In the early 1900s, Delaware established itself as the place for corporations to incorporate. Delaware consciously set out to become the state to be incorporated in by establishing an advanced corporation statutes, a highly respected Court of Chancery, and a proactive Secretary of State's office. As a result of these efforts, over half of the current Fortune 500 companies are incorporated in Delaware and the state has over one million registered entities. Virtually every provision of the Delaware corporate code has been addressed in case law by the Court of Chancery, giving large corporations a large amount of certainty in any actions they take or disputes they encounter.
This certainty is almost completely wiped out when unclaimed property is thrown in the mix.
Unclaimed Property in Context
Unclaimed property is not a tax, rather it is a property right. The goal of unclaimed property statutes is to reunite lost property with the rightful owner. Historically, escheat was used to return land back to the Crown, to put it back into useful production during feudal times. In the United States, escheat was limited to decedents without heirs under a will or the laws of intestacy and then to corporate stock. Over time, property types were added, including corporate bonds and bank accounts. It was only relatively recently that general corporations came under the purview of unclaimed property, reporting wages, vendor checks, accounts receivable credits, gift cards, and rebates. Under the modern unclaimed property statutes, all companies (called holders) are required to turn over to the state any property that rightfully belongs to someone else. The state then holds the property, usually in perpetuity, until the rightful owner claims the property.
After conflicting claims by several states over the same property, the United States Supreme Court, in Texas v. New Jersey and subsequent cases, established a reporting priority. The first reporting priority is to the state of the owner of record, as established by the holder's books and records. If the books and records do not establish a first priority reporting requirement (no name or no address), then the second priority is triggered and the property goes to the holder's state of incorporation.
How to Increase State Revenues Without Taxes
Delaware uses this second priority as the basis for most of its unclaimed property collections. Since the second priority rule requires either no name or no address and most people would never think to search in Delaware for their unclaimed property, the state is able to convert almost all of its collections into general revenue for the state. According to the Delaware Economic and Financial Advisory Committee ("DEFAC"), in fiscal year 2012, Delaware collected $319.5 million in unclaimed property. Claims are not specifically listed in the budget as a separate item, but are instead lumped in "Other Refunds" of $34.1 million. "Other Refunds" does not include personal or corporate income tax or franchise tax refunds, but could include refunds relating to business entity fees, UCC fees, lottery, and miscellaneous other taxes. In any case, the amount is so miniscule that it does not even require a separate line entry on the DEFAC General Fund Revenue Worksheet.
Through May 2013, Delaware had collected over $566.5 million. DEFAC predicts another $500-$550 million for each of the next fiscal years. That is over half a billion dollars, annually, to the state's general fund in money that belongs to someone other than the state. Money that the state never intends to return to any specific individual. However, the state can find plenty of other uses for the revenue. $155 million was used on infrastructure programs in the state, to maintain roads, parks and public buildings.
To maintain the steady flow of unclaimed property revenues, the state has engaged the services of several outside audit firms. The lead auditor on the majority of cases, and the auditor that is most closely associated with Delaware, is Kelmar Associates. Kelmar is generally paid on a contingent fee basis, although there are aspects of consulting work the firm does on behalf of the state for which it is paid an hourly fee. This pay arrangement, coupled with the state's goal of increasing revenue, has provided all the necessary incentive for Kelmar to become the aggressive foe that it is for corporations incorporated in Delaware.
In an unclaimed property audit, Kelmar will examine in detail a company's records for any source of money that might belong to someone other than the company under audit. They will ignore logical assumptions, written contracts, and rules of evidence. When records are unavailable for review, which is likely in an audit going back to 1981, Kelmar will make guesses at what the company should have reported as unclaimed property if the records had been available through a process called extrapolation. In this process, they will often ignore the fact that the company may have accurately reported unclaimed property when it had the necessary records available. Remember, most companies retain no more than seven years of records, under federal tax statute of limitations and SEC requirements. Yet, these audits can cover up to 30-plus years worth of transactions.
Even the voluntary disclosure or compliance program was no safe harbor for companies. Under a voluntary disclosure agreement ("VDA"), a company would come forward with unclaimed property, for the purposes of coming into compliance without the need for an audit. In return, the company would receive a waiver of all penalties and interest associated with the reported property. Furthermore, the company could book-end potential liability for covered property types, periods or subsidiaries. However, this process did not work as intended in Delaware. Two recent cases illustrate the problems with VDAs in Delaware - Staples, Inc. and Select Medical Corporation. Both companies entered into the VDA program and then paid money over to the state only to be subject to a full-scale audit by Kelmar after the fact. These audits then led to litigation in the Court of Chancery. Unfortunately for Staples, Delaware's Court of Chancery did not live up to the pro-business reputation and ruled on some preliminary matters in favor of the state, the same state's budget that paid the Court's salaries and expenses. Staples later settled out-of-court. Select Medical has just begun the litigation process and no results have been reached yet.
Delaware estimates that only 6% of Delaware incorporated companies voluntarily complied with the state's unclaimed property laws. This ignores all the companies that are holding companies and shell companies with no operations, nor all the subsidiaries that may be filing in coordination with parent companies. Regardless of the real compliance rate from operating companies, Delaware has begun a campaign to audit each entity incorporated in the state.
Recent Criticisms of Delaware's Unclaimed Property Program
In January 2009, the Council on State Taxation ("COST") did a comprehensive review of all 50 states' unclaimed property laws and implementation. It ranked the states on seven criteria, important to corporations, like business to business exemptions, appeals processes, auditors, and statute of limitations. Delaware was the only state to receive an F. Delaware has no exemptions, no statute of limitations, no independent appeals process, and imposes excessive interest and penalties on holders for failure to comply.
In 2012, after years of increasing criticism of the Department of Finance's handling of unclaimed property, the Secretary of State convinced the state legislature that an alternative method of voluntary disclosure was needed. As part of the program, the state was statutorily prohibited from auditing a company if it successfully completed the VDA process and maintained compliance. However, a company was not eligible to participate in the Secretary of State program if the company was currently under audit. Therefore, the Department of Finance began issuing audit letters in February 2013, with over 125 new audits currently underway.
On August 1, 2013, the head of the unclaimed property program, Mark Udinski, stepped down from his position. Even this was not without criticism, as Udinski immediately moved into a senior role with Kelmar Associates. Udinski authorized the unclaimed property audits and then joined the contingent fee audit firm responsible for conducting those audits. Udinski's former boss, Tom Cook, the Secretary of Finance, insisted that there was no conflict of interest with Udinski joining Kelmar. This is no surprise, considering that Udinski's predecessor, Patrick Hurley, also left state employment to immediately go to work for Kelmar. Meanwhile, the Deputy Secretary of Finance that was responsible for the DEFAC budgets has been named as the new Delaware State Escheator.
It Doesn't Have to Be This Way
It has become a matter of not if, but when a company will undergo an unclaimed property audit if it is incorporated in Delaware. These audits are no easy matter, either, as the record requests are voluminous and resource consuming. The potential liability could run into the tens, if not hundreds, of millions of dollars, not even accounting for legal fees. These audits are disruptive to business processes, with allegations of being uncooperative if responses are delayed because all resources are tied up in year end closing. It is no wonder that corporate advisers are looking elsewhere to incorporate.
For years, Barganier has recommended that companies not incorporate their entities in Delaware. However, there are more concerns than just unclaimed property when incorporating - the overall business environment, the certainty of laws and administrative rules, and tax friendly approaches. However, all states have now established comprehensive corporate laws, leaving Delaware as one among many. Other states have no state corporate income tax and thus no information sharing with other jurisdictions, notably the Internal Revenue Service. The increased aggressiveness of the state's unclaimed property enforcement is killing the overall pro-business culture that Delaware once established, leaving the state with no advantage over competing jurisdictions for companies' incorporations.
Human Events: Unclaimed, Unreal Property May 9, 2013
American Spectator: Delaware’s Unclaimed Property Racket: John Gotti Would Be Proud May 16, 2013
Forbes: Once A Friendly Locale To Business, The Modern State Of Delaware Is A Bully May 16, 2013
WSJ: Delaware Shows Two Faces June 18, 2013
Overlawyered: Delaware: your escheating heart July 11, 2013
Red Alert Politics: Delaware companies find staying in the state comes at a high price July 13, 2013
BNA: Unclaimed Property Lurks Beneath Delaware’s Business Friendly Surface August 5, 2013
Cape Gazette: Lopez finds partisanship worse than he expected August 13, 2013
Washington Post: Delaware Names New Escheator August 20, 2013
WSJ: Unclaimed Property Generates Big Revenues for States August 20, 2013
Legal Newsline: Attorneys find ‘formidable’ opponent in Kelmar September 4, 2013
Forbes: In Its Quest For Easy Money, Delaware Risks Its Reputation As The Place To Incorporate September 11, 2013