Unclaimed Property Laws of Securities and IRAs: How States Are Claiming Your Investments

Daily Tax Report: State provides authoritative coverage of state and local tax developments across the 50 U.S. states and the District of Columbia, tracking legislative and regulatory updates,...

Bloomberg BNA regularly spotlights the insights of state and local tax professionals at Grant Thornton. In this installment of Grant Thornton Insights, David M. Glad and Guinevere S.M. Seaward Shore discuss state unclaimed property laws, and a recent trend to shorten dormancy periods for investments with their sale shortly after being reported dormant.

David M. Glad Guinevere S.M. Seaward Shore

By David M. Glad and Guinevere S.M. Seaward Shore Contributions by Kendall Houghton

David M. Glad, CPA, JD, is a Director of State and Local Tax in Grant Thornton, LLP’s Philadelphia office and is the leader of the firm’s unclaimed property practice. Guinevere S.M. Seaward Shore, JD, LL.M, is an Experienced State and Local Tax Manager in Grant Thornton’s Metro DC office and is a firm leader for the unclaimed property practice. The authors would like to thank Sonia Shaikh, a tax associate in the DC Metro office, for her research assistance. Kendall L. Houghton is a Partner in the Washington, D.C. office of Alston & Bird LLP, and the practice group leader for the firm’s SALT group, which includes the unclaimed property practice.

At their core, state unclaimed property laws are designed to protect citizens’ property. These laws often achieve this goal, but have a history of being used not to safeguard the assets of owners, but to serve as a source of revenue for states. [ See, e.g., Douglas L. Lindholm and Ferdinand S. Hogroian, The Best and Worst of State Unclaimed Property Laws, Council on State Taxation (COST) (Oct. 2013), at http://www.cost.org/state-tax-resources/cost-studies-articles-and-reports/.] When cash-strapped states view unclaimed property as a revenue stream, the protection theoretically afforded by unclaimed property laws can become diluted in practice. One area of concern is the increasing trend of states to reduce the dormancy period of investment accounts, including individual retirement accounts, and to sell the securities that holders (banks, brokerages firms, mutual fund companies, transfer agents and similar financial services firms) are required to report, often soon after being reported. In many instances, state unclaimed property laws do not provide owners with notice that their investment assets are subject to sale after a certain period of time, if at all.

This trend is certainly disconcerting, but it is not a new development. In fact, it has been longstanding and prevailing. Initially, the tendency among states to take custody of and liquidate assets, with no effort to notify owners or return their assets, was publicized as a result of 2007 litigation concerning California’s unclaimed property practices. [ Taylor v. Yee, 780 F.3d 928 (9th Cir. 2015), cert. denied, 136 S. Ct. 929 (2016), prompting California’s pre-escheat notification process.] The continuity of these questionable state practices is also evidenced in the ongoing Delaware case of JLI Invest S.A. v. Cook, [Case No. 11274 (Del. Ch. 2015)], and recently includes new laws in states such as South Dakota, which allow the state to sell unclaimed securities within 90 days of being reported, [S.D. Codified Laws § 43-41B-23(c) (effective March 2017)]; and Pennsylvania, which requires (according to State representatives) the state to sell unclaimed securities immediately. [72 P.A. Stat. Ann. § 1301.17.] Perhaps the most troubling part of the trend is evidenced by Pennsylvania’s experiment with claiming retirement accounts whose owners have not yet reached the age of required minimum distribution under federal law, but who are deemed to have “lost contact” with their accounts. [ Id. at § 1301.8.] Aggressive state actions to claim, and eventually liquidate, securities raises questions as to the perceived public policy that should motivate unclaimed property laws. It also raises underlying questions as to whether various security holders (banks, mutual funds, etc.) are correctly applying state laws that may lead to the eventual liquidation of their customers’ accounts.

PUBLIC POLICY CONSIDERATIONS OF UNCLAIMED PROPERTY LAWS

While it has become common for states to use unclaimed property to increase state revenue, the true purpose behind unclaimed property compliance was to unite owners with their property. [ See K. Reed Mayo, Virginia’s Acquisition of Unclaimed and Abandoned Personal Property, 27 Wm. & Mary L. Rev. 409, 419-20 (1986) (noting the various policies of the uniform laws include the protection of owners for purposes of reuniting them with their property while providing states with another method to raise revenue).] Unclaimed property uniform acts have gone through many iterations, the most recent being the introduction of the Revised Uniform Unclaimed Property Act (“RUUPA”) in 2016. [Unif. Unclaimed Prop Act (2016).] However, the original version, the Uniform Disposition of Unclaimed Property Act (the “1954 Uniform Act”) was not only enacted to promote uniformity among states, but also to protect unknown owners by attempting to facilitate a rightful reunion with property. [Unif. Disposition of Unclaimed Prop Act (1954).] In the 1954 Uniform Act’s prefatory note, it was clear that one of the purposes of creating a uniform act was to highlight the custodial nature of states’ roles in unclaimed property administration:

The Uniform Act is custodial in nature – that is to say, it does not result in the loss of the owner’s property rights. The state takes custody and remains the custodian in perpetuity… . Not only does the custodial type of statute more adequately preserve the owner’s interests, but, in addition, it makes possible a substantial simplification of procedure [Unif. Disposition of Unclaimed Prop Act, Commissioner’s Prefatory Note (1954).]

According to the Council on State Taxation (“COST”), “[m]any State unclaimed property programs have deviated from their true purpose of uniting owners with their property and have instead become alternative revenue sources for states.” [Council on State Taxation, Unclaimed Property Policy Position (last updated Oct. 29, 2008), athttp://www.cost.org/state-tax-resources/cost-policy-positions/.] COST points out that, while this trend not only harms owners who are unable to claim their property once it is escheated to states, it also poses increased administrative costs to holders who may be required to turn over “property” that is not truly unclaimed. And understanding the states’ varying, and ever more aggressive, targeting of securities and security holders highlights the danger of owners losing their investments. [ Id.]

STATES’ VARYING TREATMENT OF SECURITIES AND SECURITIES HOLDERS

States’ treatment of securities differ depending on the type of holder of the securities, the type of the account, and whether the security is governed by the Employment Retirement Income Security Act of 1974 (“ERISA”). [Pub. L. No. 93-406, 88 Stat. 829.] A “holder” is the person or company obligated to hold for the account of, or deliver or issue payment to the owner of the property. [Unif. Unclaimed Prop. Act §102(12) (2016).] Generally, holders of securities may include corporate issuers, transfer agents, financial institutions, mutual funds, and broker-dealers. However, because several companies can be involved with a customer’s investments, disagreements can arise as to which company is the holder and has the unclaimed property reporting responsibility, whether this obligation can be shifted contractually, and whether multiple parties may be deemed to be the holder in different contexts. [ See, e.g., SIFMA White Paper, In Brief: Unclaimed Property Compliance Obligations and Challenges for BrokerDealers (Jan. 2015)” at https://www.sifma.org/resources/submissions/unclaimed-property-compliance-obligations-and-challenges-for-broker-dealers/]. Once the holder is determined, that company has the responsibility to track a customer’s account and identify property for which the owner has not indicated an interest for the relevant period of time, or has become “dormant.” States will generally consider securities to be dormant after either three or five years from the date a state’s dormancy period begins (“dormancy trigger”). [ See Unif. Unclaimed Prop. Act §208 (2016) (listing presumptions of abandonment); see, e.g., Cal. Code. Civ. Proc. §1516(a), stating that the dormancy period is triggered three years after the date prescribed for payment or delivery.] The crucial issue for the securities holder then becomes how to determine when the state’s dormancy trigger arises.

The dormancy trigger varies by state, but is generally either based on whether a mailing to the owner is returned by the post office, or in some cases, for failed electronic mail correspondence (“RPO” or “lost contact”); or the owner has failed to “indicate an interest” in the securities, such as by failing to make a transaction or access the account (“inactivity”); or a combination of the two. For example, California’s law states that securities are dormant three years after the owner has not claimed a distribution, corresponded in writing or indicated an interest, and the holder does not know the location of the owner at the end of the three-year period. [Cal. Code. Civ. Proc. §1516.] However, Delaware’s new law states that securities are dormant three years after the last indication of interest in the property. [12 Del. C. §§ 1133(13), 1136.] And of course, whether a state includes an owner’s “indication of interest” as a dormancy trigger or what constitutes “indicating an interest” can vary by state. According to RUUPA, an owner’s indication of an interest in property includes an owner’s written or oral communication (so long as the holder or its agent makes a contemporaneous record of the oral communication), an owner cashing a dividend or similar distribution, an owner’s activity on the account, including accessing the account or changing the balance of the principal, and any other action by the apparent owner which reasonably demonstrates to the holder that the apparent owner is aware that the property exists. [Unif. Unclaimed Prop. Act §210 (2016).]

Further, state statutes can have a separate dormancy trigger for property held by a fiduciary (or perhaps an agent-in-fact), as defined by state law. For example, while the Massachusetts dormancy trigger for securities includes both an inactivity and RPO standard [ALM GL ch. 200A, §5B(b)], the state’s dormancy trigger for dividends, stocks and bonds held by fiduciaries is whether the beneficiary claims the property within three years after the date prescribed for payment or delivery. [ALM GL ch. 200A, §5.] Pennsylvania’s law includes a provision for property held by fiduciaries or “agents-in-fact,” which act under a power of attorney agreement. [Reporting Standards for Fiduciary Accounts General Unclaimed Property Notice Requirement, Pennsylvania Department of the Treasury, Bureau of Abandoned and Unclaimed Property, 3-4 (2017) (hereinafter “PA Reporting Standards for Fiduciary Accounts Notice”)]. Under Pennsylvania’s law, property held by a fiduciary or agent-in-fact is presumed abandoned three years after the holder has lost contact with the owner (based on RPO with an email attempt), unless the owner increases or decreases the principal, accepts payment of principal or income or otherwise indicates and interest in the specific property or other property in possession, custody or control of the holder. [72 P.A. Stat. Ann. § 1301.8.]

Clearly, the varying and changing dormancy triggers used by states can create great complexity for the companies that hold investments. For example, in 2015 when Morgan Stanley entered into a 35-state audit resolution agreement (“ARA”) with contract auditor Verus Financial, which established an agreed-upon process for the audit, the state dormancy standards for brokerage accounts were sorted between five distinct groups. [Morgan Stanley Audit Resolution Agreement, athttp://www.sco.ca.gov/Files-EO/Morgan_Stanley_Audit_Resolution_Agreement.California.Final.pdf.]. The states participating in the Morgan Stanley ARA used dormancy standards that they held to apply to brokerage accounts, as opposed to securities held by the company that issued the shares or by transfer agents. This was a critical distinction, as certain states, despite having an RPO standard for stock held by the issuing company or transfer agents, concluded that securities held in a brokerage account were a type of “miscellaneous property” to which only an inactivity standard applied. In the years since, some of these states have agreed to apply an RPO standard to such property held by brokerage accounts.

TAX-DEFERRED RETIREMENT ACCOUNTS

Whether the state should even accept the securities from a tax-deferred retirement account depends on whether it is governed by ERISA. Although ERISA governs many types of employer-created retirement plans, such as 401(k) accounts and corporate pensions, it does not cover self-created IRAs, despite whether the IRA is tax-deferred or not (e.g., Roth IRA). [29 U.S.C. §1002(1).] The Federal Department of Labor has taken the position that state unclaimed property laws interfere with the administration of claims, although a plan administrator may voluntarily escheat the securities of a terminated plan [Dept. of Labor Op. No. 94-41(A) (1994)]; and state administrators and courts have issued differing viewpoints. For example, Pennsylvania will not attempt to challenge federal treatment over retirement accounts, but will require the holder to prove that any account not reported is in fact subject to ERISA oversight. [ PA Reporting Standards for Fiduciary Accounts Notice, 5.] Because reporting a retirement account to a state as unclaimed property may be considered an early distribution of the plan assets, almost all states, with the possible exception of Pennsylvania, do not require the reporting of tax-deferred retirement securities until three to five years, depending on the state, after the actual date of the distribution, the distribution date in the plan or trust agreement, or the date specified in the Internal Revenue Code by which distributions must begin. [IRC § 408, requiring minimum distributions of an individual retirement account upon the owner reaching the age of 70 1/2.]

Typically states do not have special provisions for non-traditional retirement accounts, such as Roth IRAs, which do not require minimum distributions, so that such property’s dormancy trigger typically falls under the general rule for securities. However, certain states include special provisions for these “non-traditional” retirement accounts. For example, New Jersey provides that property in IRAs for which there is no required distribution becomes dormant three years after the earlier of the second mailing of a statement of account or other communication returned as undeliverable, or after the holder discontinued mailings to the apparent owner. [N.J. Stat. §46:30B-38.1.]

PENNSYLVANIA TREATMENT OF SECURITIES AND RETIREMENT ACCOUNTS

Pennsylvania amended its unclaimed property law in 2016, which among other things, created the requirement that the investment would not be deemed unclaimed unless the holder had lost contact with the owner and the owner did not indicate an interest in the property within three years. [72 P.A. Stat. Ann. § 1301.8(a); PA Reporting Standards for Fiduciary Accounts Notice, 4.] Specifically, for individual retirement accounts, a retirement plan for self-employed individuals or similar retirement account, the account – and the underlying securities – will become dormant three years after the holder has lost contact with the owner, unless within that three-year period the owner: commenced receiving distributions, increased or decreased the principal, received payment of principal or income, or otherwise indicated an interest in the account or plan or in other property of the owner in possession, custody or control of the holder. [72 P.A. Stat. Ann. § 1301.8(a).2.] Unlike other states that provide for escheatment of tax-deferred retirement accounts only, Pennsylvania’s law encompasses non-tax-deferred accounts, such as Roth IRAs, as well.

If owners do not evidence an interest in their accounts, the fiduciary will be deemed to have “lost contact” with the owner based on two different standards, depending on whether the owner has indicated a preference for receiving communications via mail or email. [ PA Reporting Standards for Fiduciary Accounts Notice, 4-6.] If the owner opts to receive communications via mail, the holder will be deemed to have lost contact with the owner on the date a second consecutive communication sent by the holder through first class United States mail to the owner is returned to the holder as undeliverable by the United States Postal Service or, if the second communication is made later than thirty (30) days after the first communication is returned, the date the first communication is returned undelivered to the holder by the United States Postal Service. [72 P.A. Stat. Ann. § 1301.8(b).] If the owner opts to receive communications via email, the holder must attempt to confirm the owner’s interest in the property by emailing the owner not later than two years after the owner’s last indication of interest in the property. [72 P.A. Stat. Ann. § 1301.8(c).] If the holder receives notification that the email was not received, or if the owner does not respond to the email within thirty (30) days, the holder must promptly attempt to contact the owner by first class United States mail. [ Id.] If the mail is returned to the holder undelivered by the United States Postal Service, the holder will be deemed to have lost contact with the owner on the date of the owner’s last indication of interest in the property. [ Id.]

An important issue concerns retirement accounts that are subject to a 10 percent tax on early distribution. Pennsylvania views the taking of a retirement account as not subjecting the owner to a 10 percent early distribution tax, because the state is not taking possession of the account but merely acting as a trustee. [ PA Reporting Standards for Fiduciary Accounts Notice, 9.] However, because of the uncertainty, Pennsylvania is continuing to review whether the early distribution tax would apply. Until the Pennsylvania Treasury Department issues new policy guidance, Pennsylvania will neither demand nor accept any retirement account except: (1) an individual retirement account (including those for self-employed individuals) for which the beneficiary cannot be located for a period of three years following the death of the owner and that is not subject to a mandatory distribution requirement, or (2) an individual retirement account (including those for self-employed individuals) for which the owner is at least 70 1/2 years old and is not subject to a mandatory distribution requirement. [ Id. at 10.]

OWNER OUTREACH

When securities become dormant, as with all unclaimed property, the holder must attempt to notify the owner, unless the property falls below a minimum threshold, which varies by state but is generally $25 or $50. If the owner fails to respond to this outreach, the holder must report the property to the state. Of course, if securities have become dormant after the holder receives mailings returned from the post office, a later due diligence letter will not be received by the owner. Consequently, some states require an owner to conduct a reasonable search for the owner’s new address. Even without a state requirement, many securities holders will conduct a database search for the owner’s new address. Beyond state unclaimed property laws, if securities are held by a transfer agent or broker-dealer, the Securities and Exchange Commission requires the holder to conduct database searches for lost owners within only months after losing contact, and to send direct notice to unresponsive payees. [17 C.F.R. §240.17Ad-17.]

STATE LIQUIDATION OF SECURITIES

Despite the application of dormancy triggers and database searches for owners’ correct addresses, securities holders will often have account owners with abandoned accounts. Unfortunately for these owners, once securities are reported to the state, several states will liquidate the securities upon receipt. Many states may wait some period of time before liquidating the securities, but that period of time is never longer than three years, and the trend is for states to reduce this waiting period, despite RUUPA’s specific provision of a three-year plus notice threshold. [Unif. Unclaimed Prop. Act §702.] For example, in March 2017, South Dakota reduced the waiting period from three years to 90 days. [S.D. Codified Laws § 43-41B-23(c).] Some states may provide small protection in the form of a public notice, although most owners may never read or receive the notice. [ See e.g., 765 ILCS 1025/17(b).] Pennsylvania, however, will not only sell the securities upon receipt, but has no obligation to provide any public notice. [72 P.A. Stat. Ann. § 1301.17(b), (e).] The owner may have to recognize a gain or loss on the liquidation for tax purposes, but may avoid a gain or loss if the property is converted into similar property within a certain period of time under the federal involuntary conversion rules. [ See IRC § 1033(a)(2)(B); I.R.S. Priv. Ltr. Rul. 200946006 (Jul. 29, 2009); I.R.S. Priv. Ltr. Rul. 200714002 (Dec. 22, 2006).] Under RUUPA, if the state administrator sells the security sooner than six years after the security was escheated to the state, an owner is entitled to seek relief in the form of replacement, or to be made whole through payment of the market value of the security at the time the owner’s claim is filed, including interest. [Unif. Unclaimed Prop. Act §703.]

Often, the minimal dormancy period results in significant losses to the rightful owners. In an ongoing action against the state of Delaware, the state liquidated securities only three days following escheatment, resulting in an estimated loss of over $12 million for two Belgian citizens. [ JLI Invest SA et al. v. Cook et al., Case No. 11274 (Del. Ch. 2015).] In the complaint, the Plaintiffs emphasized that the escheatment was neither required nor permitted under both state and federal laws because escheatment only comes into play when the property concerned involves “lost” owners and foreign-owned stock is not required to be escheated to Delaware. [Complaint at 9-11, 14]. Delaware’s statutory use of the term “lost” references federal securities law, which defines a lost security holder as an individual who has been sent correspondence that is subsequently returned as undeliverable. [ See 12 Del C. §1198(9); 17 C.F.R. §240.17Ad-17.] In the JLI case, Delaware had record of a valid mailing address, but there was no evidence that any communication was sent to the owner’s address. [Complaint at 10-11]. Additionally, the state retroactively applied a diminished dormancy period of three years, while the shares in question would have fallen under a previous dormancy period of five years. [ Id. at 12.] Delaware justified escheatment by claiming that it is required upon inactivity and that holders are responsible for reestablishing contact with shareholders on their accounts to prevent triggering dormancy. [ Id. at 11-12.] However, the state never instructed the holders to “reestablish contact.”[ Id.] According to the owners and plaintiffs, at all relevant times, the holders were in regular contact, fully aware of the owners’ locations, and throughout the process, owners were fully aware of their shareholder status, thus nullifying any argument that they had indeed abandoned their ownership. [ Id. at 15.]

This question of whether a state’s escheat and liquidation practices violate the Due Process Clause or if such methods of notice are constitutionally adequate have consistently been raised. Most notably, in Taylor v. Yee, a putative class action brought by property owners, the plaintiffs claimed that the California State Controller failed to take satisfactory measures in locating and notifying property owners using the data sources required by Section 1513.5 of the state’s unclaimed property law. [780 F. 3d 928 (9th Cir. 2015).] The case initially began in 2001 and focused on the Controller’s failure to publish the names of the owners in newspapers and complete further outreach in attempting to locate the rightful owners. [ See Taylor v. Westly, 402 F.3d 924, 929-36 (9th Cir. 2005)]. In the 2015 case, the Court held that the applicable statute only states that such records be furnished “upon the request of the Controller.” The statute does not require the Controller to actually request or use any databases. [780 F. 3d 928, 937.] The plaintiffs and owners also argued that the process itself is inadequate as it is carried out by third-party auditors with potentially conflicting interests since they receive a portion of the escheated property’s value. [ Id. at 930]. In its writ of certiorari, the owners asked the U.S. Supreme Court to vacate and remand the Ninth Circuit’s decision on a separate basis, claiming that the Circuit Court had applied the incorrect legal standard and should have reviewed the case under the Takings Clause of the Fifth Amendment. The owners asserted that California’s remedy practices of returning only the proceeds of the liquidation rather than the stock’s current value was an unconstitutional taking without just compensation. [Petition for Writ of Certiorari at 32, 136 S. Ct. 929 (No. 15-169) filed Aug. 8, 2015.] In a concurrence to the denial of certiorari, two justices of the U.S. Supreme Court noted that the tendency to shorten escheat periods while maintaining minimal notification procedures raised due process concerns on a national basis. [ Taylor v. Yee, 780 F. 3d 928 (9th Cir. 2015), cert. denied 136 S. Ct. 929, 930 (2016).] However, the concurrence ultimately advocated denial of review stating that the “convoluted history of [the] case makes it a poor vehicle” to address the issue. [ Id. at 930].

CONCLUSION

State unclaimed property laws can, and often do, serve their original purpose of protecting individuals’ property. These laws are most effective when applied to traditional property such as uncashed payroll checks. In addition, these laws have the capacity, if applied by states conservatively, to protect individuals’ investments. However, when states limit the dormancy rules and sell reported investments to generate additional revenue, the states distort the effectiveness of these laws and can actually harm their citizens. Not only are individual investors negatively affected, but so are the companies that hold these investments, who risk the relationships with their clients and incur the costs of tracking and complying with varying state laws. Until states apply their unclaimed property laws with the goal of maintaining their citizens’ investments, both holders and owners must share that burden.

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