Section IV: State Taxes

State taxes were the final operational challenge identified in the Report to Congress. The

report said, “Research indicates that taxpayers expect to be able to file federal, state, and

local returns in one place. Any solution would require collaboration with state and local tax

administrators to enable integration and avoid creating additional burden for filers.” ²¹ A key

learning objective for the pilot was to evaluate whether the experience of filing state taxes

separately could be made sufficiently seamless so as to not present a barrier to taxpayers in

income tax states, and to not negatively impact state tax administration.

Although states’ tax codes have varying degrees of conformance to the federal code, states

typically ask taxpayers to provide certain information from their federal return, from which state

tax liability can be calculated. As a result, tax preparation can be thought of as a two-step

process: first prepare a federal return, then prepare a state return using the federal return

information.

Direct File aimed to facilitate this two-step process by 1) directing taxpayers to a state tax tool

following completion of their federal return, ensuring that taxpayers understand that they may

have state tax obligations, and by 2) optionally allowing taxpayers to import their federal return

data into that state tax tool, minimizing duplicative data entry. For an illustration, see Figure

Figure 17. Conceptual overview of state taxes in Direct File

To facilitate the taxpayer importing their federal return data into the state tool, Direct File

implemented a secure Application Programming Interface (API) that was adopted by state

tools in Arizona, Massachusetts, and New York. Instead of downloading an unencrypted file

that could be stolen by malicious actors, taxpayers were able to transfer encrypted data from

21 IRS. IRS Report to Congress: InflaƟon ReducƟon Act §10301(1)(B) IRS-run Direct e-File Tax Return System. Page 20. htps://www.irs.gov/pub/irs-pdf/p5788.pdf

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Figure 18. The taxpayer must sign in to Direct

File to iniƟate the transfer of their tax return

via the secure API.

their Direct File account to their account with the

state tool. Figure 19 shows the consent screen

for taxpayers who requested to transfer their data

to New York’s FileYourStateTaxes tool. ²²

Of the twelve states where resident taxpayers

were eligible to participate in the pilot, eight of

them have no state income tax. Four do (Arizona,

California, Massachusetts, and New York), and

one non-income tax state had a state sales tax

credit that eligible taxpayers can apply for

(Washington’s Working Families Tax Credit). For

taxpayers in each of these five states, filing a

federal return with Direct File was just the first

step.

However, the pilot enabled the IRS and states to

trial different approaches to understand the pros

and cons of potential paths forward. Table 3

shows how these approaches varied by state.

Table 3. Direct File integration approaches by state

Arizona, New York

Transfer method Secure API to enable

taxpayers to import data

from Direct File

Massachusetts

Secure API to enable

taxpayers to import data

from Direct File

California

Taxpayer uploads a PDF

of their federal return

Return status Federal return must be Federal return cannot be N/A

accepted before transfer rejected before transfer

22 Video demonstraƟons of these tools are available online.

Arizona: htps://www.youtube.com/watch?v=TSbjAhBmDmQ

Massachusets: https://www.youtube.com/watch?v=VEeShEevXpU

New York: https://www.youtube.com/watch?v=ENUHe6hKj1U

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Digital identity Email verification only (in

addition to Direct File

identity measures)

User experience Information is pre-filled

from the federal return;

taxpayer answers state specific questions

Knowledge-based

authentication using state

tax information (in

addition to Direct File

identity measures)

Information is pre-filled

from the federal return;

taxpayer answers state specific questions

Knowledge-based

authentication using

state tax information (in

addition to Direct File

identity measures)

No data is imported from

Direct File; some returns

may be pre-filled using

income and prior-year

returns from the state

State return State return is submitted State return is submitted State return is submitted

submission via the MeF Fed/State directly to the state directly to the state

Program

• Return status. The states that integrated with Direct File adopted different

approaches to whether they would allow the taxpayer to transfer a pending return, i.e.,

one that the IRS has neither accepted nor rejected. The advantage of waiting for

acceptance, the approach taken by Arizona and New York, is that it ensures the state

return will not need to be revised or amended should the federal return be rejected,

and the taxpayer need to fix an issue. The advantage of allowing pending returns, the

approach taken by Massachusetts, is that it allows the taxpayer to immediately

transfer their return without waiting to learn whether it was accepted or rejected.

• Digital identity. As Direct File provides strong guarantees that taxpayers transferring

data to state tools have submitted a federal return bearing a Taxpayer Identification

Number (TIN) that the IRS verified at the IAL2 level, integrated states could optionally

leverage these guarantees to mitigate identity theft risk (as did Arizona and New York).

Massachusetts built its Direct File integration into an existing tool that provides

taxpayers with access to other account information, and thus required the use of its

existing knowledge-based authentication (KBA) methods. California did not integrate

with Direct File for the pilot.

• State return submission. MeF supports a Fed/State Program that enables registered

transmitters to use the system as a single point of submission for both federal and

state returns. The majority of e-filed state returns are submitted in this way, and states

receive benefits including “linking” the state and federal returns. The IRS worked to

make it possible for state tools to submit state returns linked to the Direct File return

via MeF. In this way, there would be no disruption to how states receive e-filed returns

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today (Arizona and New York chose to use this approach). Massachusetts and

California submitted their returns directly to their own systems, without making a round

trip through MeF.

The IRS partnered closely with each of the integrated states and their partners to develop the

secure API and worked collaboratively with them throughout filing season. States provided

input on the design of relevant Direct File screens and provided language about the

capabilities of their tools for the eligibility checker both before and during the pilot.

Opportunity: Move away from tax forms

The secure API transferred an Extensible Markup Language (XML) version of the forms and

schedules of the federal tax return, using the existing MeF schema that is already in use by

states. This provided a number of advantages, particularly that the IRS and states needed to

coordinate their efforts in just a few months, and both parties were well-versed in the MeF

schema. This minimized the coordination challenge by limiting the number of technical

decisions that needed to be made.

Although the MeF schema provides an effective machine-readable version of tax forms, this

may not be the best long-term data interchange format for Direct File and states should Direct

File continue in future years. Tax forms only communicate what the taxpayer claimed on their

return, for example, that they and their children were eligible for the Earned Income Tax Credit

(EITC). However, when states adopt provisions similar to EITC, the eligibility requirements

may differ from the federal requirements in small ways, meaning that taxpayers who are

ineligible for EITC at the federal level may be eligible at the state level, or vice versa.

The impact is that state tools may need to re-ask questions already asked by Direct File to

establish eligibility for state credits or other provisions. If instead of transferring the tax forms,

as represented by the MeF schema, Direct File instead transferred the answers taxpayers

gave to questions, or transferred the conclusions that Direct File reached from those answers,

the experience of the state tools could be further streamlined.

Exchanging answers instead of forms, however, does create new challenges, among them the

need to ensure that taxpayers understand and consent to the information being transferred.

Direct File leveraged the one-to-one correspondence between the machine-readable

information and the forms and schedules of the tax return to explain concisely what

information would be transferred to the state tool. If more complex information is exchanged,

the complexity of ensuring taxpayers understand what information they are providing to the

state tool would also be increased.

Should Direct File continue in future years, this is a potential area for exploration, in

coordination with states and the Federation of Tax Administrators (FTA).

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Previous research has suggested that the absence of state tax preparation and filing from

Direct File would depress taxpayer interest in income tax states. ²³ In order to establish

whether Direct File’s approach to separate federal and state filing is viable, Figure 19

compares uptake of Direct File in states with and without a state income tax.

Figure 19. Accepted Direct File returns per 1,000 eligible taxpayers, by state

Income tax states are represented among the states with both the highest and the lowest

uptake. There is a great deal of variation between states, which may reflect different inherent

levels of interest or differences in media coverage, but this data does not reveal a statistically

significant difference in Direct File uptake between income tax and non-income tax states.

Direct File did not require taxpayers to use the integrated state tool to file their state taxes, but

the ease of importing Direct File data made this a popular option. Across the integrated states,

a majority of taxpayers chose to transfer their data to a state tool, at rates that in some states

exceeded 90%. It should be noted, however, that just because a taxpayer transferred their

data to a state tool does not necessarily mean that they ultimately used the state tool to file.

The IRS will work with states to analyze the rates at which Direct File taxpayers filed using

their state tools.

One initial finding is that Massachusetts taxpayers transferred their data at a lower rate than

the other integrated states. This could be attributable to the account creation process used by

the Massachusetts tool, which required verifying the taxpayer’s identity using state tax

information (e.g., first-time filers in Massachusetts or taxpayers who did not file in

Massachusetts in the last three years could not use this option). The Massachusetts tool also

23 MITRE CorporaƟon. MITRE Taxpayer Filing Preference Surveys, February 2023. htps://www.mitre.org/sites/default/files/2023-05/PR-23-1221-MITRE-Taxpayer-Filing-Preference-Surveys.pdf

39

supported filing tax returns without importing data from Direct File, unlike the Arizona and New

York tools, so taxpayers could have used the state tool without importing their data. In the

coming months, the IRS will work with all of the income tax states who participated in the pilot

to assess the impact of Direct File on state tax compliance, reconciling state and federal data

to understand full range of methods that Direct File taxpayers used to complete their state

taxes.

Arizona and New York chose to require that the federal return be accepted prior to transferring

the information to the states, so that the state return did not need to be revised or amended if

the federal return was rejected and the taxpayer needed to fix an issue. The downside of this

approach is that taxpayers needed to wait for acceptance, potentially causing frustration or

even abandonment if Direct File took too long to relay an accepted or rejected status. For the

vast majority of filing season, however, this was not an issue, as Direct File was generally able

to provide a status within 10 minutes of submission. There were exceptions to this, including

on Tax Day, when delays in providing a status peaked at more than two hours around 5:00pm

Eastern. While the delays abated in the early evening, this was a moment when the division of

federal and state returns caused additional stress for taxpayers.

Recognizing that the pilot was limited to four states with income tax, it enabled the IRS to test

integrating with states in different ways to preserve a seamless taxpayer experience and avoid

negatively impacting state tax administration.

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