Tuesday, September 6, 2011

Unclaimed Property: The Nontax State Revenue Generator

by Angela R. Gebert, CPA, Fort Wayne, IN (formerly with Crowe Horwath LLP), and Chris Hopkins, CPA, New York, NY

Miscellaneous

Why should tax professionals care about unclaimed property? After all, unclaimed property is not a tax but a property right. However, unclaimed property looks and acts very much like a tax. In fact, similarities can cause compliance responsibilities and audit notices to drop squarely in the lap of a tax practitioner. To recognize the issues and potential risks, the fundamentals of unclaimed property need to be understood.

Background

Unclaimed property, also known as abandoned property, consists of 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). All 50 states, the District of Columbia, Puerto Rico, the U.S. Virgin Islands, and Guam, as well as a handful of foreign countries, have enacted unclaimed property laws. Unclaimed property can include uncashed payroll and vendor checks, accounts receivable credit balances, dormant bank and brokerage accounts, life insurance policies, gift certificates and gift cards, customer refunds and rebates, publicly traded securities, benefit plan payments, and the contents of safe deposit boxes. While unclaimed property or escheat laws date back to the Middle Ages, aggressive compliance enforcement by states is a relatively recent phenomenon. When dealing with the state taxes, tax practitioners think in terms of physical presence, nexus, and equitable apportionment. But since unclaimed property is technically not a tax, these concepts generally do not apply.

The Supreme Court established the jurisdictional rules for states claiming property in the 1965 case Texas v. New Jersey, 379 U.S. 674 (1965). The priority rules are:

* The jurisdiction of the owner’s last known address as reflected in the holder’s records is entitled to custody of the unclaimed property; and

* If the owner’s last address is unknown, the jurisdiction in which the holder is domiciled (incorporated) is entitled to claim the unclaimed property.

As discussed below, liberal interpretations of the second rule by some states create the biggest challenge—and potential liability—for many companies. A number of states have also adopted a third-priority or “throwback” rule. Under this rule, if there is no owner address and the holder’s state of domicile does not have unclaimed property laws that apply to the property, the state in which the transaction giving rise to the property occurred may claim the property. The Supreme Court has not sanctioned the third-priority rule.

Current Economic Climate and Trends

Due to the current economic environment and the budgetary problems of many states, unclaimed property is turning into what amounts to a tax—or at least a means to fill depleted state coffers. A number of states now view unclaimed property enforcement as a politically neutral, no-cost revenue generator and participate in multistate audits conducted by contract audit firms.

Some unclaimed property administrators have expanded the definition of what constitutes unclaimed property, leading to new and sometimes creative types of property being subject to state claim. Increased legislative activity has also resulted in the enactment of shorter statutory dormancy periods. While dormancy periods were historically often 7–15 years, dormancy periods of three years or less are becoming the norm. The purported rationale for the shorter dormancy periods is to more quickly reunite property with owners, but the reality is that they accelerate states’ receipt of funds.

While the purpose and intent of the unclaimed property laws in most states is to reunite lost property with owners, cash-strapped states sometimes lose sight of this objective. In 2007, a U.S. appeals court effectively enjoined the state of California from taking unclaimed property due to inadequate efforts by the state to return property to owners (Taylor v. Westly, 488 F.3d 1197 (9th Cir. 2007)). After the state tightened its custodial safekeeping practices, the order was lifted.

In 2009, a U.S. district court ruled in favor of an issuer of traveler’s checks after the Kentucky legislature attempted to shorten the dormancy period for uncashed traveler’s checks from 15 to 7 years (American Express Travel Related Servs. v. Hollenbach, 630 F. Supp. 2d 757 (E.D. Ky. 2009), vacated and remanded, No. 09-5898 (6th Cir. 5/5/11)). The court concluded that the legislative change was “arbitrary and capricious and violate[d] the Due Process Clause of the United States Constitution.” However, the Sixth Circuit disagreed and held that the amendment does not violate the Due Process Clause.

On January 31, 2011, the Third Circuit issued a temporary injunction against New Jersey’s statutory requirement that stored value card issuers obtain and maintain a record of the zip code of stored value card purchasers (American Express Travel Related Servs. v. Sidamon-Eristoff, No. 11-1141 (3d Cir. 1/31/11)). The law, which included a presumption that the place of a card’s sale or issuance was the purchaser’s address if the purchaser’s name and address were not known, was a not-so-subtle attempt by the state to collect unredeemed stored value card balances. Notwithstanding these and other decisions, states continue to increase enforcement efforts to shore up budget gaps. Along with this increased enforcement comes significant audit exposure and financial risk.

Traditional Taxes Versus Unclaimed Property

While traditional state taxes and unclaimed property both serve as revenue generators for states, there are some significant differences that are important to recognize. In addition to tax nexus rules and equitable methodologies for apportionment not applying to unclaimed property, most states have no or limited statutes of limitation. Even companies that have a long history of compliance may be shocked to find that an unclaimed property audit can cover a period of up to 25 years. And although no state provides written rules for estimating a liability when a holder’s records are “incomplete,” there are limited or no rights for holders to administratively challenge assessments that seem unreasonable or egregious. Another significant difference is that contract auditors, not state employees, usually perform unclaimed property audits. States typically compensate contract audit firms on a commission or contingent fee basis, creating an incentive for such firms to propose very large assessments.

A major factor in the discrepancy between money collected by states on audit and money returned to owners is the fact that estimation techniques are often used to determine a holder’s liability. An estimated liability is outright revenue for a state since there is no owner to whom the state can return the property. A company needs to change its approach when considering unclaimed property issues. Unlike traditional taxes, where liability generally relates to the geographies in which the company has a business presence, most risk and exposure for unclaimed property usually lies with the company’s state of legal domicile. Risk and exposure increases if there is a lax history of compliance or there are limited available historical financial records. Liability is typically estimated in such circumstances, and the state of legal domicile is generally entitled to claim the entire estimated amount.

Interestingly, while the Supreme Court has addressed unclaimed property jurisdictional rules several times (Standard Oil Co. v. New Jersey, 341 U.S. 428 (1951); Texas v. New Jersey; Pennsylvania v. New York, 407 U.S. 206 (1972); Delaware v. New York, 507 U.S. 490 (1993)), there have been no federal cases that address the use—or permissibility—of estimates. And the authors are aware of only one state case that has considered the use of estimates in the context of an unclaimed property audit (New Jersey v. Chubb Corp., 570 A.2d 1313 (N.J. Super. Ct. Ch. Div. 1989)). It is worth noting that in Chubb, the New Jersey court concluded that the jurisdictional guidelines established by the Supreme Court in Texas v. New Jersey were relevant only to conflicts among states, and the rules did not apply to disputes between the state and a holder.

Relevance to Tax Practitioners

The relevance of unclaimed property to tax practitioners should now be obvious. Despite the differences, as administered and enforced by a number of states, unclaimed property looks and acts very much like a tax. Unclaimed property compliance is also often an organizational hot potato. It is technically not a tax, and it does not fall squarely into any single corporate function—there are legal aspects of rights to unclaimed property, accounting records to be tracked and analyzed, and annual reports to be filed with states. As a result, frequently no department within an organization claims ownership. If a company has not specifically assigned unclaimed property responsibilities to a functional group, chances are that no formal unclaimed property policies and procedures or reporting processes exist. This leads to heightened risk of audit and potentially significant unfavorable financial implications. Unfortunately, when the audit notice comes, it will usually find its way to the tax practitioner, who will be charged with “fixing the problem.”

What should tax practitioners do? At a minimum, they should educate their company’s CEO, CFO, or general counsel. While they can be reminded that unclaimed property is not a tax, executives should be made aware of the potential risks and financial exposure. Taking further steps, practitioners can determine if there is a history of compliance and if someone in the organization already has responsibility for tracking and reporting unclaimed property. Evaluating the company’s current policies and procedures and its compliance processes will provide a starting point for addressing possible gaps. Next, estimate potential unreported liability. Factors to consider include the company’s history of compliance, the availability and location of owner and historical financial records, states in which the company conducts business, and most important, the unclaimed property laws of the company’s state of legal domicile. If the amount of estimated exposure is significant, the company should consider entering into a voluntary disclosure agreement with one or more states. Most states have formal or informal voluntary disclosure programs under which penalties and interest are usually waived and lookback periods are shortened. Finally, once historical exposure has been addressed, companies need to adopt policies, procedures, and processes for prospective compliance.

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