Yet little has been discussed about the federal tax consequences of unclaimed property payments to the states, even though securing the benefit of a federal tax deduction can help offset up to 40% of the cost of remittances made to the state.
Among the issues facing unclaimed property holders falling subject to audits - potentially extending back 10-25 years - is not only what is deductible for federal tax purposes, but when these amounts can be claimed as deductions. For federal tax purposes, taxpayers and the IRS have a limited period in which to assess a deficiency or alternatively request a refund for overpaid taxes, ranging from three to six years. No such limit generally exists under state unclaimed property provisions, meaning that the states can, and often do, assess liabilities than can extend far longer than that in which refunds can be claimed under the Federal tax rules.
Unclaimed Property as a Business Expense
Deductibility of expenses for Federal tax purposes is based on satisfying a series of criteria including qualifying as an ordinary and necessary business expense under Section 162 of the Internal Revenue Code. Under Section 162, the first threshold for deductibility is that an expense must meet both the “ordinary” and “necessary” requirements. Ordinary means customary or usual expenses in the business to which the expense is incurred, it need not however, be habitual. In fact, the expense could be a onetime expenditure, much like the one time payments that a company pays in satisfaction of an unclaimed property audit. Correspondingly, the term “necessary” is defined as being an amount having been incurred as being “appropriate and helpful,” rather than being absolutely essential. Lack of a formal legal obligation does not necessarily preclude an expense from being necessary, including payments made to satisfy a voluntary settlement for unclaimed property.
Timing of Deductions
Assuming a taxpayer satisfies the initial threshold of an expense, the next hurdle is determining “when” the amounts are deductible. Under the Treasury Regulations, taxpayers must meet a three-prong test to determine the period in which expenses may be deductible. These tests include:
- “All events” have occurred which establish the fact of the liability;
- The “amount” of the liability can be determined with reasonable accuracy; and
- “Economic performance” has occurred with respect to the liability.
When it comes to unclaimed property there are a series of possible scenarios which can impact deductibility including:
Scenario 1: Common Recurring Items
These items are typically amounts that remain outstanding in the taxpayer “holder’s” books and records in the form of uncashed vendor or payroll checks, long standing customer credits, or in those states that escheat gift cards/certificates, the unredeemed balance remaining on the cards.
In these instances, the remittance of the unclaimed or abandoned property to the states clearly would not be deductible because presumably the amount relates to a specific expense that was previously deducted. In other words, no new obligation arose therefore no event has occurred which would support the taxpayer/holder incurring a new expense. The origin of the claim (an obligation to the original property owner), is tied to an amount previously deducted.
Scenario 2: Disputed Property Items
Disputed property items are cancelled or voided checks, customer credits or other such items reflected in books and records as no longer posing a liability to the vendor/customer, but are identified upon audit by the states or third party auditors. These items can arise on either Voluntary Disclosure Agreement (VDA) negotiations or under audit where the holder’s books and records do not reflect any unclaimed or abandoned property, yet the state or its third-party auditors challenge that the taxpayer/holder has satisfied its burden of disproving a “presumption” of abandonment.
In this situation, the obligation to pay the state does not arise from a previously deducted expense because either the original item (outstanding check) was voided or customer credit reversed in the taxpayer’s books and records. The event which gives rise to the deemed abandoned property would be fixed and determinable upon the VDA or audit settlement, and under the IRS treasury regulations, economic performance would be considered having been met when payment of the abandoned property is remitted to the state(s).
Scenario 3: Extrapolated Liability
Arises when a taxpayer/holder is under audit or VDA and the state of incorporation or organization estimates an unclaimed property liability for prior years in which the taxpayer/holder does not have adequate available records to research the ultimate disposition of an outstanding item (e.g. uncashed check or customer credit balance).
Much like scenario 2, it appears that even though the amounts remitted to the state(s) as unclaimed property in fact may not ultimately be claimed by the potential owner of the property, since there is no contact information attached to the estimated amounts remitted to the states. Such amounts may still constitute deductible expenses under the Internal Revenue Code. Under this fact pattern, the three prong test would appear to be met:
- the event giving rise to the expense is the audit or VDA assessment or settlement agreement, respectively;
- the amount of the liability would become fixed (even though based on estimated information); and
- the economic performance would occur when payment is rendered to the state(s).
What remains unclear in Scenarios 2 and 3, is whether or not the IRS would argue that the amounts remitted to the states were in fact deducted in prior years, or if payments were not remitted as abandoned property in a timely manner. Abandoned property due to states after expiration of the standard dormant or inactivity period typically ranges from 3-5 years. Despite not having appropriate records, the IRS may claim the statute of limitations for claiming the original expense under IRS guidelines, typically three years, would have expired. If the IRS were to prevail, then the taxpayer holder could be prevented from claiming a deduction when the estimated liability remitted as abandoned property to the state is remitted to close out the audit or VDA.
There are certain avenues for taxpayers to pursue in order to prevent amounts described in Scenarios 2 and 3 from being disallowed by the IRS including the filing of protective refund claims. Such opportunities are typically fact-specific and dependent on both the taxpayer’s federal audit history as well as the estimation period included in the unclaimed property VDA or audit settlement.
For further discussion of the Federal tax deductibility of unclaimed property remittances I encourage you to join me at the upcoming UPPO Annual Conference where I will be presenting, “Uncle Sam May Owe You: Federal Tax Consequences of Unclaimed Property,” Tuesday, March 10, 2015.
To register for the conference click here.
Also, look for additional information following the UPPO conference where I will provide further guidance on the Federal tax consequences of unclaimed property and what taxpayers can do to strengthen their position.