United States: U.S. District Court Finds Delaware Unclaimed Property Audit Procedures Unconstitutional

On June 28, 2016, the United States District Court for the District of Delaware determined that Delaware's unclaimed property audit procedures violated substantive due process.1 Specifically, the Court found that the technique used by Delaware to estimate a holder's Delaware unclaimed property liability subjected the taxpayer to liability imposed by multiple jurisdictions.

Background

The taxpayer, Temple-Inland, is a Delaware corporation principally engaged in manufacturing corrugated packaging with its primary place of business in Texas and additional operations in Indiana. In 2008, Delaware began an unclaimed property audit of Temple-Inland through the use of a contract auditor, which audited both accounts payable and payroll transactions. The audit period spanned 22 years, from January 1986 to December 2007. However, pursuant to its document retention policy, Temple-Inland could only produce complete books and records for its accounts payable and payroll beginning in 2003 and 2004, respectively. Temple-Inland also produced copies of its Delaware unclaimed property reports for its 1998 through 2008 tax years, as well as a couple of reports from pre-1998 years. Further, Temple-Inland produced two Texas unclaimed property audit reports relating to its 1985-2005 tax years.

For those years for which Temple-Inland did not have complete records, Delaware estimated its unclaimed property liability.2 To compute the estimate, the auditor based its calculations on the base years for which Temple-Inland had complete accounting records.3 Also, the auditor selected 217 of the highest value checks (purportedly on a random basis) and asked Temple-Inland to research these checks to determine if they were remediated or unclaimed property. Temple-Inland was able to remediate all but four checks from accounts payable totalling $4,508.73 and three checks from payroll totalling $805.90. Only one of these checks was associated with a Delaware address. Nevertheless, all of the checks were included in the calculation to estimate the total unclaimed property amount for the audit period. Specifically, the estimate was based on the total amount of the unclaimed checks divided by the adjusted sales amount in each of the base years. This amount was further adjusted by excluding sales for which payments were made by ACH rather than by check.4 Based on this estimate, Temple-Inland's liability was determined to be $2,128,834. The minimal amount of unclaimed property that Temple-Inland had previously reported to Delaware in its timely filed reports, $1,357, was deducted from the estimated liability in computing the amount assessed.

In response to the assessment, Temple-Inland filed an administrative appeal to the Audit Manager, who concluded that Delaware was forced to estimate a liability because Temple- Inland "failed to maintain records sufficient to permit the preparation of a report."5 The Audit Manager reduced the liability by $95,435 for two double-counted checks and increased the sales amount used in the denominator relating to the ACH payments, finding that the original adjustment was unreasonable. In April 2014, the Secretary of Finance adopted the adjustments and declared that Temple-Inland owed $1,388,573.97. Although the Delaware statute stated that Temple-Inland was to appeal to the Court of Chancery,6 Temple-Inland instead sued Delaware in federal district court, claiming that Delaware's audit procedures and use of estimation violated substantive due process, the takings clause and the ex post facto clause of the U.S. Constitution. The District Court took jurisdiction because of the constitutional claims.7

Delaware and Unclaimed Property

In consideration of the issues, the Court cited three historic factors contributing to the reason for this dispute: (i) Delaware's dependence on unclaimed property revenue; (ii) the United States' Supreme Court rules for escheating unclaimed property; and (iii) Delaware's historically lax enforcement of its unclaimed property laws. Notably, unclaimed property is Delaware's third largest revenue source, making it a "vital element" in the state's operating budget.8 Although the money still belongs to its owners, Delaware is permitted to treat collected amounts as general funds until claimed. Secondly, to address claims by multiple states attempting to escheat the same property, the United States Supreme Court has adopted a primary rule, which allows the first opportunity to escheat to the state of the owner's last known address, as shown by the holder's books and records.9 If the primary rule fails because the holders' records disclose no address for the owner, the secondary rule awards the right to escheat to the state in which the owner is incorporated. Since Delaware is the legal state of incorporation for a significant number of corporations, it benefits greatly from the secondary rule.

Despite this advantaged position, Delaware recognizes that taxpayer compliance with its unclaimed property tax laws, like that of most states, remains at less than 10 percent. As a result, most of its unclaimed property revenue results from its compliance efforts, which lacked a formal unclaimed property audit program until 2001. The Court observed that large corporations like Temple-Inland, with a "greater chance of escheatable property escheatable property being collected," tend to be the targets of these efforts.

District Court Decision

After making these observations, the Court addressed the taxpayer's assertions that Delaware's audit practices violated the substantive due process clause, the takings clause, and the ex post facto clause of the U.S. Constitution.10

Substantive Due Process

The Due Process Clause provides that no state shall deprive any person of life, liberty, or property, without due process of law, which the Court stated has at its core protection against arbitrary government action.11 The criteria of whether due process is violated depends on whether the plaintiff is challenging a legislative or executive action. While a legislative action can be sustained if there is a rational basis for the state to pursue a legitimate state interest, executive action violates due process only if it "shocks the conscience."12 As the Court noted, although there is precedence applying this test to civil matters, there is no precedence considering whether executive action with respect to unclaimed property shocks the conscience because most cases dealing with executive action involve claims of excessive force or physical brutality. Finding no precedence, the Court considered Delaware's combination of "troubling" audit procedures and found that they did shock the conscience and violated substantive due process.

Delaware's statute of limitations provides that Delaware may audit an unclaimed property report within 3 years from the date the report was filed, unless the report understates the liability in excess of 25 percent, in which case the statute of limitations is 6 years.13 If no report is filed, there is no statute of limitations. In this case, Temple-Inland admittedly did not file a report for each year of the look-back period. For these years, Delaware assumed that it had unreported unclaimed property, making these years open for audit. However, the Court recognized that there were several other possible explanations as to why Temple-Inland did not file reports. First, Temple-Inland might not have held unclaimed property during those years.14 Also, Temple-Inland could have actually filed reports, but disposed of them pursuant to their document retention policies.

Notably, Delaware is only one of four states which have not adopted a document retention statute, most of which require holders to keep records for a range between 5 and 10 years.15 Also, the Court noted that the Delaware General Assembly considered, but never passed, a law requiring holders to retain their records for 5 years, and questioned "what role, if any, Delaware's concern about reduced revenue played in its decision not to adopt a record retention statute."16 Specifically, the Court could "not help but wonder" that Delaware used the lack of a codified document retention requirement to wait to audit Temple-Inland so that the audit period could cover 22 years. Further, the Court found that Delaware did not give proper notice to holders that unclaimed property could be estimated if a holder did not keep its records. In summary, the Court found it troubling that Delaware sought to assess property in excess of the statute of limitations by expressly telling holders (other than financial institutions) that they do not need to file negative reports, failing to codify a document retention requirement, assuming that a lack of a report assumed that the holder had unclaimed property that it did not report, and placing the burden on holders to show that they had filed reports.

Temple-Inland claimed that Delaware's statute allowing for estimation violated due process because it allowed Delaware to apply estimation retroactively, covering years before the statute was enacted.17 The Court explained that in order for a statute to be applied retroactively, a state had to show that the retroactive legislation "shifted the benefits and burdens of economic life" between a party that created a harm to innocent parties who might not otherwise have the financial means to rectify that harm. By applying retroactive estimation to Temple-Inland, the state may benefit, but its owners do not. Instead, owners could find it even more difficult to claim money out of funds derived from estimation, since the state will not have the owner's name and address. In examining other decisions, the Court found that "burden shifting" legislation has previously been found constitutional in instances where states were experiencing a financial shortfall. However, Delaware's unclaimed property fund is not experiencing a financial shortfall, and Delaware has collected significantly more unclaimed property than it returns to owners. Delaware argued that even if the use of estimation precludes owners from claiming their property, it is better that estimated property is given to the state for public benefit. The Court responded by noting that, although unclaimed property should not become a windfall for holders, "unclaimed property laws were never intended to be a tax mechanism whereby states can raise revenue." While other cases have found that due process is not violated so long as raising revenue was not the only basis for estimation, Delaware could not point to any credible reason for using estimation other than to raise revenue.

Importantly, the court found that while estimation itself is permissible so long as it is based on a sound statistical basis, Delaware's use of estimation – notably using property due to other states in the numerator of the estimation ratio – created misleading results. Delaware argued that because the estimates applied to years for which the holder had no records, the property included was "unknown address" property due to the taxpayer's state of incorporation, Delaware.18 Rejecting this reasoning, the Court held that the estimation allowed in Texas v. New Jersey19 was based on holders that could identify actual transaction records, but did not have the associated name and address. It found that Delaware's "logic stretches the definition of address unknown property to troubling lengths."

Further, the Court found that Delaware's inclusion of property due to other states in its estimation calculation created the risk that Temple-Inland would be subject to multiple liability in other states. Temple-Inland was also audited by Texas for 19 of the same years included in Delaware's audit. To compute its audit assessment, Texas also used estimation based on Texas-addressed property, so that Temple-Inland paid at least $299,085 to both states related to the same property. Although Delaware asserted that other states were violating the secondary rule of Texas v. New Jersey20 by using estimation, the Court found that other states' laws do not limit the use of estimation under the secondary rule. Further, Delaware's statutory requirement to indemnify holders for liability imposed by multiple jurisdictions was inadequate, because there is no identifiable property in an estimation to which another state could prove it had a priority under the primary rule, especially if the other state also estimated the liability.

In summary, the Court stated that Delaware:

(i) waited 22 years to audit plaintiff; (ii) exploited loopholes in the statute of limitations; (iii) never properly notified holders regarding the need to maintain unclaimed property records longer than is standard; (iv) failed to articulate any legitimate state interest in retroactively applying Section 1155 except to raise revenue; (v) employed a method of estimation where characteristics that favored liability were replicated across the whole, but characteristics that reduced liability were ignored; and [(vi)] subjected plaintiff to multiple liability. To put the matter gently, defendants have engaged in a game of "gotcha" that shocks the conscience.

Takings Clause and Ex Post Facto Clause

While the court granted Temple-Inland's motion for summary judgment on substantive due process, the Court rejected Temple-Inland's claims under the takings and ex post facto clauses. The takings clause prevents states from taking private property without just compensation.21 The Court dismissed Temple-Inland's takings clause claim because Delaware could use estimation, if that method was reasonably applied, and there was still a dispute as to whether Delaware's estimation was reasonable in this context.

The ex post facto clause of the Constitution prevents the imposition of a law that punishes a person for an act which was not punishable when it was committed, or imposes additional punishment than prescribed at that time.22 The court dismissed Temple-Inland's ex post facto claim because a statute only violates this clause if it is a disguised criminal punishment, and there were factors that showed that the General Assembly did not mean the use of estimation to be a criminal punishment.

Commentary

Without doubt, this is a monumental decision that has the potential to change the landscape of Delaware and other states' unclaimed property audits and voluntary disclosure agreements. It is also a vindication of the arguments that many holders have been making for decades and have seen as obvious – that Delaware should have no right to estimate a liability based on the property due to other states. The decision could create a significant opportunity for holders that have remitted property to Delaware in past audits and voluntary disclosure agreements using Delaware's apparently unconstitutional methods to pursue adjustments. It may also encourage other states to expand the use of estimation not just to corporations domiciled in their states but to all holders based on property with in-state addresses.

However, this decision is appealable, and there are potential arguments that could be made by Delaware if such an appeal is taken. Although states other than the state of incorporation of a holder may estimate a liability in practice, this practice does appear to violate the secondary rule. Further, another court could find that raising revenue was not Delaware's only legitimate reason for requiring estimation, as the 3rd Circuit Court of Appeals found in N.J. Retail Merchants Ass'n v. Sidamon-Eristoff.23 While holders should continue to carefully watch whether Delaware appeals this decision, they should also review their past unclaimed property audits and voluntary disclosures. Holders currently under audit or pursuing a voluntary disclosure agreement should also consider whether the methodology being applied follows the conclusions in this case.

Footnotes

1 Temple-Inland, Inc. v. Thomas Cook, U.S. District Court for the District of Delaware, Civil No. 14- 654-GMS, June 28, 2016.

2 Delaware has historically estimated a holder's liability for years that the holder does not have complete accounting records. However, Delaware did not have statutory authority to estimate a liability until 2010, when the Delaware General Assembly amended DEL. CODE ANN. tit. 12, § 1155 to provide that where the records of the holder are insufficient to prepare a report, the State Escheator may reasonably estimate the amount due.

3 The base years were the 2003-2007 for accounts payable and the 2004-2009 tax years for payroll.

4 This conclusion was based on Delaware's view that ACH payments were less likely to be unclaimed property. The exclusion of these amounts resulted in a reduced denominator, which increased the unclaimed property percentage used to estimate the taxpayer's unclaimed property liability.

5 Pursuant to DEL. CODE ANN. tit. 12, § 1155, 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 Delaware 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. This statute was added in 2010.

6 DEL. CODE ANN. tit. 12, § 1156(j).

7 Temple-Inland Inc. v. Cook, Case 1:99-mc-09999 (May 21, 2014).

8 Delaware's General Fund Revenue Portfolio: a Report Submitted in Fulfillment of Senate Joint Resolution No. 5 144th Gen. Assembly, Dept. of Fin., Office of Mgmt. & Budget, Controller Gen. Office (Feb. 2008).

9 Texas v. New Jersey, U.S. Sup. Ct., 379 U.S. 674 (1965), et al.

10 Before examining these claims, the Court rejected Delaware's request that it abstain from ruling until Delaware had the opportunity to interpret its allegedly "ambiguous statute," DEL. CODE ANN. tit. 12, § 1155. The Court found the statute to be unambiguous and denied the request, which was based on the decision in Railroad Commission of Texas v. Pullman Co., 312 U.S. 496 (1941).

11 United States Constitution, Amendment XIV, § 1.

12 Ecotone Farm LLC v. Ward, 2016 WL 335837 (3d. Cir., Jan. 28, 2016), quoting United Artists Theatre Cir., Inc. v. Warrington, 316 F. 3d. 392 (Ed. Cir. 2003).

13 DEL. CODE ANN. tit. 12, § 1158

14 Delaware provides taxpayer guidance that negative reports are typically not required, except in the case of financial institutions.

15 The Court provided an Appendix listing the retention periods in each state.

16 See DE00001115 (noting that improved recordkeeping could reduce revenue from unclaimed property).

17 DEL. CODE ANN. tit. 12, § 1155, enacted in 2010.

18 Based on Texas v. New Jersey, U.S. Sup. Ct., 379 U.S. 674 (1965).

19 Id.

20 Texas v. New Jersey, U.S. Sup. Ct., 379 U.S. 674 (1965).

21 United States Constitution, Amendment V, XIV.

22 United States Constitution, Art. 1, §§ 9(3), 10.

23 669 F. 3d. 375 (3d. Cir. 2012). The Third Circuit Court of Appeals affirmed a U.S. District Court of New Jersey decision to preliminarily enjoin provisions of New Jersey's recently amended unclaimed property statute (Chapter 25). Importantly, one of the enjoined provisions would have created an assumption that, if the issuer sold a gift card in New Jersey and did not have the address of the owner or purchaser, the address of the owner or purchaser of the card would be the New Jersey place of purchase. New Jersey has since repealed the provision.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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