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Estimating unclaimed property liability: the wild west of accounting.

Complying with state abandoned and unclaimed property (AUP) reporting requirements has become a significant issue for many business organizations during the past 10 years. A handful of states have turned to their AUP statutes to generate growing amounts of revenue, sometimes catching companies off guard by imposing substantial assessments, which in some cases date back three decades. Delaware, the state of incorporation for thousands of U.S. companies, has been particularly aggressive in its pursuit of AUP assessments.

Companies do not need to take these assessments lying down. Such levies often are based on arbitrary and unpredictable estimates posited by contract audit firms working on a contingent fee basis. These auditors work without authoritative guidance on how estimated AUP liabilities should be determined. In fact, whether an estimated liability even is AUP might be open to debate. (1)

Case in Point: CA, Inc.

CA, Inc. (formerly known as Computer Associates) is just one company that has fallen victim to Delaware's AUP axe. In 2004, as part of a voluntary disclosure agreement (VDA) program that allowed holders of unreported AUP due to Delaware to come forward and report the property, CA informed Delaware that it had not filed AUP reports for 1991 through 2004. (Delaware conducts AUP audits going back to 1981, but its VDA program reached back only to 1991.)

In 2005, after working with consultants, CA reported its AUP liability as $684,000. Delaware rejected that amount and requested that CA recalculate its liability. After several rounds of negotiation, CA's offer had risen to $2.3 million in 2007. In 2008, after applying an estimation method developed by a contract audit firm, Delaware sent CA a report showing AUP liability of $7.6 million plus interest, totalling more than $8 million.

The parties sued each other in Delaware Chancery Court. (2) They ultimately settled in 2010, with CA agreeing to pay $17.6 million for the 1991 through 2010 period. (3)

Legal Authority for Estimating AUP Liability

AUP is 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, Guam, and a few foreign countries have AUP laws. AUP can include uncashed payroll and vendor checks, unapplied 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.

Notably, although AUP laws do not technically impose a tax, some states have applied their laws as such over the past 15 years. In these states, enforcement may be administered by state revenue departments, and property received may be treated as revenue in state budgets. AUP laws are not, however, subject to the same constitutional constraints as taxes. Without these constraints, the enforcement of AUP laws has mutated into a constitutionally questionable revenue collection exercise in certain states. (4) From 2001 to 2011, for example, Delaware collected almost $4 billion in AUP revenues. (5)

After a dormancy period expires, the holder of the AUP must turn it over to the state. But which state? The Supreme Court of the United has established jurisdictional rules for states' claims to AUP. Generally, AUP must be reported to the state of the rightful owner's last known address as reflected in the books and records of the holder. If the owner is unknown or the holder lacks the owner's address records ("no-address property"), the AUP must be remitted to the state of the holder's legal domicile (state of incorporation). (6) The Court also has established that the state of incorporation can claim property that is held by entities legally domiciled in the state if the owner's last known address is in a state whose laws do not provide for escheat.

Most modern AUP laws--including the AUP laws based on the Uniform Unclaimed Property Act of 1981 or the Uniform Unclaimed Property Act of 19957--have provisions that allow a state to estimate a holder's liability for AUP that the holder failed to report if the holder has not complied with recordkeeping requirements. (8) No state has issued guidance, however, on how to formulate a liability estimate. Moreover, no federal court ever has ruled on acceptable estimation techniques for determining AUP liability. In fact, no federal court has concluded that estimating a liability is even permissible. (9)

In recent years, some states, including Delaware, have seemingly applied a broad interpretation of the common law jurisdictional rules, relying on auditors' estimates rather than actual records to determine the amount of AUP that holders should submit to the state. These states assume that any estimated AUP liability represents no-address property, meaning the holder's state of incorporation is entitled to the entire amount. (10) Statutory, regulatory, and judicial authority for this interpretation seem to be nonexistent.

Only one state court ever has addressed the use of estimation in the context of an AUP reporting obligation. In State of New Jersey v. Chubb, (11) the New Jersey Superior Court considered the state's estimation methodology to compute uncashed checks. Additionally, it ruled that the state could estimate an AUP liability for a holder that was not incorporated in the state.

Commentators sometimes refer to Chubb to support the notion that states generally have the authority to impose an AUP assessment based on an estimate, but several factors make this contention dubious:

* Chubb was decided by the Superior Court of New Jersey, the lowest court in the state. A New Jersey trial court decision clearly has no precedential authority in other states.

* According to the decision, the defendant-holder in the case had "apparently ... transferred these items into income" on its books. In many instances when states estimate a holder's AUP liability, the holder has not taken unclaimed items into income.

* The liability proposed by New Jersey was based on the lowest of four statistical estimates. Although states' preliminary estimated assessments usually employ some type of numerical measurement, amounts ultimately paid often have little or no statistical or other quantitative support.

* The state's estimate of liability was based on the number of office locations of the holder in New Jersey, not on the holder's state of incorporation. This treatment runs counter to some states' view that estimated AUP should be remitted only to the holder's state of incorporation.

* The New Jersey AUP law expressly permits the state to base an assessment on "reasonable estimates," but only when a holder does not maintain owner records for the requisite statutory period of five years from the date the holder files an AUP report. (12) Delaware does not require holders to--or even suggest that holders should--retain owner records for any period of time. The AUP laws of virtually every other state, however, do have specific holder record-retention requirements. (13)

The Typical Contract Auditor Approach to Estimation

Many states rely on contract auditors who usually are compensated on a contingent-fee basis to perform AUP examinations. This compensation model provides a built-in incentive to apply the estimation techniques that generate the largest--some might say extreme--estimated assessments. A white paper on AUP laws issued by the Council on State Taxation summarizes this problem well:
   Contingent-fee arrangements encourage auditors to be overly
   aggressive, to interpret State laws to their own advantage rather
   than in society's best interest, to "cherry pick" audit targets,
   and to ignore holder errors that would result in lower assessments.
   The risk of abuse creates a perception of unfairness that colors
   holders' relationships with administrators and creates an
   atmosphere of mistrust that hinders compliance. Equally important,
   excessive payments to contingent fee auditors significantly reduce
   funds that would otherwise be available for the owners of the
   property or for the general revenue of the state. (14)


A quick review of the typical contract auditor approach to estimation illustrates the subjective nature of most estimated liabilities:

1. The contract auditor identifies a base period--a multi-year period starting with the earliest year for which complete books and records are available.

2. A sample is drawn from a population of potential unclaimed items, such as uncashed checks, from the base period.

3. The holder attempts to remediate identified exception items to prove they are not AUP, a challenging proposition in the absence of contemporaneous transaction-level detail.

4. All items that cannot be remediated to the satisfaction of the auditor are included in the numerator of an error rate (adjusted for any sampling techniques applied), regardless of the addresses associated with the unreconciled items. The denominator of the error rate typically is total sales during the base period.

5. The error rate is applied to annual sales for years prior to the base period to determine the total amount of AUP due and owing to the state of incorporation.

What Is "Reasonable"?

In the absence of formal guidance and appropriate holder records, AUP laws typically provide that the state can use a "reasonable" method to estimate liability. (15) The Delaware statute, for example, provides:
   Where the records of the holder available for the periods subject
   to this chapter are insufficient to permit the preparation of
   a report, the State Escheator may require the holder to report
   and pay to the State the amount of abandoned or unclaimed
   property that should have been but was not reported that the State
   Escheator reasonably estimates to be due and owing on the basis
   of any available records of the holder or by any other reasonable
   method of estimation. (16)


Significantly, the Delaware AUP statutes made no reference to estimating liability until July 2010. Prior to this time, there was no statutory provision that sanctioned the use of estimates. Additionally, Delaware does not have--

(1) recordkeeping requirements for unclaimed property;

(2) holder due diligence rules; or

(3) negative reporting requirement (except for banking organizations) that would require a company to file a report if it had no AUP to report.

Thus, for many holders, the amount that "should have been ... reported" to Delaware would be zero, or close to zero. Would not such holders have substantially complied with the state's reporting requirements, such that it is not reasonable to assess an estimated liability?

Consider this example: Company ABC is chartered in Delaware but conducts all of its business activity in Florida. Because it had no AUP in Delaware, it has not filed AUP reports. Delaware audits the company back to 1981 and finds that it does not have owner or address records dating that far back. Delaware then uses existing records for more recent years to deduce that X percent of Company ABC's payroll checks go uncashed and claims X percent of the company's payroll expense back to 1981, the entire estimated liability--even though the company's employees, and therefore the owners of any uncashed payroll checks, have always been Florida residents working in Florida. Is that "reasonable"?

Moreover, is it reasonable to estimate a liability going back 25 to 30 years? (17) To estimate a liability when a holder has a documented history of compliance in states with a higher-priority jurisdictional claim on the AUP? To conclude that all estimated liability is owed to the state of incorporation when data obtained by the state's auditors suggest that it should be sourced to a different state?

It could be argued that if it is reasonable to use estimation techniques purportedly grounded in unbiased statistical sampling theory to produce an estimate of liability, the same techniques can be applied to determine the no-address AUP liability allocable among various jurisdictions.

Companies should bear in mind that states other than the holder's state of incorporation are not necessarily precluded from applying estimation techniques (as demonstrated in Chubb). In the previous example, Florida could decide to audit Company ABC and assert that because all of the employees lived and worked there, the company owes Florida's estimate to the state.

Some states do take a more rational approach, estimating liability based only on AUP with addresses in the state. These states determine how many state-addressed items are AUP for the sample period and apply the resulting ratio to the years for which a company doesn't have sufficient records. They take this more narrow approach even for domiciliary companies (with the inclusion of actual sample period no-address property in the numerator of the ratio).

Challenging Times

Companies facing a significant AUP assessment need to realize that these assessments often are based on subjective and arbitrary estimates--and that no rules exist for formulating such estimates. The clear statutory requirement that an estimate be "reasonable," along with the dearth of any guidelines, provides ripe grounds for challenging unreasonable liability estimates, particularly those originating with incentivized contract auditors.

(1.) States' claims to AUP are based on state succession laws related to property rights. States hold property in a custodial capacity until the rightful owner or the owner's heirs claim the property. If a liability is estimated, there can be no identifiable--or for that matter actual--owner; therefore, is there any basis for the custodial taking and holding of property?

(2.) CA, Inc. v. Cordrey, Del. Ch. C.A. No. 4111-CC.

(3.) Pfeiffer v. CA, Inc., Case Nos. 4111-CC, 4195-CC (Del. Ch. 2010).

(4.) See Chris Hopkins and Matthew Hedstrom, Unclaimed Property Laws: Custodial Sail, keeping or Disguised Tax, Journal of MultiState Taxation and Incentives 22-35 (January 2012).

(5.) State of Delaware Department of Finance, Delaware Fiscal Notebook, 2011 Edition, http://finance.delaware.gov/publications/fiscai_notebook_11/fiscal_notebook_11.pdf.

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

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

(8.) See, e.g., the New Jersey AUP law, N.J. Rev. Stat. [section] 46:30B-94, which states that "If ... a holder does not maintain the records required ... and the records of the holder available ... are insufficient ... , the administrator may require the holder to report and pay ... the amount the administrator reasonably estimates, on the basis of any available records of the holder, or by any other reasonable methods of estimation acceptable to the administrator, that should have been but was not reported." Notably, however, New York does not appear to have a statute permitting the estimation of an AUP liability.

(9.) In Delaware v. New York, 507 U.S. 490 (1993), the Supreme Court rejected New York's proposal to use "statistical sampling" to demonstrate that "virtually all" the financial intermediaries had addresses in New York.

(10.) In circumstances where the audit sample data used for estimation includes owner name and address information, this approach appears to violate the common law concept of "mobilia sequuntur personam" (intangible personal property is found at the domicile of its owner) on which the primary jurisdictional rule as elucidated in Texas v. New Jersey is based.

(11.) 570 A.2d 1313 (N.J. Super. Ct. Ch. Div. 1989).

(12.) N.J. Rev. Stat. [section][section] 46:30B-94, 46:30B-95. See also NCCUSL Model Act of 1981, [section] 30(e); NCCUSL Model Act of 1995, [section] 20(f).

(13.) See also NCCUSL Model Act of 1995, [section] 21.

(14.) Jana S. Leslie, The Best and Worst of State Unclaimed Property Laws--Scorecard on State Unclaimed Property Statutes: The Holders" Perspective, Council on State Taxation (January 2009).

(15.) NCCUSL Model Act of 1981, [section] 30(e); NCCUSL Model Act of 1995, [section] 20(f).

(16.) 12 Del. C. [section] 1155 (2010) (emphasis added).

(17.) A new Delaware regulation, effective December 1, 2012, limits the look-back period for audits to 25 years--transactions beginning in 1986--as long as the audit is completed by June 30, 2015. PRACTICES AND PROCEDURES FOR RECORDS EXAMINATIONS, Section 2.3.1, Uncodified.

Chris Hopkins is a partner with Crowe Horwath LLP in the New York office. A certified public accountant, he received his B.B.A. degree in accounting from the University of Cincinnati College of Business. He formerly worked for Deloitte Tax LLP and Grant Thornton LLP. Mr. Hopkins can be reached at chris.hopkins@crowehorwath.com.
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Author:Hopkins, Chris
Publication:Tax Executive
Date:Nov 1, 2012
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