property audit could span a period of 30 years (Temple-Inland, Inc. v. Cook, 192 F. Supp. 3d 527 (D. Del. 2016)).

¹⁴Univar, Inc. v. Geisenberger, No. 1:18-CV-01909 (D. Del. 12/3/18) (complaint for declaratory and injunctive relief, ¶4).

¹⁵See, e.g., Del. Code, tit. 12, §1171.

¹⁶Ohio Admin. Code §1301:10-3-04.

¹⁷Mich. Comp. Laws §567.251(4); Ohio Admin. Code §1301:10-3-04(A); Tenn. Code §66-29-158(b).

¹⁸Council on State Taxation (COST) Unclaimed Property Task Force, “Select Responses From the COST Survey” (Oct. 1, 2014).

¹⁹16 Del. Reg. 630.2.4 (12/01/12).

²⁰Delaware’s 2017 revision to its unclaimed property statutes mandates the completion of expedited audits and voluntary disclosure agreements within a two-year period (Del. Code, tit. 12, §§1172(2) and 1173 (d); see also 12 Del. Admin. Code 104-2.15.3).

²¹National Conference of Commissioners on Uniform State Laws (NCCUSL), Revised Uniform Unclaimed Property Act (RUUPA), §404 (2016).

²²Delaware’s regulatory provision for the retention of records (12 Del. Admin. Code 104-2.9 (10/1/17)) might exceed the boundaries of the statute (Del. Code, tit. 12, §1145): “Records to be retained by the Holder include the date, place, and nature of the circumstances that gave rise to the property right. These records may include the following: tax returns (including consolidated and affiliation schedules), organization charts, charts of accounts, unclaimed property filing history (for all states if the Holder is incorporated or formed in the State of Delaware), prior completed and accepted voluntary disclosure agreements (VDAs) and examinations, bank statements, bank reconciliations, outstanding check lists, detail general ledgers, aged accounts receivable reports, aged accounts payable reports, policies and procedures related to record retention, accounting, and unclaimed property, and if applicable, information surrounding gift card issuances and redemptions.” Prior to 2017, Delaware had no records retention requirement and usually benefited (due to the state’s liability estimation methodology) when a holder failed to retain detailed accounting records for 20-plus years.

²³Delaware, for example, will estimate a liability for entities formed in the state for years open to audit for which complete records have not been retained (12 Del. Admin. Code 104-2.18, 2.19, and 2.20).

²⁴UPPO, “Business-to-Business Exemption Position Statement” (2019, p­ublication pending).

²⁵Delaware v. New York,507 U.S. 490, 499 (1993).

²⁶“The State’s right is purely derivative; it takes only the interest of the ­unknown or absentee owner” (New Jersey v. Standard Oil Co. 74 A.2d 565, 573 (N.J. 1950), aff’d, 341 U.S. 428 (1951)).

²⁷765 Ill. Comp. Stat. 1026/15-1006.

²⁸Texas v. New Jersey, 379 U.S. 674 (1965).

²⁹Temple-Inland, Inc. v. Cook, 192 F. Supp. 3d 527 (D. Del. 2016).

³⁰Id., slip op. at 34.

³¹Id. at 11.

³²Id. at 34.

³³12 Del. Admin. Code 301-2.3 (7/1/17); 12 Del. Admin. Code 104-2.18 (10/1/17).