New Delaware Case Challenges Kelmar's Extrapolation Methodology

Photo by smokedsalmon on FreeDigitalPhotos.netDelaware is the subject of another unclaimed property lawsuit, by a holder with a history of compliance, and despite the lawsuit, the audit is not yet completed.

Temple-Inland, Inc., a Delaware incorporated company, filed a lawsuit subsequent to an audit assessment on payroll and accounts payable of $1,388,573.97. Temple-Inland concedes that $147.30 is due to Delaware, as it missed one payroll check during its compliance process and has since reported it to Delaware. The remaining balance was determined in accordance with Kelmar's estimation and extrapolation methodology during the audit.

The original request for payment issued by Audit Manager Michelle Whitaker was $2,033,398.74. This was reduced during the administrative appeals process to $1,388,573.97. It is also important to note that this lawsuit was filed after a demand was issued for payroll and accounts payable; the audit is still pending on accounts receivable.

Perhaps the most telling fact of this audit is that Temple-Inland paid $1,338,116.70 to all states for the time periods covered by the audit.

Understanding the Math

The final assessments are calculated using an escheat percentage multiplied by the company's revenues. As detailed by the complaint, "The escheat percentage is calculated as a fraction: the numerator is the sum of purported uncashed checks (irrespective of the payees’ addresses) chosen from the years Kelmar audited (i.e., checks issued in 2003-2007 for accounts payable and 2004-2009 for payroll) plus amounts previously escheated to all other states and property returned to owners during the reviewed period (so it is not unclaimed property as a matter of law). The denominator of the escheat percentage is the total revenue for the years reviewed by Kelmar, as improperly “adjusted.” Defendants determined the percentage of disbursements made by ACH payments and then reduced revenues in the audited years by that same percentage. This reduced the denominator used to calculate the escheat percentage. Then the escheat percentage was multiplied by revenues for 1986 through 2004 (which were not similarly “adjusted”) to calculate a liability for unreported unclaimed property."

Temple-Inland argues that this calculation is flawed in several fundamental ways. First, there is no relationship between revenues and the amount of unreported unclaimed property. Second, the adjustment of revenues, by removing ACH payments incorrectly inflates the final assessment because no similar adjustment for ACH payments was made during the estimation years. This reduces the revenue in the denominator in the escheat percentage but does not reduce the revenue in the earlier estimation years.

This case highlights several of the weaknesses of the Kelmar extrapolation methodology. The complaint lists several specific examples, which practitioners have all seen before:

  1. Using a B2B check in a continuing relationship state as the basis for unclaimed property, even though the check is not yet reportable to the state. A $1,312.72 check payable to to a vendor in Tennessee turned into a Delaware assessment of $101,463.27.
  2. A vendor check that was voided because it was issued in error and where no liability exists turned the original $3,050.49 check issued in error into $144,028.97 under the extrapolation.
  3. A series of four vendor checks of $4,335.19 that were voided and reissued (and subsequently cleared within the dormancy period) turned into $237,339.18 of liability under the extrapolation.
  4. A $100 uncashed check that was escheated to another state was used in the extrapolation.
  5. A voided check that was issued to an employee for vacation time already compensated was extrapolated to $87,386.75 in liability.
  6. Payroll checks that were reissued to employees in states other than Delaware for $8,355.94 turned into $174,223.29 in the extrapolation.
  7. A check that was originally issued under payroll, then reissued under accounts payable, turned $1,641.50 into $95,090.73.

According to the complaint filed by Temple-Inland in Federal Court, Temple-Inland paid an average of $15,206.33 to all states for a five year period for accounts payable. Following the Kelmar audit, Delaware demanded an estimated $102,017.39 per year for prior years due solely to Delaware. Meanwhile, Kelmar identified $147.30 in unreported payroll for a six year period and estimated that $952,066.36 was due to Delaware for the seven prior years.

Arguing the Law

Delaware law, in 12 Del. C. § 1155, requires a holder “to report and pay to the State the amount of abandoned or unclaimed property that should have been but was not reported” and that this amount may be calculated by estimation if records are not available. As shown by several examples above, the assessment estimated property that should have been and was in fact paid to other states, was reunited with owners, or was exempted from reporting. Delaware would therefore be in violation of federal common law and the reporting priority rules as established in Delaware v. New York and Texas v. New Jersey. In addition to violating the priority rules, Temple-Inland argues that Delaware's estimation methodology violates due process by requiring the company to report identical property to two different states. Delaware's interest in collecting revenue is insufficient to overcome the company's legitimate property interest, in violation of the Fourteenth Amendment.

In addition to federal common law principles, Temple-Inland argues that the estimation is fatally flawed because Delaware cannot punish a company for not maintaining the proper records when there was no statutory requirement to do so. It was not until 2010 that Delaware passed a record retention requirement for holders of unclaimed property. To now apply this requirement to time periods before the law was passed would be applying it retroactively, in violation of Article I, Clause 1 of the U.S. Constitution.

The extrapolation also uses exempt property in the calculation of the liability, in violation of the Commerce and Full Faith and Credit clauses. By requiring the payment of exempt properties, Delaware is interfering with commerce in states which expressly exempt such property from reporting.

Conclusions

Barganier and Associates has often said that your best defense against an audit is a compliance history. However, this case shows that even with a compliance history, you may need guidance and legal counsel to make it through an audit and that litigation may ultimately be necessary. The audit process has been stacked against the holder for many years now; please do not go through this process alone.

Despite the allegations in this lawsuit, we expect that the case will ultimately be settled. Delaware relies too heavily on the revenues provided by unclaimed property to risk a bad precedent that this case could set.

Finally, Mark McQuillen, Kelmar's president, needs to revise his statements made in Tuesday's Tax Analyst article - he has now been sued.

See Also:
Audit Nightmares
New Michigan Law on Audit Practices
Lost that Loving Feeling in Delaware