GT Alert

State Anti-SUTA Dumping Legislation and Enforcement Proceedings on the Rise

October 2005

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Spurred by the passage of the August 2004, SUTA (State Unemployment Tax Act) Dumping Prevention Act (hereinafter “the Federal SUTA Dumping Law”), P.L. 108-295 (August 9, 2004), and subsequent funding from the United States Department of Labor (“DOL”), many States have begun introducing significantly more stringent legislation and enforcement procedures to combat employers’ efforts to reduce State unemployment taxes. “SUTA dumping” is a term used to describe various techniques used by some employers to obtain reduced State unemployment tax rates by “hiding” high rates of unemployment claims. Prior to the passage of the 2004 Federal SUTA Dumping Law, there existed little to no State or Federal legislation that expressly prohibited SUTA dumping. As a result, accounting firms and tax advisors widely marketed the practice to employers as an effective method of reducing their state unemployment tax rates. However, new State anti-SUTA dumping legislation and enforcement proceedings may leave employers who continue to engage or assist in the practice of SUTA dumping vulnerable to significant civil and criminal penalties.

Background on SUTA Dumping

States generally fund their unemployment insurance programs through a system of “experienced based” taxes, where an employer’s tax rate is determined by its history of layoffs. Those with high layoff rates are taxed at higher rates than those who have low layoff rates. New employers, because they have no history of layoffs, are generally taxed at a rate somewhere between the rates applicable to those employers with high layoff rates and those with low layoff rates.

The term “SUTA dumping” refers to a set of practices used by some employers in order to secure lower State unemployment tax rates than their history of layoffs would otherwise permit. The two most common methods of SUTA dumping involve “purchased shell transactions” and “affiliated shell transactions.”

In a purchased shell transaction, a newly formed company, which would normally be assigned a mid to high SUTA tax rate, buys an existing business that has a low termination experience rating, and therefore a lower SUTA tax rate, with the sole or primary goal of obtaining the benefits of the existing business’s lower SUTA tax rate. As a result of its purchase of the existing business, the newly formed company is able to transfer the existing business’s lower SUTA tax rate to itself, thereby avoiding, or “dumping,” a significant amount of its SUTA tax liability.

In an affiliated shell transaction, an already established and operating company effectively sheds its higher SUTA tax rates by transferring its employees to a number of wholly owned “shell companies.” First, an existing business with high SUTA tax rates forms a number of additional “shell” corporations with new tax identification numbers. These “shell” companies are typically staffed with relatively few employees and are operated until they have established a moderate to low unemployment experience rate for purposes of SUTA taxation. Once the “shell” companies have obtained lower SUTA tax rates, the original business shifts all or a substantial portion of its workforce to these “shell” companies, thereby shedding much of its SUTA tax liability.

Prior to August of 2004, few States had enacted legislation or established the enforcement mechanisms necessary to deter either of these practices. As a result of the lack of legislation prohibiting these practices, many accounting firms and tax advisors encouraged employers to engage in SUTA Dumping as an effective method for reducing their SUTA liability. A 2003 General Accounting Office study indicated that three out of four accounting firms encouraged clients to engage in SUTA dumping. The same General Accounting Office study indicated that 14 States had identified widespread use of SUTA Dumping tactics by employers, at an overall cost of $120 million in lost revenue.

The SUTA Dumping Prevention Act

In August of 2004 Congress passed the Federal SUTA Dumping Law in response to the findings of the General Accounting Office study and pressure from various interest groups. This law requires States to enact laws prohibiting SUTA dumping, impose significant civil and criminal penalties for violations, and establish effective enforcement programs for these laws as a precondition to the receipt of Federal grants for the operation of the States’ unemployment insurance programs.

Specifically, the Federal SUTA Dumping Law requires States to transfer the higher unemployment tax rates of a company that has transferred its employees to “shell” companies with lower tax rates under substantially common ownership, management or control, to these “shell” companies. The Federal SUTA Dumping Law also requires States to prohibit the transfer of unemployment experience from an existing business to a person if that person is not otherwise an employer at the time of such acquisition and the State finds that the person acquired the business solely or primarily for the purpose of obtaining a lower rate of taxation. These provisions would effectively prevent employers who engage in purchased shell transactions and affiliated shell transactions from reaping any tax benefits from such tactics.

State Response to the SUTA Dumping Prevention Act

Following the passage of the Federal SUTA Dumping Law, virtually all of the 50 States have now enacted some form of legislation to detect and prevent the practice of SUTA Dumping. At least 16 of the States that have enacted SUTA Dumping prevention laws in response to the Act have adopted the penalties proposed by the DOL for those employers and tax advisors who are found to have engaged in SUTA Dumping. Employers who are found to have knowingly engaged in SUTA Dumping in these States are subject to the imposition of the State’s maximum SUTA tax rate for a period of 4 years, or, where the employer is already subject to the State’s highest rates, an additional tax of 2% over and above the maximum rate.

Some States, such as North Carolina, Minnesota and Colorado, have enacted particularly stringent Anti-SUTA Dumping laws. For example, North Carolina’s Anti-SUTA dumping statute classifies violations as felonies, carrying a presumptive sentence of six months incarceration in addition to harsh civil penalties. Colorado’s anti-SUTA dumping statute provides for the imposition of a tax equal to the State’s maximum SUTA tax rate, plus an additional 2.7% on employers who have been found to have engaged in SUTA dumping.

Additionally, a growing number of States, including Michigan, North Carolina and Minnesota have engaged in particularly vigorous efforts to enforce their anti-SUTA dumping laws. Michigan recovered roughly $2.4 million in one anti-SUTA dumping action. North Carolina recovered over $9 million in several anti-SUTA dumping actions, and has over 200 other cases pending. Minnesota has instituted a number of anti-SUTA dumping suits which could result in substantial recoveries and penalties.

The DOL has encouraged and supported these State enforcement efforts by making substantial grants to assist States in developing stronger anti-SUTA dumping enforcement programs. In the 2005 fiscal year, the DOL awarded nearly $5,000,000 in grants to States solely for the purpose of assisting in the improvement of their SUTA dumping detection programs. These DOL grants have been used by some States to help finance advances in SUTA dumping detection technology. North Carolina, for example, is currently developing SUTA dumping detection software that may later serve as a model for use in other States. The DOL’s recent increase in grants to State anti-SUTA dumping enforcement programs has significantly improved the ability of many States to carry out vigorous and comprehensive investigations into the conduct of employers and tax advisors suspected of engaging in or advocating SUTA dumping.

Accordingly, employers who have engaged in SUTA dumping in the past on the advice of their accountants or tax advisors, or those seeking to limit their State unemployment tax liability in the future should proceed with extreme caution to ensure that they avoid any practices that could be prohibited under State and Federal law. Employers are well-advised to seek legal advice before engaging in any structuring techniques that could be viewed as having the purpose or result of illegally avoiding unemployment taxes. Employers who have questions or concerns as to whether their current or past structuring techniques may be prohibited under Federal and State Anti-SUTA Dumping laws should seek legal counsel in order to ensure their compliance with these laws and limit their potential liability.

This Alert was written by Craig A. Etter, John F. Scalia, and Matthew H. Sorensen in the Tysons Corner office. Please contact Mr. Etter, Mr. Scalia or Mr. Sorensen at 703.749.1300 or your Greenberg Traurig liaison if you have any questions regarding the subject matter of this Alert.

© 2005 Greenberg Traurig

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