What Causes – and Stops – State Tax Deficits?

Direct state reporting for 1099s has increased regulations over the past decade. These regulations include earlier due dates, lowered thresholds and additional reporting requirements. States have also seen late reporting, inaccurate and non-reporting for decades. When an individual or business does not pay the proper amount of taxes owed to a state, either by reporting inaccurately, late or not reporting at all, this creates a state’s tax deficit.

Why do states collect taxes?

Income taxes from individuals and businesses is the largest source of state tax revenue for 41 states, according to the Tax Foundation. Receiving these payments is crucial to many daily operations, and also funds numerous state services, including road maintenance, law enforcement, education and health services.

Over the past few decades, state deficits have grown substantially, reaching billions of dollars in some states. For example, California’s annual budget for 2023-2024 estimates a budget deficit of nearly $24 billion.

Who has direct reporting obligations?

There are currently 43 states that require direct information reporting for at least one type of Form 1099. If you or your payees (customers or vendors) reside in one or more of these states or you do business in one or more of these states, you likely have direct state reporting obligations. When a business is unaware of its state reporting obligations or chooses to be out of compliance, it leaves no choice but for states to get creative for where they will close these gaps. This can include increasing tax rates, expanding the tax base, improving enforcement and levying new tax requirements (such as 1099 reporting requirements).

Annually, states require businesses to report 1099 information for payments made to U.S. vendors and other payees for nonemployee compensation (i.e., Forms 1099-NEC, 1099-MISC and 1099-K), payments of gambling and lottery winnings (Forms W-2G and 1099-MISC) and financial payments of all kinds including interest (Form 1099-INT), dividends (Form 1099-DIV), gains from investments (Form 1099-B) and retirement distributions (Form 1099-R).

It is important to remember that each state can set its own due dates and thresholds for each 1099 it requires. For example, if you are a business that files forms 1099-MISC and 1099-NEC in three different states, each state likely has different thresholds, due dates and possibly filing methods too.

How can states close the tax deficits?

There are changes underway at the state level to try and combat tax gaps. However, because this is a problem with individual filers and businesses of all sizes, there is a not a simple solution. Even so, the following changes are being made by states:

• New information tax systems
  • Several states have implemented new or updated tax systems to modernize reporting and receive more accurate information. For tax year 2022 Maine, Pennsylvania and Oregon implemented new or updated systems.
• Lowered thresholds
  • Several states lowered their thresholds for multiple 1099 forms. Remember that the majority of states do not follow IRS threshold guidelines. For example, with the late IRS change of Form 1099-K threshold for 2023, six states held the $600 threshold and three more changed their thresholds altogether.
• Income offsets
  • Adjustments, deductions and exemptions: the push for bank account reporting and detailed transaction reporting is likely to continue.
• New form requirements
  • State changes happen throughout the year. Each state can control what 1099s it requires and at what thresholds. Having a system in place to keep track of these changes is one of the best ways to stay compliant and avoid penalties.
• Higher penalties
  • Many states have begun to implement or raise tax information penalties to try and combat the issues of late, inaccurate and non-filings. Some states have fines up to $100 per return with annual maximums reaching $250,000. These penalties can prove costly to any business, especially those with reporting obligations in several states.

States also use third-party tax information reporting and withholding as a key compliance enforcement tool. IRS data indicates that taxpayers underreport income 55% of the time when that income was not subject to information reporting. While this research was done on federal data, the same likely happens at the state level. Less 1099 reporting means less accuracy in taxes paid. States are starting to catch on to this and are, therefore, requiring more information to be reported as it helps to increase tax collection accuracy.

Having a solution in place to track all state regulatory changes and ensure compliance is the easiest way to avoid state audits, costly penalties and ensure accurate direct state reporting.