Articles & Alerts

Are You Paying Tax on Someone Else’s Money?

November 22, 2021

What’s worse than paying tax on your hard-earned income? How about paying tax on money that isn’t even yours? Believe it or not, many businesses are unknowingly doing just that when they file their year-end tax returns. Right now, countless businesses are holding onto money known as unclaimed or escheatable property that actually belongs to their customers, employees or vendors. Instead of turning over these funds, they are erroneously recorded as income and create a false tax liability.

How Escheat Laws Work

All states have escheat laws that mandate businesses to remit certain properties held to state governments if such property remains unclaimed for a “dormancy period,” a specified length of time varying by state and property type. Companies are tasked with tracking and segregating these properties or funds while performing due diligence in the hopes of returning them  to the rightful owner. The most common types of unclaimed property include uncashed wages, accounts receivable balances and customer deposits. If such property remained unclaimed for the entirety of the respective dormancy period, typically 1-3 years, the business must transfer the property to the state, which holds it in trust for the rightful owner.

Audit Risk for Prior Years

Unlike laws pertaining to income taxes, for many states, there is no statute of limitations within the escheat laws, thus allowing for government audits to extend back years, or sometimes even decades. When conducting audits of businesses lacking financial records going back that far, state authorities extrapolate an escheat property error rate using current books and records and apply the percentage to the previous years in computing a liability. Interest and penalties are then assessed on top of the liability calculation.

Paying Tax, but No Refunds

When audited companies are held accountable for years’ worth of unclaimed funds, the financial consequences are further exacerbated if such property was previously reclassified from an expense item to that of income. While rebooking stale expenses to income might have at the time been thought of as beneficial in terms of increasing the bottom line, it is problematic because (1) the property should have been addressed using the escheat rules, and (2) income taxes were likely paid on those monies. For businesses facing this situation, many attempt to amend past income tax returns in the hopes of correcting their overstatement of taxable income to obtain tax refunds. However, most states have a three- or four-year statute of limitations for income tax purposes thereby barring refund claims for most of the prior years subject to the unclaimed property assessment. In other words, taxes were paid on someone else’s income and there is no recourse to get it back.

Options to Avoid Pitfalls

Thankfully, there are ways for businesses to avoid this harmful error. Reverse audits allow companies, together with their advisors, to review unclaimed property compliance, institute proper policies and procedures and file the necessary reports (and timely tax refund claims where applicable). Most states have ongoing voluntary disclosure programs that permit unclaimed property holders to limit the periods of missed back filings, while avoiding resource-draining audits and the imposition of onerous interest and penalties.

If you have any questions about your unclaimed property compliance or the possibility of having paid tax on someone else’s money, please contact Alan Goldenberg, Anchin Principal and Leader of State and Local Taxation, or your Anchin Relationship Partner.

Private Client