Unclaimed property audit fallacies and myths.

• Author: Hopkins, Chris

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...