Many states have their own personal income tax.  Generally these states also have laws that require a taxpayer to submit a copy of the IRS audit report if the federal liability is adjusted due to a reallocation of income or deductions on a previously filed return.   The failure to do so may cause bankruptcy discharge problems .  Changes to federal law contained in the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 may render any undisclosed increase in liability a non-dischargeable debt for bankruptcy purposes. The amended language of 11 USC 503(a)(1)(B) says that a discharge under Chapter 7 “does not discharge an individual debtor from any debt — (1) for a tax . . . (B) with respect to which a return OR EQUIVALENT REPORT OR NOTICE, if required — (i) was not filed or given late and within 2 years of filing the bankruptcy, or was fraudulent or evasive.

The 4th Circuit Court of Appeals in State of Maryland v. Ciotti, decided that the failure of a taxpayer to comply with a Maryland state statute requiring her to report changes made to her federal tax liability as a result of an audit conducted by the Internal Revenue Service. In spite of the intergovernmental agreement between the State of Maryland and the US Treasury that actually did provide a copy of the IRS audit report to the state, the court determined that failure of the taxpayer to supply the report herself rendered the increase in state tax non-dischargeable.

The tax code of the State of Oregon includes a provision that mirrors the requirements of the Maryland law in that it creates a specific duty, under ORS 314.380, that the taxpayer “report to the department any change in the taxpayers tax liability paid to or owing this state because . . . The Internal Revenue Service or other competent authority has changed or corrected the amount taken into account in determining the taxpayers tax liability as reported on a federal income tax return or an income tax return of another state for any taxable year. . .” The law also requires the taxpayer to give notice of the filing of an original or amended return that is accepted by the Internal Revenue Service or the taxing authority of another state.

It is tempting for taxpayers who are delinquent in filing personal income tax returns, when contacted by the IRS with a request to file missing returns, to ignore state and local tax return filing requirements. The IRS has access to information and other resources not available to state revenue officers. Since it is generally, although not always the federal tax authorities who first detect a non-filing taxpayer, this is a quandary that many face. The Ciotti decision adds force to the argument that the state authorities will likely detect any omission and that it is best to come forward with any reportable information promptly.

Of course, non-filed tax returns of any sort are excluded from discharge by section 523 of the bankruptcy code. In addition, another problem arises when a taxpayer fails to file a return and the taxing authority calculates and assesses tax by a substitute process. While the issue is far from clear in the 9th Circuit Court, which supervises the Oregon bankruptcy court, there is substantial support for the premise that, after the state has assessed in absence of a voluntary return, no effort to file a tax return will render the tax dischargeable in the future.

Federal law provides for assessment of tax by an alternative process through tax code section 26 U.S.C. 6020(b). This is referred to by IRS employees as the Substitute For Return process or “SFR” for short. The Chief Counsel of the IRS has publicly taken the position in Chief Counsel Memorandum 2010-16, that tax liability can be corrected by a late filed tax return that is accepted by the IRS after assessment under the SFR procedures. However, it is the IRS position that regardless of whether or not the liability is changed, that portion of the tax originally assessed by the SFR will be excluded from bankruptcy discharge under 11 U.S.C. 503(a)(1)(B).

If the courts agree with the IRS interpretation of the bankruptcy code discharge provision when applied to a state substitute assessment this spells trouble for a non-filing taxpayer who has satisfied the IRS but neglected the state. Not only will the un-assessed state tax lurk in the background waiting to spring forth at a particularly inopportune moment, but it will forever elude bankruptcy discharge when the state gets around to assessment.