Preparing for an Estimated Liability Assessment in an Unclaimed Property Audit
Sara Lima and Freda Pepper, Reed Smith LLP
August 28, 2019
August 28, 2019
When initially faced with an unclaimed property audit, most holders believe that their company possesses very little to no unclaimed property. Unfortunately, these beliefs are quickly dispelled as holders traverse the audit landscape artfully sculpted by third party, contingent fee audit firms. By the end of an audit, holders learn that the audit techniques utilized by the auditors seemingly create unclaimed property. The method that can draw the most ire is the estimation of liability. Depending on the methodology used, holders can be hit with an assessment that is far in excess of any actual unclaimed property uncovered in an unclaimed property exam. Understanding the varying methodologies used by the states to estimate unclaimed property liabilities along with some suggested best practices will serve to guide holders to take the necessary steps to minimize such exposure.
Why is Estimation Used?
Estimation of liability is commonly used in both unclaimed property audits and unclaimed property voluntary disclosure agreements (VDAs). It is used to establish liability for years in which holders cannot provide complete and researchable records for testing. In its most simplistic form, states use estimation to establish past-due underreported liability in accordance with the respective lookback period when records do not exist. The combination of the length of the audit period, lack of available records, lack of what an auditor may deem “sufficient support,” and extrapolation methods used often leads to assessments well in excess of what a company believes is owed.
Most unclaimed property reviews comprise two types of liability: first, is the liability for which actual researchable records exist (known as base period or address property liability). The second is the liability derived through estimation because no records or unsupportable records exist (estimation years). The two types of liability reviews (address property and estimation) arise largely because the average state unclaimed property lookback period exceeds other business mandated record retention requirements. That is, the average unclaimed property lookback period is 10 to 15 years, while general IRS and banking guidelines typically require organizations to retain records for only a seven-year period. This creates a potential gap of six to eight years for which estimation would be used. Indeed, the unclaimed property laws are seemingly designed so that estimation is inevitable.
Delaware’s historical view, and perhaps the view of other states, was that only a company’s state of incorporation is entitled to amounts received in estimation used to establish an underreported historic liability in the absence of records. In more recent times, however, some states are enacting or contemplating estimation techniques in the form of a penalty for failure to keep records in accordance with state-specific unclaimed property record retention laws.
The Estimation Methods
Delaware has adopted an estimation method that calculates total liability regardless of the jurisdiction to which the specific property is owed. Stated differently, Delaware’s estimation calculation uses amounts from property deemed abandoned from ALL states during the years for which a holder has records as a basis to determine liability for the years in which the holder does not have records. This basis of estimation is often referred to as the gross method.
This is how it works: In the course of a multi-state audit the holder will be presented populations to research and remediate for the years in which records are available (base years). At the end of this phase of the audit, the total amount of unclaimed property due to all states will be calculated. An error rate will then be calculated using that total liability amount divided by an objective measure; typically the total revenue for each year in the base period, although other measures have been used.
Total Unclaimed Property Liability (ALL STATES) for researchable years
Total Sales for Base Period
The error rate is then applied to total sales for years in the audit review period when no records or unsupportable records exist to determine liability for those years.
Error Rate X Total Sales in Non-Base Period = Total Estimated Liability
The actual reportable property from the years in which records do exist is then added to the total estimated liability to determine the total liability owed.
Total Estimated Liability + Address Property = Total Liability
Holders typically receive a credit against the total amount of extrapolation owed for any previously reported amounts in the extrapolation period.
Because the error rate is calculated from liability to all states, the gross estimation usually leads to an estimated liability seemingly out of proportion to property actually deemed reportable to Delaware in the base period. For obvious reasons, this has created some controversy as most holders do not agree that it is reasonable or fair to use all states exposure to estimate exposures owed to Delaware, especially in cases in which the company conducts little or no business in the state. Similar arguments apply to other states that use the same method of estimation.
Delaware’s application of gross estimation in the context of an unclaimed property audit was called in to question in Temple-Inland v. Cook. There, Delaware stated that the use of estimation based on all states liability is premised on the logic that if records do not exist, then the address is unknown and therefore due to Delaware as the state of incorporation. According to the Court, however, the state’s “logic stretches the definition of address unknown property to troubling lengths. Because defendants employed estimation in a manner where the characteristics and qualities of the property within the sample were not replicated across the whole, it created significantly misleading results.” Despite the opinion in Temple-Inland, Delaware continues its gross estimation methodology in calculating liability in both audits and in its VDA program.
The net method of estimation is similar to the gross method in terms of application. However, the net method calculates an estimated liability on a state-specific basis. That is, under the net method an apportionment of liability to a particular state based on the direct unclaimed property to that state is calculated.
Specifically, the error rate is calculated based only on the property owed to the estimating state. If Delaware was using this method, for a Delaware incorporated company, the error rate would be calculated using the following formula:
DE Addressed Property + Unknown Property + Foreign + Previously Filed DE Items
DE Sales or Total Sales
Indeed, the error rate is directly tied to unclaimed property liability to just the state of Delaware during the period for which records exist. That error rate would then be applied to sales for years in the audit review period when no records or unsupportable records exist to determine the estimated liability. Like the gross method, previously reported unclaimed property is factored into any result as a credit against estimation in same years and actual reportable from the base period would be added to determine total liability. The result is an estimated liability that directly corresponds to the base period liability for that particular state.
The Intersection of the Estimation Methods
Various states have enacted laws providing for the use of the net method of extrapolation calculation over the years, including Florida, Ohio, and Texas, with Illinois the most recent. However, when net estimation is used to estimate liability for a holder who is also assessed liability by Delaware after utilizing gross estimation, the holder is caught in the middle and invariably exposed to multiple liability for the same property.
In Temple-Inland, Texas had, in fact, estimated unclaimed property based on outstanding payroll amounts to Texas employees for years in which records were available. However, Delaware, using gross estimation, had estimated property reportable to Delaware based on the same payroll amounts. The court objected to such double-counting, finding,
“It seems logical that if two states use the same property in the base years to infer the existence of unclaimed property in the reach back years, then a holder is being compelled to escheat the same estimated property to two states, in violation of the principles articulated in the Texas cases.”
It was Delaware’s position that the availability of indemnification overcomes the threat of multiple liability. However, the court found that when estimation is involved, indemnification is not sufficient protection as indemnification has historically been used in the context of a particular item of property remitted as abandoned. For example, when a specific item of property associated with an Illinois address is remitted to Delaware, state law requires Delaware to indemnify the holder against claims for that specific amount asserted by either Illinois or the owner. However, experience tells us that when another state makes an estimate based on the same property, Delaware does not appear to be willing to reimburse holders for the difference. Indeed, Delaware continued to claim its right to the Texas estimated amounts in Temple-Inland.
The Temple-Inland situation is not necessarily an outlier. Florida’s audit manual expressly permits estimation for companies either incorporated within the state or when “100% of the holder’s account represents Florida payees.” Accordingly, like Texas, when a Delaware-incorporated company employs all its personnel in Florida, Florida may estimate payroll exposure to Florida for years in which records are not fully available, based on amounts owed to Florida employees. Delaware, likewise, would estimate a liability, based on the same data, for such years.
Ohio also permits an estimation method inconsistent with Delaware’s view. The regulation articulates three alternative methods — the asset method, the sales method, or another method agreeable to the holder, the state, and the contract auditor. Both the assets and sales methods are based on “the average of actual annual reportable unclaimed funds with Ohio addresses.” Like Florida and Texas, the Ohio estimation method is based on amounts that Delaware would use to estimate liability to the state of incorporation, creating the imposition of multiple liabilities for the same item of property.
In 2018, the Illinois Department of Finance promulgated proposed regulations in support of recent legislation, which revised the unclaimed property act. Those regulations expressly contemplate “net” or “first priority estimation” inconsistent with Delaware’s position. In particular, the regulations require estimation for non-Illinois-domiciled entities to “reasonably approximate the amount of unclaimed property that should have been reported to Illinois if all reports had been filed and records had been maintained as required by the Act.” The regulation clarifies that “estimation should attempt to determine the amount of unclaimed property that should have been reported to Illinois under Sections 15-301, 15-302, and 15-303 (addressed property) and 15-304 (unaddressed property when the holder is domiciled in Illinois). In other words, Illinois estimation should be based on Illinois-reportable amounts.
In summary, states like Florida, Illinois, Ohio, and Texas are poised to implement estimation techniques more similar to that of the net approach. This creates the possibility of double liability assessments.
Steps to Take to Minimize Estimation
Understanding the impact of the estimation methodologies, holders can employ best practices in an effort to minimize the impact of estimation by the states.
- First and foremost, holders must evaluate and clarify record retention policies. Such policies should be crafted to be consistent with the average state reach back period (10-15 years) and should provide for the retention of documents auditors will demand in the course of an audit. Those documents include monthly bank statements, monthly void and outstanding listings, monthly reconciliations, check registers, void and check paid support, settlement documents, tax returns, and merger and acquisition documentation. There is no doubt expenses associated with retaining records for this period of time. However, the expense must be weighed against the savings that will be derived in the event of an audit. That is, significant estimation can be avoided for years for which records exist.
- Another helpful measure comes at the conclusion of an audit. When negotiating a final assessment, if possible, craft a closing document that ensures indemnification of all property and all periods reported, including property attributable to the estimated years. That way, you increase the likelihood of indemnification if another state estimates for the same years and property type.
- Undertake a self-assessment in order to understand your company’s vulnerabilities. Identify those gaps and initiate efforts to resolve them. As is often the case, it is not about what is actually owed, but rather an exercise in bookkeeping that can demonstrate what a holder does not owe. This can have significant impact on the numerator of either the gross or net method, whichever is used. Nevertheless, if the risk is determined to be material or shows little to no escheatment compliance, steps can be taken in state VDA or amnesty programs to relieve the risk, without penalty or interest in most cases.
- Challenge states using gross estimation. The methodology has already been called into question by one court. While not considered precedent due to procedural issues, it is illustrative of how an unbiased arbiter may view Delaware’s methods. Litigation, however, is only available in the context of an audit. Holders finalizing a VDA as part of Delaware’s VDA program, for example, relinquish their legal rights and will be required to accept Delaware’s estimation practices.
States continue to conduct audits and demand compliance. The number of third party audit firms and their state clients willing to use their services continue to rise. No doubt, the use of estimation by the states will escalate as well. Regardless of which method is utilized, gross or net, escheatment obligations can result in a multimillion dollar assessment for organizations depending on facts and circumstances. While there appears to be some conflict in the rules on which method applies, especially with recently adopted provisions in Utah and Illinois making extrapolation a penalty for failure to keep records, the states continue to pursue estimation. Preparation along with good record keeping can minimize the impact of the use of estimation. The most important goal, however, is that holders comply with state laws without paying more than their fair share if chosen for audit.
 Illinois RUUPA, 765 ILCS 1026/15-1006 and 1007 (“[E]stimation under this Section is a penalty for failure to maintain the records required by Section 15-404.”). See also Utah RUUPA, Chapter 4a, 67-41-1006, Failure of person examined to retain records (“[E]stimation under this Section is a penalty for failure to maintain the records required by Section 67-4a-404.”).
 Temple-Inland v. Cook, 192 F. Supp. 3d 527 (D. Del. 2016).
 Delaware’s position is rooted in the “priority rules” set forth by the U.S. Supreme Court in Texas v. New Jersey. 379 U.S. 674 (1965). The first priority rule declares that any property for which the owner’s last known name and address is known to the holder is subject to escheatment in that specific state. The second priority rule comes into effect when the address is not known; at that point property is reportable to the company’s state of.
 Temple-Inland, 192 F. Supp.3d at 549.
 Id. at 550.
 Id. at. 449-550.
 Del. Admin. Code tit. 12 section 104 – 2.24.2. Notwithstanding, the closing agreement required in Delaware’s VDA waives the holder’s right to indemnity to another claimant state for such amounts.
 Temple-Inland, 192 F. Supp.3d at 550.
 Florida Form DFS-UP-220
 Ohio Admin. Code 1301:10-3-04(J)(2).
 Id. at subsections (a) through (c).
 Id. at subsections (a) and (b).
 Illinois Proposed Rule 760.790(e) (Estimation), 42 Illinois Register 39 (Sept. 28, 2018) at 17209-17210.