14. IRS Substitute For Return - What To Know

Industry Observer with Ocean Consulting Services LLC

OK I know I should have filed a tax return - but life got in the way…. Now the IRS has told me they prepared a “substitute for return” - what does this mean!

The US tax system is referred to as a “voluntary” tax system - I know, hold the jokes. This means each person is tasked with determining if they have a tax return filing obligation, and - if so - they “voluntarily” prepare and file an annual tax return.

But the IRS does not maintain a list of all people in the country and monitor whether or not a tax return is required and filed. That’s not to say the IRS solely relies on individuals to ensure compliance with the rules.

The responsibility of the IRS is to ensure compliance with the tax law - the filing of tax returns and the payment of tax obligations. The IRS uses a number of tools to ensure compliance with the tax return filing obligation.

The primary tool is use of “information returns” - i.e. W-2 and 1099 forms. The IRS imposes an obligation on certain businesses to report payments made to individuals. The IRS then uses this information for two purposes - primarily to check against figures self-reported on filed tax returns, but also to assist in identifying individuals who potentially have a tax filing obligation but have not filed a tax return.

If an information return reports income to an individual but no tax return is on file the IRS will initially send a friendly letter - “hey someone reported that they paid you income but we see you didn’t file a tax return - please file a return or provide us with an explanation why you believe no return is required”.

Let’s pause for a moment. In earlier discussions I discussed the concept of a tax “assessment”. This is the formal recording of the tax debt in the IRS records. This usually occurs once a tax return has been filed by a taxpayer and processed by the IRS. If an assessed tax is not paid the IRS can pursue collection activities.

If the IRS has been notified of the payment of income (W-2 or 1099) but no return has been filed there has been no tax assessment. The IRS cannot pursue collection activities since they have not recorded a tax debt. They may believe a tax debt has been incurred but since no return was filed there is no actual assessed tax debt.

So what happens if you receive a W-2 and some 1099s but don’t file a tax return? Can you just ignore the reminders from the IRS and avoid paying taxes. The short answer is no. If you don’t file a tax return the IRS will calculate your tax debt - this is what is referred to as an SFR - a Substitute For Return. The computation will include all reported income but will not include all deductions that may be available to an individual.

Legally this established your tax liability and the IRS can make an assessment. At this point all collection alternatives are available to the IRS - including asset levies and seizures, wage garnishment, etc.

The IRS does not need to “audit” you before they prepare an SFR - this is a common misperception. Their view is that they provided you with an opportunity to file a return or explain why you believe no return is required. Since you took no action they compute and assess a tax.

Once the tax liability has been computed by the IRS is an individual required to then prepare a tax return? No - the SFR established a tax debt for the year at issue. If you choose to do so you can just pay the amount computed by the IRS and be done with the tax year. You could also enter into an installment agreement and make payments over time or request that the IRS reduce the debt through the Offer In Compromise (OIC) program. In other words this debt is no different from the debt that arises when an individual files a tax return.

Should an individual just accept the SFR? It all depends….

Let’s assume the IRS computes your liability based on income reported on the information returns. However the return doesn’t reflect deductions that could have been claimed by the taxpayer. Should a return be filed to reflect the decreased tax liability due to the deductions? Well of course it depends…. If the plan is for full payment of the tax (either immediate payment or over time through an installment agreement) then yes a return should be filed by the taxpayer.

But what if the individual intends to request an OIC. In this case the tax liability is irrelevant - the request will be to reduce the debt to the amount determined to be the “RCP” - the Reasonable Collection Potential. In certain circumstances if the individual files a tax return with a reduction in the tax obligation they may not be entitled to an OIC. One of the rules for requesting an OIC is that the tax debt can’t be paid off before expiration of the statute of limitations. Reducing the debt may result in the ability to full pay the debt before the expiration date - so no OIC.

But wait isn’t this “fraud” since I believe the tax computed by the IRS is incorrect. No - the IRS calculated the tax liability. You can accept the IRS computation and move on to settling the debt.

What if the IRS believes your income may be more than reported on information returns? Say you are self-employed and may have received income not required to be reported - i.e. cash paid to your business by individual customers.

In this situation the IRS will most likely issue you a summons. They will request that you appear at an IRS office with your financial information. The IRS cannot compel an individual to prepare a tax return but it can compel provision of information that will be used by the IRS to determine a tax liability.

If a summons is issued we recommend that a tax return be prepared and filed in order to avoid the requirement to provide records. The IRS will usually allow for time to prepare the return upon being contacted. Don’t just ignore the summons - the IRS will refer your case to the Department of Justice for the issuance of a court order to compel. Judges are not usually sympathetic to individuals in this situation.

My initial advice to all individuals - file a tax return if required. Immediate payment is not required. Once the tax debt has been assessed you can then work through payment options. If no return is filed and the IRS prepares an SFR consider next steps before taking action - should you just pay the IRS determined tax, should file a return to correct the tax determined by the IRS, do you intend to pay the entire tax or ask the IRS for a compromise? As with all tax matters there are no easy answers.

In our next blog post we’ll discuss the Statute Of Limitations (SOL) and the Collection Statute Expiration Date (CSED).

As always feel free to reach out if you need assistance - Contact The Author

Link to Outline Slides:  Outline SFR

Link to Video:  Video - SFR