What to Expect If You Receive a Substitute for Return
If you don't file a tax return, the IRS may generate a return on your behalf. This is called a substitute for return (SFR), and it almost always shows a larger tax liability than you owe. The IRS generates these returns so that it can start the collection process. The IRS cannot collect taxes that haven't been assessed, and the SFR kicks off the assessment process.
This guide explains how SFRs work and what to expect if you receive one.
What Is a Substitute for Return?
A substitute for return is a return generated by the IRS for a taxpayer who hasn't filed their return. The IRS uses information received from third parties to create this return.
For example, say that your employer sent a copy of your W2 to the IRS, your bank also submitted a 1099-INT, and you worked part-time for a rideshare company that issued a 1099-NEC. The IRS will use all of this information to generate a substitute for return for you.
The return will use the single or married filing separately filing status, and unfortunately, it won't include any credits or deductions so your tax liability will be higher than it should be.
Is That Legal?
The IRS has the legal right to generate an SFR based on IRC 6020 (b). This part of the Internal Revenue Code states that the Secretary can prepare a return if a taxpayer fails to file a required tax return or files a fraudulent one. It specifies that the IRS can generate the return based on its own knowledge or information obtained from testimony or other sources.
Automated Substitute for Returns
In a lot of cases, the process is automatic. The IRS's computer systems gather all the income documents submitted under your Social Security Number. Then, they generate a return and send you a notice. If you fail to respond to the notices, the automated process can start collection actions such as issuing a federal tax lien or levying your assets.
Every year, the IRS creates hundreds of thousands of SFRs, and often, the number climbs over a million. These SFRS represent billions of dollars in unpaid taxes.
What to Expect
If the IRS generates an SFR on your account, you will receive the following two notices. This generally happens at least a year after you failed to file your return, but the exact timing can vary. Once you receive the first letter, the process has started, and you should receive the following letter in about six weeks.
Letter 2566 SC/CG
This letter states that the IRS hasn't received a tax return from you, and it provides a tax assessment based on details that the IRS has received from other parties. You have 30 days to respond to this letter.
If you agree with the assessment, just sign and return the notice. Then, make arrangements to pay your tax debt. If you don't agree, you should complete a 1040 Individual Income Tax Return or write a letter explaining why you're not required to file.
Letter 3219 SC/CG (Notice of Deficiency)
This is also called the 90-day letter. It shows the assessment plus tax and penalties. It also explains your rights to appeal in front of the US Tax Court. When you receive this letter, the IRS gives you another chance to respond. Again your options are 1) agree with the assessment, 2) file a correct Form 1040, or 3) write a letter explaining why you don't need to file. However, this is your last warning. If you don't respond within 90 days, the IRS has the right to proceed with the collection process.
Why You Should File a Tax Return If You Receive an SFR
If you receive an SFR, you should almost always file a correct tax return. The IRS uses the single or married filing separately filing statuses on SFRs and only uses a single exemption, no dependents, and no credits. This means that SFRs generally show a higher tax liability than you owe.
Filing your own return ensures that you can claim the best filing status, the correct number of dependents, and all of the credits you deserve. Keep reading for a few examples.
Imagine that the IRS files an SFR using a W2 submitted by your employer. That's the only income you have, and all of the numbers are correct. However, the IRS used the single filing status and no dependents. You have two dependents and qualify for head-of-household filing status. By filing a correct Form 1040, you increase your standard deduction and claim the child tax credit. This reduces your tax liability by thousands of dollars and potentially even leads to a tax refund.
Here's another example. Let's say that your filing status is single and you have no dependents. That part of the SFR is correct. However, you qualify to itemize $52,000 in deductions, and the SFR only claims the standard deduction ($12,950 for single filers in 2022). By filing your own tax return, you increase your deduction by almost $40,000, which substantially reduces your tax bill.
It's also important to note that the SFRs don't include business expenses. Say that your clients sent several 1099-NEC forms to the IRS, showing $20,000 in business income. When the IRS puts this income on your tax return, you incur self-employment tax on the entire amount plus income tax as applicable. However, you incurred $8,000 of business expenses to earn that money. By filing your own return, you claim the expenses. That reduces your self-employment income substantially and reduces your tax debt.
What if You Receive an SFR and You Don't Have a Filing Obligation?
If you receive an SFR and aren't required to file, you must write the IRS a letter explaining why you're not required to file. Tax return filing requirements vary based on your income and filing status. In many cases, the IRS can tell whether or not you have a filing requirement based on the tax documents it receives on your behalf, but this isn't always clear.
In particular, the filing requirement can get murky for people with 1099-NEC income. You must file a tax return if you have more than $400 in net self-employment income, but you don't have to file a return if you have more than this amount in gross self-employment income. The IRS may know about your gross self-employment income but doesn't have the right information to compute your net income.
Here's an example. Let's say the IRS has received 1099-NEC forms showing $10,000 in non-employee compensation. The IRS generates an SFR showing this income and the associated tax liability. However, you have bookkeeping records and receipts that show you incurred $9,800 in expenses to earn that income. As a result, your net self-employment income is only $200, and you don't have a filing requirement.
This is the type of argument you should make when you receive an SFR but don't have a filing requirement. However, this is just a basic example. There are all kinds of other scenarios that can apply to this situation. It's also important to note that even if you're not required to file, you may want to do so to claim a tax refund.
How to Dispute Tax Assessed From an SFR
If you don't respond to either of the SFR notices, the IRS will assess the tax against you. At this point, you may still be able to file a correct tax return. The IRS will review this return as an Audit Reconsideration. During this process, you get to explain your situation and why the SFR assessment is incorrect.
If the audit reconsideration doesn't work, you may want to try the following:
- Pay the assessed tax and request a refund — Note that you only have two years from the payment date to request a refund.
- Apply for an offer in compromise based on doubt as to liability — This is when the IRS agrees to reduce your balance based on the idea that you don't really owe the tax liability. It is not the same as a standard offer in compromise, which is based on an inability to pay.
- Request a hearing through the Collection Appeals Program — If you don't meet the deadline, you may be able to request an equivalent hearing. There are strict protocols with both options, and you may want professional help to navigate the process.
- Look into currently not collectible status — If you prove that you can't afford to pay the assessment, the IRS will pause collection actions against you. However, the IRS will periodically review your situation, and you will remain responsible for the debt. To be safe, you may still want to go through the process of establishing the correct tax liability on your account.
- Apply for an offer in compromise — If you can't afford to pay the tax liability, the IRS may agree to reduce your balance through the offer in compromise program. In some cases, if you take this route, you don't necessarily need to correct your tax liability.
For example, imagine that you have several years of SFRs that show you owe $1,000,000. You can only afford to pay $50,000, and the IRS agrees to accept this settlement. If you filed the correct tax returns, you would only owe $800,000. In this case, filing the correct returns reduces the assessment by $200,000, but it doesn't save you any money because you would still qualify for the $50,000 settlement. By extension, there's really no compelling reason to pay someone to file the correct returns because it doesn't reduce the amount owed.
Get Help With an SFR Today
Dealing with an SFR can be complicated and stressful. If the IRS has sent you an SFR, you should seek help as soon as possible. Don't contact the big-name tax resolution firms. Instead, reach out to a local tax professional. Unlike the big tax debt relief companies, a local pro won't push you into a one-size-fits-all solution or make promises they can't keep.
Instead, they will work closely with you to find a resolution customized to your situation. To find a tax professional in your area, use TaxCure to search for help. Then, filter your results to look for a pro with the experience you need, and give them a call to talk about your situation.