31 Mar Failure to Report an IRS Audit Adjustment to the State may bar Bankruptcy Discharge of State Taxes
According to the 4th Circuit Court of Appeals, if you fail to tell your state taxing authorities after the IRS adjusts your taxable income, it may prevent you from discharging your state taxes in bankruptcy.
Most states with personal income taxes base their determination of taxable income on federal taxable income, subject to some additions and subtractions. As a result, they also mostly defer to the IRS on auditing individual taxpayers. When the IRS conducts an audit and makes changes to a taxpayer’s taxable income as a result, it will assess the resulting taxes and will also notify the state taxing authorities.
Despite being notified by the IRS, most states also require a taxpayer subject to a federal audit adjustment to either file an amended return or otherwise notify the state taxing authorities of the audit adjustment. The state will then make the necessary adjustments, if any, in the amount of tax owed. There is often a very short deadline after the federal audit adjustment to notify the state.
In bankruptcy, an income tax is dischargeable (absent certain tolling events, and assuming no fraud or evasion) if (a) the due date of the tax return, including any extensions, was at least 3 years before filing; (b) the return was timely filed or, if late, was filed at least 2 years pre-petition; and (c) the tax was assessed at least 240 days pre-petition. All three must be met. If the IRS assesses additional taxes after an audit, a taxpayer may only need to wait 240 days (about 8 months) after the assessment to discharge those taxes in bankruptcy, provided the 3-year and 2-year rules have by then also been met.
If the debtor timely notifies the state (in the proper manner), then it will also assess, and 8 months from that assessment (again, assuming the 2-year and 3-year rules are met as to the original return) the state taxes will also be dischargeable in bankruptcy. But if the notification or amended state return is late, or not made at all, then watch out!
Once a state filing is late, it will likely trigger its own 2-year waiting period, because, as the 4th Circuit held, even a requirement to simply report to the state (without a requirement for an actual return) is the “equivalent” of a return, triggering the 2-year rule if it is not timely filed. Even worse, if the report or amended return is late and the state assesses the taxes based on the IRS notice, then it has an argument that even if the taxpayer files the return or report later, it is simply too late to be considered a return, meaning the taxes will never be dischargeable.
While there are good arguments that the 4th Circuit got it wrong, and that a required report is not the equivalent of a return where, as is the case in many states, there is no return form, it is not required to be under penalty of perjury or even signed, and may not contain enough information for state taxes to be assessed, it is far better to avoid the issue completely and simply file a timely return or report with the state.
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