Hello again kjr,
Actually the requirement to keep tax records for 7 years only applies to the IRS and not to the individual states. And even with the IRS, depending on the circumstances, there are times they can even go back further than 7 years. So the 7 years is really just a "recommended" length of time that you keep your records. But it does not prevent them from going back further on this.
I agree with your assessment of the situation in the fact that they may have simply lost the return along with the payment, but unfortunately the burden of proof falls on the taxpayer. I am assuming that you have tried contacting the bank you used at the time this payment would have been made to see if they have anything in their archived records that would go back this far. If not, I would certainly make that attempt before doing anything.
As far as the letter, I can only suggest that you question why they waited so long to notify you of a missing payment, and explain that, as most people, you simply do not keep records going back that far. And under the circumstances, at the very least you might request that they waive the penalties and interest that are being assessed.
I honestly do not know what else to suggest to you other than getting a tax attorney involved, and that might end up costing you more than what the taxes are. It is most definitely an unfair predicament to put you in, but all I can tell you is that legally the state is within their rights to request payment if you cannot provide proof that payment was already made.
Thank you kjr