There are all sorts of reasons why you might fail to file a tax return. Sometimes life gets in the way and you can’t find the time to get the return prepared. Maybe your records were lost and you felt like you couldn’t complete an accurate return, so you didn’t. Maybe you prepared your return but couldn’t afford to pay the tax liability showing on the return, so you were afraid to file and generate a liability. Whatever the reason for not filing a return, if you haven’t filed the return within a couple of years of the due date, don’t be surprised if you receive a notice stating that the IRS has created a return for you and sends a bill for the amount of tax they think you owe, plus applicable penalties and interest. The IRS has prepared what’s referred to as a Substitute For Return, or SFR.
If the IRS has prepared an SFR for you, you may be surprised at the amount of tax they believe you owe. The IRS will tax you on any items of income that are reported to them for the year, reported via forms W-2, 1099-MISC, 1099-R, etc. They will also give you credit for any withholding reported on these forms. However, the IRS will not file an SFR that elects either Married Filing Jointly or Head of Household filing statuses. Instead, the return will either be prepared with a Single or Married Filing Separately filing status. In addition, you will only receive credit for the standard deduction associated with that filing status, even though it may be far more beneficial for you to have itemized your deductions for the year.
If you do receive a bill from the IRS for a return they’ve prepared on your behalf and the tax owing is more than it would have been had you filed your own return, don’t fret; so long as there is still a balance owed on the year, you can file an original return to replace the IRS-prepared SFR. The IRS will process an original return to replace an SFR under their Audit Reconsideration guidelines (future article coming). While this generally means the IRS has the discretion as to whether or not to process the original return, in most every instance, so long as you can substantiate the items reported on the return, the IRS will process the original return without issue, making any necessary adjustments to the balance owing. Therefore, when filing an original return to replace an SFR, it is generally best practice to have the requisite supporting documentation on hand to substantiate items reported on the return.
While the IRS will generally let you file a return to replace the SFR, it’s always best practice to file your return accurately and on time. Even if the IRS later replaces the SFR with an original return you file, there can be long lasting implications of the IRS having prepared a Substitute For Return. Most critically, while tax liabilities can generally be discharged in Chapter 7 Bankruptcy (future article coming), provided the liabilities are sufficiently “ripe,” tax liabilities that arose from a Substitute For Return, are ineligible from being discharged in bankruptcy, even if an original return is later filed to replace the SFR. Furthermore, while SFR is considered a filed return for the IRS’s 6-year filing compliance requirement in order to establish a collection alternative, a history of SFRs having been prepared for you by the IRS demonstrates a lack of compliance history with the IRS, which the IRS will still view unfavorably while working with you to establish a collection alternative.
Oftentimes, filing an original return to replace an SFR is a quick and easy way to reduce the amount of taxes, penalties, and interest the IRS claims you owe. Sometimes just making the election to file jointly with a spouse (remember, SFRs are never prepared jointly), can make a big difference in the amount of tax the IRS thinks you owe. If you’re dealing with an SFR, it is worthwhile to have a tax professional review the IRS’s assessment against any items of income and deductible expenses you may have had for the year in order to determine whether filing an original return would appreciably reduce the tax owing for that year.