Exemptions in unclaimed property: Fact or fiction?

"Escheat" refers to a jurisdiction taking possession of unclaimed property. What happens when multiple jurisdictions vie to claim such property? The Supreme Court has supplied a bright-line test and some jurisdictions have carved out escheat exceptions for certain types of property. This article addresses these and other issues.

Escheat (unclaimed property) laws can be traced as far back as feudal England; currently, 53 U.S. jurisdictions have them.(1) Obviously, there are innumerable differences between the laws then and the laws now. In feudal England, "escheat" meant that all land ultimately belonged to the king; when an individual died without an heir, the land rights and title reverted to the king as the ultimate owner. In contrast, jurisdictions today technically do not become the owners of unclaimed property; rather, they simply "step into the shoes" of the true owner and claim the same rights, second only to the missing owner's claim. Thus, if a jurisdiction takes possession of property as a holder for the true owner, should the true owner be located, the jurisdiction is legally obligated to return the property.

The Current Escheat Problem

Many practitioners would argue that jurisdictions today are claiming a greater right than that of the true owners. For example, an owner of a gift certificate generally cannot receive cash in exchange and instead must acquire merchandise. Jurisdictions; on the other hand, are requiring that the holder turn over cash, not the actual gift certificate. Some jurisdictions have attempted to mitigate this inequity by providing for an adjustment equal to either the holder's gross margin or a statutory flat rate. The theory is that, had the certificate been redeemed, the retailer would be entitled to its gross margin; thus, an implied profit is included in the certificate's face value.

Additionally, some practitioners would argue that, because jurisdictions are generally placing these funds directly into their coffers (in lieu of a trust or escrow account), they are not holding the property on behalf of the true owner, but using it for the jurisdiction's benefit.

Jurisdictions would vehemently contend that they are in the best position (and have the most incentive) to reunite an owner with property, rather than allowing it to remain with the holder (e.g., a corporation with unclaimed property in that jurisdiction). Additionally, if the true owner is never found, the theory is that it is better to use the property for the citizens' general welfare, rather than allow a holder to be unduly enriched. The dynamics of the unclaimed property laws are relatively straightforward; once an item of property has remained on a holder's books and records for a certain period without any activity or claim being made by the true owner, it is deemed abandoned. The length of time needed for the property to be deemed abandoned is the "dormancy" period, and varies by jurisdiction and property type. On abandonment, a holder must remit the property to the proper jurisdiction to hold for the rightful owner.

Increased Enforcement

Until seven to 10 years ago, the majority of jurisdictions did not aggressively enforce their escheat statutes. Jurisdictions have stepped up enforcement over the past five or six years, resulting in a barrage of audits and culminating in large assessments on holders. Arguably, the reason for such focus stems from the jurisdictions' sudden realization that unclaimed property can be a substantial source of revenue. Enforcement leads directly to greater revenue.

Jurisdictions would argue that unclaimed property is not a source of revenue, because they do not become the property's owner. However, because issuers do not track certain types of property by owner's name and address (e.g., gift certificates and customer credits), they ostensibly become revenue by default; jurisdictions do not have a means by which to reunite owners with such property.

Expanded Definition

While the genesis of modern unclaimed property laws stems from the banking, insurance and securities industries, the laws have been expanded to encompass a broader range of property types. Gift certificates, payroll checks, electronic gift cards, security deposits, mineral rights and royalties are among a plethora of property types now subject to escheat in various jurisdictions. Although the current laws may resolve who is entitled to unclaimed property as between a holder and a given jurisdiction, what happens when different jurisdictions each assert a right to the same unclaimed property? The 1954 Uniform Disposition of Unclaimed Property Act (Uniform Act) attempted to answer this question, but the U.S. Supreme Court ultimately resolved this issue in a series of cases that yielded a bright-line test to determine the priority of conflicting claims.

Supreme Court Decisions

Texas v. New Jersey

The first in a series of Supreme Court decisions was Texas v. New Jersey,(2) decided in 1965. The case involved a multistate oil company incorporated in New Jersey, with a principal place of business in Pennsylvania and outstanding debts in several other jurisdictions. The unclaimed property in issue was numerous uncashed small checks to creditors either located in Texas or evidenced on the books of the company's two Texas offices.

The Court created a "first priority rule" that the jurisdiction of the owner's last-known address, as shown on the holder's books and records, is entitled to custody of the unclaimed property. The Court also created a "second priority rule"--the jurisdiction in which the holder is incorporated presides as custodian when the owner's address is unknown.

Pennsylvania v. New York

The Court reaffirmed that decision in Pennsylvania v. New York,(3) which rejected Pennsylvania's argument that the jurisdiction in which the transaction occurs should be entitled to property when the holder, as a matter of course, does not record owner information. The Court did not want to distort the bright-line test established in Texas v. New Jersey. It thus held that owner-unknown property escheats to the state in which the debtor is incorporated.

Delaware v. New York

The Court reaffirmed its two prior decisions in Delaware v. New York.(4) That case involved competing claims between those states for the right to escheat hundreds of millions of dollars of unclaimed dividends and interest held by brokerages and other financial intermediaries for beneficial owners with unknown addresses. Delaware contended that it was entitled to the funds because the brokerages were incorporated in Delaware; New York countered that it had the right to the funds because the brokerages' principal executive offices were located there. The Court agreed with Delaware, holding that the jurisdiction in which the holder is incorporated can escheat funds belonging to unidentifiable beneficial owners. In rejecting the Special Master's proposed ruling to the contrary, the Court reasoned:

Precedent, efficiency, and equity all dictate the rejection of the [Special] Master's "principal executive offices" proposal. We accordingly adhere to Texas and Pennsylvania and award the right to escheat under the secondary rule to the State in which the debtor is incorporated.(5)

This series of cases established a bright-line test for primary and secondary priority. In essence, the first priority rule provides that the primary right to escheat a given item of intangible property belongs to the jurisdiction of the owner's last-known address, as shown by the holder's books and records. When the holder's books and records contain no owner information, the second priority rule dictates that the jurisdiction of the holder's domicile is entitled to claim the property. That jurisdiction is also entitled to the property when the jurisdiction of the owner's last-known address does not provide for escheat of such property. Finally, a jurisdiction claiming property under the second priority rule may retain the property "for itself only until some other State comes forward with proof that it has a superior right to escheat" under the first priority rule.(6)

The second priority rule (as developed in Texas v. New Jersey and Delaware v. New York) focuses on a holder's domicile (i.e., the holder's jurisdiction of incorporation(7)). However, while both the 1981 and 1995 Uniform Acts follow Texas v. New Jersey and award the secondary right to escheat to the jurisdiction in which the holder is domiciled, when the holder is not a corporation, the Acts define "domicile" as the jurisdiction of a noncorporate holder's principal place of business.

Third Priority Rule

A number of jurisdictions have enacted a third priority rule, based on the assumption that Texas v. New Jersey does not limit their powers to escheat property that no jurisdiction is entitled to claim under the first two priority rules. This so-called "third priority rule" enables a jurisdiction to escheat property if "the transaction out of which the property arose occurred in this state"; this language was adopted in the 1981 and 1995 Uniform Acts.(8) A multijurisdictional review of unclaimed property laws reveals that, by adopting either the 1981 or 1995 Act, 33 jurisdictions have, in effect, enacted a third priority role.(9)

However, there is at least some basis for the position that the Texas v. New Jersey, priority rules are jurisdictional and preempt any jurisdiction's third priority rule. The Supreme Court indicated at the outset of that opinion that it was settling a "controversy as to which State has jurisdiction to take title to certain abandoned intangible personal property through escheat.(10) Moreover, the Court expressly stated that it was abandoning any sort of "contacts" test for determining which jurisdiction has a superior right to escheat. Prior to Texas v. New Jersey and beginning in the 1940s and 1950s, the Court had resolved jurisdictions' competing claims against holders of unclaimed property doing business in numerous jurisdictions in favor of the jurisdiction with which the holder had the most significant contacts. The Court distanced itself from the contacts test in Texas v. New Jersey:

The "contacts" test as applied in this field is not really any workable test at all--it is simply a phrase suggesting that this Court should examine the circumstances surrounding each particular item of escheatable property on its own peculiar facts and then try to make a difficult, often quite subjective, decision as to which State's claim to those pennies or dollars seems to be stronger than another's.(11)

Arguably, the jurisdictions that have a third priority rule have effectively adopted a contacts test in contravention of Texas v. New Jersey. Ascertaining the location of a transaction that produced a given item of intangible property will, in many instances, involve factual vagaries similar to those produced by the contacts test (e.g., where does the transaction occur when intangible property is purchased remotely). Such an extension of the priority rules may be of questionable validity.(12)

Although a jurisdiction's third priority claim ultimately may not be successful, a jurisdiction in which a transaction occurred could attempt to raise the third priority rule to claim funds under its default provisions. The holder would likely have to litigate to resolve a third priority claim or reach a settlement.

Current Trends

In the past few years, a number of jurisdictions have enacted or amended their unclaimed property statutes to exempt some property types usually subject to escheat, such as gift certificates, credit memos, and business-to-business (13213) transactions. While jurisdictions have always created carveouts for various property types and special-interest groups, the difference between the current trend of new exemptions and the pre-existing ones is the indistinct rationale for the former.

Older Exemptions

In general, the older exemptions have an apparent purpose, whether to appease special interest groups, provide a competitive advantage to certain holders or provide a level playing field for corporate citizens. Obviously, lobbying and politicking surrounded many of the exemptions available to holders today.

For example, in Delaware, a fast-food franchise lobbied for and received an exemption for gift certificates for $5 or less used for the purchase of food.(13) Another example is Florida; theme-park admissions are exempt if the park meets certain requirements.(14) While this would seem to benefit all enterprises involved in local carnivals, entertainment and amusement parks, the exemption applies only to theme parks having one million visitors per year, at least 25 contiguous acres with permanent exhibitions and a variety of recreational activities,(15) A final example is Indiana--B2B transactions are exempt from escheat if one of the businesses is in the trucking industry.(16) These three examples, as with many exemptions, make it clear which companies were behind exemption lobbying efforts and the benefit they received on enactment. This is not necessarily true with the current trend of exemptions codified by many jurisdictions over the last few years.

Recent Exemptions

As an example, recent Virginia law exempts gift certificates from escheat. However, for a holder to benefit from the new law, one of the following would have to occur: there is no owner information and the holder is incorporated in Virginia; the owner's address is in Virginia and the holder is incorporated there; or the jurisdiction of the owner's last-known address is Virginia and the holder is incorporated in a jurisdiction that also exempts gift certificates from escheat. Although Virginia's new law may be aimed at benefiting Virginia-incorporated entities, unless these holders fall into one of these situations, the exemption only serves to shift the property from Virginia to the holder's legal domicile by application of the second priority rule.

B2B transactions: The trend toward exempting B2B transactions presents another example of an exemption with little effect in reducing a large multijurisdictional company's escheat liability. For the exemption to be of benefit, the holder must be legally domiciled in a jurisdiction that exempts B2B transactions; the owner's last-known address must also be in a jurisdiction exempting B2B transactions or must be unknown.

Example: Merchant M is domiciled in a state that exempts B2B transactions (such as Maryland), and purchases a product from a vendor that never deposits the check. If the vendor's address is also in Maryland or another jurisdiction that exempts B2B transactions, the check would not be subject to escheat; M could potentially reverse the uncashed check back into income.

Because only nine jurisdictions currently have a B2B exemption, a holder can receive a benefit from such exemption in relatively few situations.(17) Moreover, the holder can never receive the benefit of this exemption if it is domiciled in any jurisdiction other than those nine jurisdictions. For holders domiciled outside of these nine jurisdictions, a check would properly escheat to the jurisdiction of legal domicile under the second priority rule, even if it were exempt under the first priority rule. Thus, numerous conditions must be met for a holder to receive a benefit from B2B exemptions.

Given the conditions that must be met for a holder to receive a benefit, some question why jurisdictions are enacting these and similar statutes. One possibility is to encourage those businesses currently domiciled in the jurisdiction to remain there by giving them a special exemption. However, many of the small businesses already formed within the jurisdictions providing these exemptions probably do not even realize that they have an unclaimed property filing obligation (and are unlikely to be filing unclaimed property reports or remitting property). Additionally jurisdictions could be enacting these exemptions to attempt to attract businesses to incorporate or reincorporate therein. Finally, the jurisdictions may be enacting these exemptions for public relations reasons. States like Virginia generate very little revenue from dormant gift certificates; by allowing an escheat exemption, it may be creating a pro-business perception that potentially attracts businesses to the state without losing much potential revenue.

Although the reasoning behind some of these exemptions may not be readily apparent, many holders appear to be lobbying for them. Why, given the conditions that must be met to take advantage of a B2B exemption? Given their access to a wealth of resources available (including holder advocacy groups), it is unlikely that they do not fully understand the application of the law and the priority rules of Texas v. New Jersey and Delaware v. New York. One likely scenario may be that one or more tax, industry and special interest advocacy groups representing these holders are lobbying for these exemptions on a jurisdiction-by-jurisdiction basis, hoping to create a trend in which all (or most) jurisdictions will ultimately exempt these transactions. However, as many large companies are incorporated in Delaware, unless Delaware enacts a similar exemption, holders incorporated in Delaware will receive no benefit from other jurisdictions enacting these exemptions, as the property would still revert to Delaware by virtue of the second priority rule.

Whatever the reasons for the enactment of these exemptions, it is clear that they present both potential planning opportunities and pitfalls. To the extent possible, holders will want to structure their transactions to take the fullest advantage of the limited exemptions available. At the same time, they should appreciate that the priority rules can operate such that the exemptions have no practical effect other than to shift escheat liability from one jurisdiction to another.

The 10-year Compact

One final explanation for the recent changes taking place to the unclaimed property laws may be the expiration of the reported 10-year "compact" between Delaware, New York and Massachusetts (on one side) and 47 jurisdictions on the other, that agreed not to challenge the Delaware v. New York decisions for 10 years. In exchange, Delaware, New York and Massachusetts agreed to remit approximately $182 million to the other jurisdictions over that period.

The agreement was the result of the Supreme Court's reaffirmation in Delaware v. New York of its earlier decision in Texas v. New Jersey. Both cases held that owner-unknown unclaimed property is reportable to the holder's state of incorporation, which resulted in a windfall to Delaware, the state of incorporation of a large number of publicly held companies. By holding as it did, the Court apparently left the other jurisdictions with no recourse other than to lobby Congress for a law change. Given the combined power of the various jurisdictions involved, such a law change would seem imminent. In fact, such legislation had already been proposed as the Equitable Escheatment Act. It was not passed, due in part to New York's efforts in the negotiations that resulted in the 10-year compact.

This change would have left Delaware with very few funds stemming from unclaimed property, which currently is that state's third-highest revenue source (after personal income and corporate franchise taxes), resulting in approximately $159 million in revenue last year. Clearly, it is easy to see why Delaware would be willing to enter into such an agreement. By ensuring that none of the other jurisdictions would lobby Congress to challenge the decision, Delaware would presumably receive a windfall (at least for the agreement's term).

Incidentally, Congress has already passed such a law (in a limited capacity) when it statutorily instituted a predominately transaction-based test for traveler's checks and money orders.(18) The law is very narrowly tailored; the test can be used only to capture funds from travelers' checks and money orders sold within the jurisdiction's boundaries or by the jurisdiction in which the issuer's principal place of business is located.(19)

While very few people have even seen the compact in writing (and others consider it merely a myth), conversations with various jurisdictions' unclaimed property administrators have confirmed that a compact does exist. This explains why other jurisdictions, having the power to change the laws in Congress, have done nothing to force a change. In the absence of such a compact, the other jurisdictions would not likely have allowed Delaware to receive this windfall of revenue from unclaimed property.

One pressing question is what will happen in 2003, when the compact is scheduled to expire. Will the other jurisdictions rush to Congress to seek law changes or simply ignore the situation? What would most jurisdictions have to gain from such law changes? Jurisdictions with a large amount of business transacted within their boundaries (e.g., New York, Texas, Pennsylvania, Ohio, California, Illinois and Florida) may stand to gain significantly from a law change. However, most other jurisdictions would not realize any significant increase in revenue from unclaimed property if the laws were transaction-based. Thus, what does the expiration of the agreement among the jurisdictions mean to them? Perhaps the development of the current trends (discussed above) indicates how these jurisdictions view the expiration of the compact; they do not see a sufficient amount of unclaimed property to warrant much attention. However, it is still highly unlikely that any jurisdiction is going to relinquish a potential source of revenue merely because the amount appears, at first glance, insignificant.

In the end, a review of the current exemption trends raises more questions than it answers. At first, the exemptions seem to be extremely favorable, but the question remains--why are increasingly more jurisdictions enacting new changes to the unclaimed property laws? Perhaps time will tell.

EXECUTIVE SUMMARY

* Jurisdictions would contend that they are in the best position to reunite an owner with his property, rather than allowing it to remain with the holder.

* Once an item of property has remained on a holder's books and records for a certain period without any activity or claim being made by the true owner, it is deemed abandoned.

* Gift certificates, payroll checks, electronic gift cards, security deposits, mineral rights and royalties are among a plethora of property types now subject to escheat in various jurisdictions.

(1) The 50 states, District of Columbia, Puerto Rico and Guam.

(2) Texas v. New Jersey, 379 US 674 (1965).

(3) Pennsylvania v. New York, 407 US 206 (1972).

(4) Delaware v. New York, 507 US 490 (1993).

(5) Id. at 507.

(6) Texas v. New Jersey, note 2 supra, at 682.

(7) Id. at 679.

(8) See Section 3(6) of the 1981 Uniform Act; Section 4(6) of the 1995 Uniform Act.

(9) These jurisdictions are: Alaska, Arizona, Colorado, Connecticut, District of Columbia, Honda, Georgia, Hawaii, Idaho, Indiana, Kansas, Louisiana, Maine, Maryland, Michigan, Montana, New Hampshire, New Jersey, New Mexico, North Dakota, Oklahoma, Oregon, Rhode Island, South Carolina, South Dakota, Tennessee, Texas, Utah, Virginia, Virgin Islands, Washington, Wisconsin and Wyoming.

(10) Texas v. New Jersey, note 2 supra, at 675; but see New Jersey v. Chubb Corp., 540 A2d 1313 (NJ Super. Ct. 1989), and Texas v. Liquidating Trustees of Republic Petroleum Co., 510 SW2d 311 (TX Sup. Ct. 1974), which indicate that the Texas v. New Jersey priority roles were intended only to resolve jurisdictions' competing claims to the same unclaimed property.

(11) Texas v. New Jersey, note 2 supra, at 679.

(12) See American Petrofina Co. of Texas v. Nance, 697 FSupp 1138 (WD OK, 1986), aff'd, 859 F2d 840 (10th Cir. 1988) (state law was pre-empted to the extent it conflicted with the priority scheme established in Texas v. New Jersey, note 2 supra).

(13) See 12 Del. Code [sections] 1198(10).

(14) Fla. Stat. Ann. [sections] 717.1355.

(15) Fla. Stat. Ann. [sections] 509.013(9).

(16) SB 227 (effective 7/1/00), amending IC [sections] 32-9-1.5-17(7)(C).

(17) At press time, the following states had a form of a B2B exemption on their books: Arizona, Illinois, Indiana, Kansas, Maryland, North Carolina, Ohio, Virginia and Wisconsin.

(18) 12 U.S.C. [subsections] 2501-2503.

(19) Travelers Express Co., Inc. v. Minnesota, 664 F2d 691 (8th Cir. 1981).

For more information about this article, contact Mr. Hall at [e-mail].

Noel E. Hall, Jr., CPA
Senior Manager
State and Local Tax
Andersen LLP
Los Angeles, CA

Matthew B. Chenowth, J.D., LL.M.
Senior Consultant
State and Local Tax
Andersen LLP
Los Angeles, CA

Garth V. Jensen, J.D.
Consultant
State and Local Tax
Andersen LLP
Los Angeles, CA