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Mary Bernard
Mary Bernard

Remedies for State Income Tax Noncompliance

What do you do if you discover you should have been filing income-tax returns in a state but have not filed for many years?

July 28, 2011
by Mary Bernard, CPA

With the sophistication of current technology, it has become easier for states to discover noncompliant taxpayers. Revenue agents no longer have to sit in rest areas on highways to take down business names on trucks passing through the state. In spite of easy access to a wealth of information on the Internet, errant taxpayers sometimes fall through the cracks. If you are lucky enough to have avoided detection by a state and subsequently determine that you should have been filing in a state, but have inadvertently missed deadlines, what can you do?

Voluntary Disclosure

Most states have a process for taxpayers who discover noncompliance to voluntarily come forward without severe consequences. The voluntary disclosure process in most states is designed to allow a taxpayer to come forward to file prior tax returns, sometimes avoiding interest and/or penalties.

The purpose of the program is to promote tax compliance and generate additional tax revenues by providing nonfilers with an incentive to voluntarily pay taxes for prior years. It allows the state to collect unpaid taxes that would not otherwise be detected through traditional audits. Generally, a taxpayer would not be eligible to enter into the program if the state had already contacted them requesting a nexus questionnaire be completed or if the taxpayer had received an audit notice. Under certain circumstances, states will consider a “modified” voluntary disclosure involving a taxpayer who is already registered with the state but may have become delinquent in filing or remitting taxes.

In many states, the taxpayer can request acceptance into a voluntary disclosure program anonymously through a third person, such as their accountant. This allows the negotiation process of limiting years, interest and penalties to conclude before the taxpayer has been disclosed. The features of the various state programs include the number of years involved in the look-back period, the method of tax calculation and the amount of interest or penalties assessed. Most terms are open to negotiation, although the look-back period generally runs between three years and six years. With many states having the ability to look-back to the date business began in the state, the limited-look-back feature becomes an attractive incentive for a voluntary disclosure to effectuate compliance.

As part of the voluntary disclosure program, all tax returns for the agreed-upon look-back period must be filed within the terms of the agreement with the state and all taxes must be paid, along with any interest and penalties assessed. In many states, interest is imposed by statute and cannot normally be waived. Texas is one of the few states that will generally waive interest and penalties for taxpayers who voluntarily disclose taxes due, provided the taxes were not collected (such as sales tax collected from customers, but not remitted.) The majority of states will waive penalties or do not assess any penalties as part of a voluntary disclosure agreement.

Amnesty Programs

Another remedy for state income tax noncompliance is available through various state amnesty programs. In response to shortfalls in tax revenues caused by the economic recession, many states enacted amnesty programs in hopes of increasing revenues. The state legislature authorizes these types of programs typically for a specific period of years and tax types. Amnesty programs typically waive part or all of the penalties and interest otherwise due on the unpaid taxes during a specified amnesty period. During 2009, amnesty programs in 11 states produced revenues in excess of $1.2 billion covering all major business and personal-income taxes.

In contrast to a voluntary disclosure, the process for amnesty seldom involves anonymity. An application is typically submitted requesting amnesty, detailing the types and amounts of taxes involved. Amnesty programs are often available to taxpayers who are already registered with the state, but may be delinquent in filing or payment of taxes.

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Mary F. Bernard, CPA, is director — income/franchise tax, at the Dallas, Texas-headquartered tax services firm of Ryan. Bernard formerly worked as principal, director of State & Local Tax Services, at Providence, RI-basedKahn, Litwin, Renza & Co., Ltd.