What Is a Substitute for Return? What To Expect if the IRS Files For You

A Substitute for Return (SFR) is a return that the Internal Revenue Service (IRS) files on behalf of a taxpayer who did not file a return for a specific year. The IRS typically uses the income documents that third parties reported to prepare this return to assess the tax amount that the taxpayer owes.

However, the IRS does not include deductions and credits on SFRs, which means these returns usually overstate tax liabilities. If you received IRS notices urging you to file a return or if you suspect that the IRS has filed an SFR, you must take immediate action to resolve the matter. 

In this post, we at The W Tax Group discuss the legal basis for an SFR, the SFR filing process, and the financial implications for taxpayers. We also outline your options in responding to an SFR. To get help now, contact us today. 

Substitute for Return – An Overview

Under Internal Revenue Code Section 6020(b)(1), the IRS can prepare and file a return using its available knowledge and any obtainable information. This authority applies when a person fails to file a return or files a false or fraudulent return. 

Under Internal Revenue Manual Section 4.25.8.5(2), the IRS has the authority to prepare and file an SFR on a taxpayer’s behalf if:

• The tax return filing due date and the extension date have both passed.
• All the IRS’s efforts to obtain the return were unsuccessful.

If your tax return is delinquent and the IRS has notified you to file the return, the agency has the legal authority to file an SFR on your behalf and assess the tax you owe. Once the IRS files an SFR, it typically starts collection action. 

Events Triggering the SFR Filing Process

Before the IRS starts the SFR filing process, the agency will notify you that you must file a return. You will likely receive the first notice around ten months after the return due date or extension date or when the IRS detects a filing obligation on your account but no return record. 

This message sequence consists of the following notices:

• Notice CP59 – initial notice informing you that the IRS has no record of your tax return for the previous year.
• Notice CP515 – a reminder indicating that the IRS still has no record of your tax return.
• Notice CP516 – a more urgent reminder, signaling that the IRS intends to escalate its efforts to get you to file your return.
• Notice CP518 – a final reminder to file your return before the IRS takes further action, including filing a substitute return on your behalf.

If you do not file a return or respond to these notices, the IRS will proceed with the SFR filing process. 

The SFR Filing Process

The IRS’s Automated Substitute for Return (ASFR) Program prepares SFRs. This program uses a system on a SUN Microsystems platform, which means the SFR filing process is automated. However, the ASFR Program has employees who manually review some SFRs and responses by taxpayers regarding SFRs that the IRS has filed for them. 

Automated SFR Preparation

After the referral of an account to the ASFR Program, the system will prepare an SFR using the income information that third parties reported to the IRS. These informational returns include W-2s, 1099s, and K-1s. 

The ASFR system does not include deductions, credits, or exemptions on SFRs, a crucial reason why taxpayers must avoid this IRS action at all costs. When preparing an SFR, the IRS will not estimate your business expenses against the 1099 income it has on record. Additionally, the system will ignore expenses that third parties reported, such as mortgage interest that your bank reported using Form 1098. 

If you are self-employed, an SFR filing can result in a tax liability that is significantly overstated. 

For example, suppose Taxpayer A, a contractor, has a gross income of $350,000 that has all been reported on 1099s. A’s legitimate business expenses for the year, including equipment, material costs, wages, office expenses, marketing, licenses, permits, and depreciation, amount to $270,000.

Taxpayer A fails to file a return stating a taxable income of $80,000. As a result, the IRS files an SFR based on the 1099s it has received, assessing A’s tax liability on an income of $350,000. 

Letter 2566

Once the ASFR System has prepared the SFR, it will automatically generate and send Letter 2566. This letter informs taxpayers that:

• No tax return is on record on the taxpayer’s account for the specified year.
• The IRS prepared a Substitute for Return on the taxpayer’s behalf.
• The IRS computed the taxpayer’s tax, penalty, and interest amounts according to income that third parties reported.
• Filing an original return for the original year will be to the taxpayer’s advantage.

This letter also notifies the taxpayer that the IRS proposes to assess tax, penalty, and interest amounts on the taxpayer’s account. Additionally, the IRS will proceed with the assessment if the taxpayer does not take one of the following actions within 30 days:

• File the original return for the specified year.
• Submit a written statement explaining why filing a return is unnecessary.
• File additional information that the taxpayer wants the IRS to consider.
• Appeal the assessment that the IRS proposes.

Taxpayers who agree with the assessment can complete and submit a Consent to Assessment and Collection form to the IRS. 

90-Day Letters

If you do not respond to a 30-day letter, the IRS will proceed with the next step: sending you a 90-letter via registered mail. In most cases, taxpayers who reach this stage receive Letter 3219N, a Statutory Notice of Deficiency. However, the IRS may send other 90-day letters depending on the circumstances.

This letter explains how the IRS calculated the tax, penalties, and interest in its proposed assessment and provides the details of the person you can contact regarding the letter. This letter also informs taxpayers that they may qualify for a payment agreement once they become tax-compliant.

The 90-day letter also lists the options available:

• Filing a Tax Court petition to challenge the IRS’s proposed assessment within 90 days of the letter’s date.
• Filing your original return for the year. 
• Agreeing to the assessment by completing and submitting the included Response Form.

After receiving this letter, you have 90 days to file a Tax Court petition, an original return, or agree to the assessment. If you do not respond within this period, the IRS will assess the proposed tax, penalties, and interest against you and proceed with collections.

Manual SFR Preparation

In some cases, IRS tax examiners prepare SFRs manually. When this happens, you will receive Letter 1862 as the 30-day letter and Letter 3219 as the 90-day letter. Upon assessing the tax amount in the SFR, you will receive IRS Notice CP22E indicating your tax liability. 

The Implications of an SFR for Taxpayers

The implications of an SFR filing can be far-reaching, including financial consequences and impacts on their rights and options for future filings. In addition to a higher-than-necessary tax liability, you may face the following financial consequences:

• Penalties: Failure to file a tax return can result in a failure-to-file penalty, which is usually 5% of the unpaid taxes for each month the return is late, up to 25%. Upon filing an SFR, the IRS may apply this penalty retroactively to the return’s original due date.
• Interest: In addition to penalties, interest accrues on any unpaid taxes from the due date of the return until the date you pay the tax. The interest rate is determined quarterly and is the federal short-term rate plus 3%.

Impact on Taxpayer’s Rights and Options

Once the IRS issues a notice of deficiency based on an SFR, the taxpayer has 90 days to file a petition with the Tax Court to challenge the assessment. Respond within this time frame to avoid the loss of the right to contest the tax liability in court. Other potential issues you may face include:

• Loss of refunds: If you are entitled to a refund, you must file a return within three years of the original due date to claim it. If the IRS files an SFR after this period, you may lose the opportunity to claim the refund.
• Future filings: An SFR filing does not eliminate the obligation to file a proper tax return. Ideally, you should file your return to replace the SFR, resulting in a more accurate tax assessment and potentially lowering your tax liability.
• Impact on future IRS actions: An SFR filing can lead to further IRS collection actions, such as levies or liens if the assessed tax liability is not paid or resolved.
• First-time penalty abatement: If you file a return after the IRS has contacted you, a first-time penalty abatement may not be available. 
• Collection Statute Expiration Date (CSED) extension: The sooner you file a return, the sooner the clock starts ticking on the IRS’s collection statute of limitations, which is ten years. 

An SFR filing can impact you on several levels. But, don’t lose hope—even after the IRS has filed an SFR and assessed a tax, you can still take action to reduce your tax liability and resolve this debt. 

Responding to an SFR

In most cases, filing an original return is the best response to an SFR filing by the IRS, as doing so usually reduces the taxpayers’ liability. Before filing a return, pull your IRS transcripts to review the income and wage information that the IRS has on record for your account. 

You must also collect all other records of your business, medical, and childcare expenses and other deduction items, such as property tax payments and charitable donations. Use this information to prepare and file your original return. 

However, there is an exception to this standard advice. If you think that you may be eligible to settle your taxes for less than you owe through an offer in compromise, you may not need to file a return. Instead, you can apply for a settlement on the amount assessed through the SFR. To determine if this might be the right option, consult a tax professional.

Avoiding a Substitute for Return

You can avoid an SFR filing by doing the following:

• Ensure you file your tax returns by the due date each year. If you need more time to file, submit Form 4868 to request an extension, and then make sure to file by the extended due date.
• Maintain accurate and complete records of your income, deductions, and credits throughout the year. Accurate recordkeeping will help you prepare a tax return and provide documentation if the IRS has questions.
• Respond to notices from the IRS indicating that they have not received your tax return. Provide the information that the IRS requests or file your return as soon as possible to avoid further action. If you’re not required to file and the IRS sends you a notice, write them a letter explaining that you don’t need to file as soon as you can. 
• If you did not file returns for previous years, file those returns as soon as possible. The IRS is likelier to file an SFR for taxpayers with multiple unfiled returns.

FAQs About IRS SFRs

How can I tell if the IRS has filed an SFR?

If you haven’t received any notices, you can check if the IRS has filed an SFR by looking at the balance due for that particular year on your online IRS account. Generally, if you haven’t filed, you won’t have a balance due unless the IRS has issued an SFR.

You can also pull your account transcripts. If the IRS has filed an SFR, a Code 150 will appear under the transactions section. Alternatively, you can call the IRS to determine if the agency has filed an SFR. 

Can the IRS file an SFR for any previous year?

Yes, the IRS can file an SFR for any previous year in which a taxpayer has failed to file a tax return. There is no statute of limitations on unfiled returns, meaning the IRS can go back an unlimited amount of time to file SFRs. In practice, though, the agency usually only goes back six years unless fraud is suspected.

How does filing a late return affect an SFR the IRS has prepared?

The IRS will process an original return even after issuing an SFR. The information on the original return will supersede the information on the SFR.

Are there any ways to reduce penalties and interest on an SFR?

You can reduce the penalties and interest on an SFR by filing an original return and requesting first-time penalty abatement. 

Can an SFR lead to more serious legal actions from the IRS?

A taxpayer may face a criminal investigation if the IRS suspects willful intent to evade taxes or commit tax fraud. However, in most cases, the IRS resolves tax matters, such as delinquent returns, through civil procedures, which may include a higher-than-necessary assessment, monetary penalties, and collection actions such as wage garnishment or asset seizures. 

Partner With a Reputable Tax Professional

The IRS has extensive powers to assess and collect taxes, penalties, and interest from taxpayers. If you have ignored filing requests by the IRS, you may face a substantial tax liability. Once the IRS has assessed a tax against you, the agency can aggressively collect this debt, including wage garnishments and bank levies. 

If the IRS has filed an SFR on your behalf, contact us at The W Tax Group. We will provide you with a personalized solution to resolve the matter. If you owe substantial back taxes, we can also help you pursue a tax resolution option, such as an offer in compromise, currently-not-collectible status, or an installment agreement.

Lead Tax Attorney at The W Tax Group

Stephen A Weisberg