Unclaimed property audits: George Orwell would be proud.

In his book 1984, George Orwell described a totalitarian state where Big Brother monitored every person's movements and government employees, such as Winston Smith, worked in the Records Department of the Ministry of Truth, rewriting and altering records of the past.

Sound familiar? It does to some companies undergoing unclaimed property audits. If you don't understand the analogy, you have not been sufficiently educated regarding the scope of state unclaimed property laws or the incumbent problems in resolving unclaimed property audits.

After reading this article, you should have a better idea of the application of unclaimed property laws and the issues faced by companies in complying with -- and state auditors in enforcing -- such laws.

What Is Unclaimed Property?

The concept of returning unclaimed or abandoned property to its rightful owner originated in English common law. These laws developed to prevent entities or individuals with custody of another's property (the "Holder") from retaining such property for their own benefit. Otherwise, the Holder would have little or no incentive to locate the rightful owner and return the property.

Many state legislatures have adopted statutes incorporating this same concept. Under these laws, a business holding another person's property cannot legally retain the unclaimed property for its own benefit, but must make efforts to locate the rightful owner and return the property. If the Holder of the property cannot locate the rightful owner within a certain period of time (the "dormancy period"), it must turn over ("escheat") such property to the State.

Unclaimed property generally includes any type of property "abandoned" by its rightful owner. Historically, unclaimed property included stock certificates, dividend checks, and bank accounts never claimed by their rightful owner. Recently, however, states have expanded their audit focus to include assessments for uncashed payroll, refund, or vendor checks; unclaimed credit balances, credit memos or duplicate payments; deposits; and unredeemed gift certificates and rebates (a category of property typically referred to as "intangible" property). In many states, this category of property includes any intangible property held or owing in the ordinary course of business. As a result, the property subject to escheat is not the uncashed checks themselves, but the underlying debt, obligation or liability.

What Happens to Unclaimed Property?

A Holder must remit unclaimed property to the applicable state, based on the payee or creditor's "last known address," if available. If the payee or creditor's last known address is unknown, the Holder must generally remit the unclaimed property to the payee's state of incorporation (for a corporation) or domicile (for non-corporate businesses). The state then independently attempts to locate the rightful owner. If the rightful owner does not claim the property after a certain period of time, the state may permanently claim the property for the benefit of the general public.

Why Should a Company Be Concerned About Unclaimed Property?

Unclaimed property audits are about the hottest and most controversial issue in state and local tax circles. While incorrectly referred to as an unclaimed property "tax," unclaimed property assessments are really only an assertion of the payee's or creditor's property rights by a state government. The state government therefore has no greater rights to that property, but merely steps into the shoes of the payee or creditor, with one big exception. In most states, no practical statute of limitations exists.

Every company doing business knows that it must pursue its claims prior to the expiration of the applicable civil statute of limitations (the terms of which vary based on state law and type of claim). After that period expires, the creditor may not pursue the claim. If the creditor did pursue its claim, it would be required to prove affirmatively every element of its claim (e.g., the debtor agreed to purchase products or services; the price, quantity, timing, and quality of such goods or services; the proper and agreed delivery of such goods or services; and other terms).

The expiration of the relevant civil statute of limitations, however, typically does not prevent unclaimed property from escheating to the state. In addition, the unclaimed property laws effectively switch the burden of proof to the alleged debtor. If the debtor has made certain accounting entries or written checks, the debtor must prove that it does not owe any amounts to alleged creditors.

If you think that is an easy burden to overcome, consider how you would prove that you don't owe me $100. To make it slightly more difficult, prove you don't owe me $100 from ten years ago.

This example may seem exaggerated, but it highlights the key issue concerning unclaimed property audits -- the cost of compliance. The unclaimed property laws presume that property exists based on the issuance of a check or the making of a particular accounting entry. For example, many states presume that all outstanding checks, void checks, account receivable credit balances, and write-offs of such items constitute unclaimed property. The Holder must then prove -- often years after the records have been stored or destroyed for the underlying transaction -- that such check or entry did not constitute a legitimate liability or such liability was otherwise eliminated, negotiated, or resolved between the debtor and creditor prior to dormancy.

Multiply this burden by thousands of transactions for several different disbursement categories for numerous divisions and subsidiaries in various locations throughout the United States for 10 years and you have one gigantic compliance and substantiation problem.

Now you should see more clearly the Orwellian analogy. Like Big Brother, states enforcing unclaimed property laws must monitor almost every transaction between and among businesses in the United States, effectively acting as one large collection agent. Like Winston Smith, both the Holder and the auditor must slave over thousands of old records to decipher the truth as they see it.

Audit Issues -- A Working Example

Assume you are the tax director of a large corporation. In the past 5 or 10 years, your company has experienced dramatic growth. In fact, the company has changed MIS systems at least twice during that period, has outsourced its payroll function, has used two different stock transfer agents, has negotiated several third-party administrator contracts for health insurance and workmen's compensation, has adopted and eliminated numerous sales incentive programs, has made several stock acquisitions, and has never filed an unclaimed property report.

You are now contacted by the state for an unclaimed property audit. What do you do?

Generally, you must plan a structured and systematic review of the various unclaimed property issues, including answering the following questions:

* What entities or divisions should be subjected to the review?

* What material acquisitions have been made during the audit period?

* What years should be reviewed?

* What categories of potential unclaimed property does the company owe?

* What type of reporting format should be used for the review?

* What type of sampling, if any, should be used in the review?

* What types of exclusions can be made from the presumed liabilities?

* What types of documentation should be developed and retained to substantiate various exclusions from liability?

* What type of extrapolation, if any, should be used in the review?

The answers to these questions vary substantially depending on the size of the company, the availability of accounting records, the contract terms of the acquisition agreements, the category of potential unclaimed property involved, the state of incorporation, and, more important, the particular state law involved. The following paragraphs set forth examples of some of the issues that must be addressed prior to completing the necessary review.

1. Dormancy Periods Vary by State

States vary in applicable dormancy periods for the same category of unclaimed property. In developing a report of liability, a company must account for such differing periods. In addition, states may have different statutes and regulations regarding what constitutes a dormant transaction. For example, some state statutes allow companies to exclude transactions to the extent the company maintains a continuing relationship with the specific customer (for account receivable credit balances) or vendor (for outstanding checks). Other states may adopt a similar policy even without a specific statute. Still other states treat such transactions as dormant solely based on the date of the particular transaction.

Even in the latter states, however, a legitimate argument could be advanced to exclude transactions with continuing customers and vendors. Assume your company paid $100 to a vendor in 1992, 1995, and 1999; the vendor is located in a state with a five-year dormancy period; and the 1992 check is still outstanding. Some states take the position that the 1992 check is dormant and must be remitted to the state. You must remember, however, that the check is only evidence of the underlying liability. The company could therefore reasonably argue that the 1992 liability was resolved by payment of the 1995 check prior to dormancy; the 1995 liability was resolved by payment of the 1999 check; and the outstanding liability from 1999 is five years from being dormant. After all, the unclaimed property statutes do not specifically set forth an inventory system for liabilities.

2. Presumptions vs. Evidence

Unclaimed property laws typically presume that the issuance of a check is evidence that a company has determined that it owes a specific amount of money to a particular creditor. Thus, the company must prove that it paid or otherwise satisfied the underlying liability. A company may, however, routinely "cut" checks based on the receipt of invoices and thereafter match the invoices with receiving reports or purchase orders to determine the legitimacy of the invoices. In such a system, outstanding and voided checks do not necessarily represent true liabilities and the presumption of liability should be challenged. In resolving its unclaimed property liability, the company should always remember that the presumption of liability is only that -- a presumption. It should therefore develop evidence to counter that presumption, either on an item-by-item or system-wide basis.

3. Reserves vs. Liabilities

Many states assess companies not only for outstanding or voided checks, but also for liabilities that were swept into miscellaneous income or other accounts. Often times, an issue may exist concerning whether such amounts constitute legitimate liabilities or merely the establishment of reserves for potential or contingent liabilities. The former may or may not be escheatable; the latter should not be.

4. Stock vs. Asset Acquisitions

If the company makes stock or asset acquisitions of companies during the audit period, it must determine its exposure. In a stock acquisition, the continuing or merged entity arguably retains all liabilities including potential unclaimed property exposure. In an asset acquisition, the unclaimed property exposure may depend on the liabilities actually assumed by contract.

Even in a stock acquisition, however, there may not be a reasonable basis to determine or presume a liability for pre-acquisition years. For example, if the acquired company continues as a separate entity after being acquired and maintains the same accounting system, the use of subsequent information to extrapolate a previous liability may be appropriate. On the other hand, if that entity is combined or merged with another or several entities, there may be no basis to presume a liability for prior periods. The resolution of this issue therefore depends on the applicable state laws, as well as the applicability of a mutually agreeable extrapolation method.

What Should a Company Do?

If you have read this far, you probably have a good understanding of the analogy of Big Brother and 1984. You may even have uttered disbelief, coupled with a few expletives deleted. All is not lost, however.

1. The Need for a Business-to-Business Exclusion

A strong policy rationale exists for states to adopt a uniform business-to-business exclusion (i.e., effectively excluding the review of most receivables and payables). The ultimate costs for the states to audit business-to-business transactions and accurately calculate a company's liability and the costs for companies to defend such audits may likely exceed the amount of escheatable property. Modern-day receivables and payables do not merely include amounts owed on purchase transactions. Rather, these accounts are adjusted daily for purchases, volume discounts, rebates, advertising credits, slotting fees, returns, purchase price protection, and numerous other adjustments. It is virtually impossible for a company or the state to accurately track such amounts on the transaction-by transaction basis suggested by many unclaimed property laws.

2. States Efforts to Assist Compliance

Certain states have recently become more lenient in excluding business-to business transactions or allowing the exclusion of transactions with customers or vendors with which a company has a continuing relationship.

In addition, the National Association of Unclaimed Property Administrators (NAUPA) has organized a nation-wide voluntary compliance program whereby 39 states have agreed to waive interest and penalties for companies voluntarily reporting their unclaimed property liabilities by October 31, 1999. Some states, although not formally participating in the NAUPA program, have indicated a willingness to consider waiving interest and penalties. California, for example, is considering legislation that will establish a formal amnesty period beginning on January 1, 2000.

Conclusion

Companies need to take a proactive role in calculating and resolving their unclaimed property liability. In doing so, however, they must be mindful of the various issues, arguments and state programs available to them in determining and minimizing their proper liability.

TIMOTHY J. SWEENEY is a partner in Deloitte & Touche LLP's Los Angeles office, where he is the partner-in-charge of the firm's unclaimed property practice and also responsible for state and local tax services to Deloitte's largest clients in the western United States.