The IRS Substitute for Return: An Overview

IRS Substitute for Return Forms

Most working Americans are legally required to file a tax return with the IRS, and if you’re reading this right now, this requirement probably applies to you, too. But what happens if you don’t file a tax return and you’re supposed to? One possibility is for the IRS to prepare and file a tax return for you.

This return is called a substitute for return (SFR). No, the IRS doesn’t do this as a favor to you, but to itself. Before explaining why, let’s first get a better understanding of SFRs and what it means for you if the IRS prepares a substitute for return on your behalf.

Understanding the Substitute for Return

Section 6020 of the Internal Revenue Code (IRC) gives the IRS authority to prepare and file a return for a taxpayer if the taxpayer fails to file a required tax return or files a fraudulent one. For purposes of this article, we’ll focus on SFRs that are created when there are one or more unfiled tax returns.

To file the SFR, the IRS needs your financial information. The IRS won’t have everything it needs to file a complete and accurate return, so the agency relies on information it receives from third parties. For instance, your employer could send the IRS a copy of your W-2 for your earned wages while your bank sends a 1099-DIV for any dividends you received from your investments.

The SFR Process

Before the IRS prepares and files an SFR, you’ll likely receive several notices from the IRS. The first one will probably be the CP59 Notice. This is where the IRS tells you they don’t have any record of you filing a tax return for a given tax year. If you don’t file the missing return or explain why you don’t have to file one for that year, the IRS will send you one or more reminder notices, such as CP516.

If you fail to respond to the IRS to resolve this tax issue, the IRS will begin the SFR process. The IRS starts by taking the financial information it has about you to prepare the substitute tax return. Because it’s missing other information about you, the SFR won’t accurately reflect your financial situation or taxpayer status.

For example, the IRS will probably prepare the SFR as if you were single or married filing separately. The IRS might also assume you have no dependents, use the single exemption, and have no credits or deductions to apply to your return. With these assumptions, the completed SFR will normally show you owe taxes.

It might seem odd that the IRS would go through all this work, but understand that much (if not most) of the SFR process is automated. When the IRS’ computers receive income information sent with your tax ID number, it’s not difficult for them to conclude you need to file a tax return. Once the computers make this conclusion, they can begin the automated process of sending out notices like CP59.

How to Respond to an IRS SFR

The first (or one of the first) notices you receive from the IRS confirming they prepared and filed an SFR on your behalf will be the CP2566 Notice. This letter explains that the IRS never received a tax return from you, so the agency calculated your taxes for you. The CP2566 should outline where the IRS got your financial information and how they calculated your tax balance.

If you get this notice, you can either agree with the IRS’ findings by signing and returning the enclosed Response Form (along with payment) or disagree by filing the missing return (or explaining why you didn’t need to file one).

If you choose to file a missing return, the IRS will examine your return under “audit reconsideration” status. This is because the IRS considers tax cases involving SFRs to be under audit. By filing the missing return, the IRS must now reconsider your tax case.

When you prepare the missing returns, you’ll want to write, “Audit Reconsideration, SFR Protest,” in red lettering at the top of the first page of your tax return. The IRS may take between one and three months to respond to this tax return.

Depending on your tax situation, you may want to consider hiring a tax professional to help you with the audit reconsideration process. This assistance could be useful if you’re still not sure if you even need to file a return. And if you aren’t required to file, you might be unsure how to convince the IRS this is the case.

Alternatively, you might acknowledge that you need to file a missing return but may want help preparing it so you can maximize any credits or deductions. A tax professional can help ensure your tax return gets prepared correctly and processed as quickly as possible by the IRS.

Filing the missing return or explaining to the IRS why a return isn’t required is your primary method of responding to the SFR. If you want to challenge the tax assessment itself, then depending on your situation, you might be able to request either a Collection Due Process hearing or an equivalent hearing.

Another option is to accept that you owe the IRS taxes, but instead of filing the missing tax returns, you ask for some form of tax debt forgiveness, such as an offer in compromise. This isn’t a common strategy for challenging an SFR, but it might apply to you in certain unique circumstances. We outline one such example below.

Asking the IRS to Reduce Your Tax Bill

Imagine you receive an SFR that says you didn’t file a return for a particular tax year and that you owe $500,000 in unpaid taxes, penalties, and interest. After reviewing your financial information (and/or speaking with a tax professional), you conclude that if you had filed the missing tax return, your tax balance would be $400,000 instead of $500,000.

If you’re like most taxpayers, having a tax debt of $400,000 instead of $500,000 doesn’t mean much. Sure, you owe $100,000 less, but from a real-world perspective, there’s no way you can realistically pay back $400,000. So, instead of wasting the time and effort of filing the missing return, you should reach out to the IRS to find a way to settle your tax debt for less than what you owe.

For instance, you could apply for an offer in compromise (OIC). You could request an OIC to reduce your tax balance because you can’t afford to pay the full balance. You could also request an OIC because there are doubts as to whether you really owe the taxes the IRS claims you owe.

In this hypothetical situation, it might be more practical to not file the missing return and instead skip straight to the part where you try negotiating with the IRS about your tax bill. However, keep in mind that this strategy doesn’t apply in most SFR cases.

What an SFR Means for Taxpayers

Having the IRS file your taxes for you isn’t a good thing. In addition to the IRS likely concluding you owe more taxes than you actually do, there are several other reasons to avoid having the IRS prepare and file an SFR.

First, if you eventually have to declare bankruptcy and need to discharge the tax debt that originated with the SFR, the bankruptcy court might refuse to discharge that tax debt.

Second, accepting an SFR instead of filing your own tax return means you’re almost certainly losing out on tax credits or refunds you might be eligible for. If the IRS owes you a tax refund, they can’t send it to you until you file the applicable tax return first.

Third, the SFR may result in state tax problems. The IRS sends state tax agencies the federal tax information for taxpayers from that state. When the IRS creates an SFR, the tax information gets sent to the taxpayer’s state. The state might then choose to assess higher tax bills or pursue unfiled tax returns it didn’t otherwise know about.

Avoiding an IRS Substitute for Return

You can prevent an SFR by promptly responding to the IRS notice informing you of the missing tax return. Explaining to the IRS why you aren’t required to file a return or filing the missing return will usually avoid the SFR.

One reason taxpayers sometimes encounter SFRs is because they don’t want to file the missing return as it will result in a tax bill they can’t pay. This is an understandable feeling, but the IRS has programs and policies in place to accommodate you if you can’t afford to immediately pay off your tax balance.

In addition to the OIC, there’s the Currently Not Collectible (CNC) program and payment plans that let you pay your tax bill in monthly installments. If you’re not sure what to do to prevent an SFR, you can always talk to a tax professional.

Substitute for Return FAQs

What is an SFR?

SFR is short for substitute for return, which is where the IRS uses third-party information to prepare and file a tax return for you. The IRS will typically use an SFR when it believes you were legally required to file a tax return but didn’t.

When Does the IRS File an SFR?

Timelines can vary, but the IRS usually won’t prepare and file an SFR until at least one year has passed since you should have filed a tax return. Most of the time, it’ll be closer to two years. During this time, the IRS will send you multiple notices explaining its need for you to file the missing tax return(s).

What are the consequences of ignoring an SFR filed by the IRS?

If you ignore the notice from the IRS letting you know about the SFR, you might eventually receive CP3219N (90-day letter). This is a type of Notice of Deficiency where the IRS provides you with 90 days to explain why you don’t need to file the missing tax return or to challenge the IRS’ tax assessment. You can also respond by filing the missing return or paying the tax balance.

Continuing to ignore the IRS will start the collection process. This can lead to the IRS filing a Notice of Tax Lien against your property or seizing your property with a tax levy.

Will an SFR affect the IRS statute of limitations for collecting unpaid taxes?

Generally speaking, the IRS has ten years and 30 days from the date of a tax assessment to collect that tax. Most tax assessments occur after a tax return has been filed. Therefore, the 10-year statute of limitation clock often starts after the SFR is filed.

How long does the IRS have to file an SFR?

There is no statute of limitations on unfiled returns. That means that the IRS can go back any amount of time and file an SFR against you.

Find Help Dealing with a Substitute for Return

Getting a notice from the IRS indicating you have a tax debt because the IRS filed an SFR can be unsettling. It might even come as a surprise if you never received prior notices about an unfiled tax return. Even after the IRS files an SFR, you still have the option of explaining to the IRS why you don’t need to file a return or filing the missing return.

If you want help responding to an IRS SFR, contact Wiggam Law today. Call our team at (404) 233-9800 or contact us online to set up a consultation with an experienced tax attorney today.