Filing a tax return begins the running of an important statute of limitations. The IRS will sometimes prepare tax returns based on the information it has in a taxpayer's file if that person hasn't filed a return in a while. This is referred to as a substitute for a tax return. The IRS does this so it can assess any tax due and begin collection activities.
You should receive a letter from the IRS telling you that this has happened. It will tell you how much you owe.
- The IRS will file a return on your behalf if it has reason to believe you’ve received income that you haven’t reported.
- The IRS is aware of all income for which you received a Form W-2 or Form 1099 because it also receives copies of these forms.
- Your substitute tax return won’t include any deductions or tax credits you might be eligible for, so it’s likely that you’ll end up owing more tax or receiving less of a refund.
- Your best option might be to file a tax return for that year within 30 days, but you can also petition the Tax Court if you believe the substitute return isn’t accurate.
Example of a Substitute Return
Suppose you're a self-employed graphic designer. You work for various companies as an independent contractor. These firms send you copies of 1099-NEC forms each year to report the income they've paid to you. They send the originals to the IRS.
You neglected to file your 2019 and 2020 tax returns. The IRS computer will notice this. The computer will then pull all tax documents regarding your income that it has on file (those 1099-NEC forms), and the IRS will use them to calculate the tax you owe.
You'll receive a letter generated by the computer saying you owe X dollars based on the information the IRS had on hand.
What Are Your Options?
You have two possible courses of action when you're faced with this problem:
- You can petition the Tax Court. You must do so within 90 days of receiving a statutory notice of deficiency from the IRS.
- You can file an original tax return.
Falisha Griffin, a tax professional who specializes in filing late tax returns, says, "It's in the taxpayer's best interest to file an original return." The original tax return can be processed within about the same amount of time that it would take to make an appearance before the Tax Court.
The Assessment Letter
Taxpayers often find out that the IRS has prepared a substitute tax return for them when they receive a letter in the mail. The IRS will mail an assessment letter indicating that it proposes to assess taxes due based on the information it's aware of, typically W-2 forms, 1099 forms, and other tax documents that the IRS has on file.
The letter will summarize the sources of income that the IRS used to calculate the tax due.
The IRS allows 30 days from the date of the letter for the taxpayer to take one of three actions. You can:
- Send in a signed, completed tax return.
- Send in a signed and dated Consent to Assessment and Collection form.
- Send in a statement explaining that you aren't required to file a tax return and why.
You have no more than 30 days to respond to the letter.
The Statutory Notice of Deficiency
The IRS will send a second letter, a Statutory Notice of Deficiency, if a taxpayer doesn't respond to the assessment letter within the allotted time frame. This one is sent by certified mail. It requires that the taxpayer sign and acknowledge receipt.
The IRS mails this notice because it's going to proceed as though the proposed tax assessment detailed in their first letter is correct. It will take whatever actions are necessary to begin collecting any unpaid tax, penalties, and interest.
Be sure to read the notice of deficiency carefully if you receive one. It advises you of your right to dispute the assessment in Tax Court. The IRS gives you 90 days to take one of the following actions:
- File an original tax return.
- File a Consent to Assessment and Collection. This means you're basically agreeing to the IRS's calculations.
- Explain that you don't have a filing requirement and why.
How Does the IRS Calculate the Tax?
"The IRS will prepare a substitute return in the best interest of the government," Griffin says. "A substitute return claims no deductions, no credits. It could result in the taxpayer having a balance owed."
It's likely that the IRS's calculation of tax will be much higher than it should be when a tax return is prepared without any deductions and without any tax credits. Griffin indicates that sometimes the IRS will owe the taxpayer a refund.
"Providing the time limit hasn't passed, the taxpayer can still get a refund or have that refund applied to any outstanding balance due that they have with the IRS," Griffin says.
Statute of Limitations for Refunds
The statute of limitations for refunds is three years from the original filing deadline for the return. The filing deadline for individual returns for the tax year 2021 is April 18, 2022. Three years from that date is April 18, 2025. You would have until that date to file an original return for tax year 2021 to claim a refund from the IRS.
The refund "expires" if the return is filed outside this three-year time limit. The IRS can't reissue the refund back to the taxpayer, nor can it apply the refund to an outstanding balance from another year. It can't apply the refund as an estimated payment to a future tax year.
Be Prepared to Wait
It could be several weeks to several months—sometimes as long as 10 months to a year—before the IRS finishes processing the tax returns that were finally filed, according to Griffin. But it will hold off on trying to collect the tax while it's doing so.
"As long as the IRS has received the original returns and they're being worked on, it will put a temporary hold on the matter," Griffin says.
The taxpayer should continue to make any payments on plans they've set up with the IRS if they owe outstanding balances for other years.
If You Find Yourself in This Situation
Track down as much documentation as you can if you find yourself in this situation. This might include:
- Any notices or letters from the IRS
- Any tax forms or documents, such as W-2s, 1099s, mortgage interest statements, interest income
- A tally of your business income and expenses if you're self-employed
- The last tax return you filed
Gather up all these documents, or as many of them as you can find. Make an appointment with a tax professional, preferably one who specializes in these kinds of situations.
Dealing with a substitute return often requires professional help.
If You Can't Find Some Documents
"Fortunately, some documents can be obtained from the IRS, such as W-2s and 1099s," Griffin says. "They can be acquired from the wage and income transcript. However, as far as expenses are concerned, those would have to be recreated from bank statements or receipts."
The important thing is to gather as many documents as you can, then meet with a tax professional to sort through everything. "If you don't know if you should bring it, bring it anyway," Griffin advises.
Questions to Ask
Griffin suggests that taxpayers ask four questions of any tax professional when they're trying to deal with substitute returns:
- How many years of unfiled tax returns should be filed?
- If the IRS does owe you money, will you receive it?
- Should you mail in the tax returns or hand-deliver the returns to an IRS walk-in location?
- Who will be working with you from start to finish? Is this matter going to be passed off to someone else?
Ask what licenses the tax professional has, and how they price their services. Ask them to put together a project plan with deadlines, and ask about their preferred method of communication. Some are most easily reached by phone, others prefer email, and some ask that you drop by for an in-person meeting.
Other Statutes of Limitations
A substitute tax return that hasn't been signed by the taxpayer doesn't start the audit statute of limitations. It has no effect on the refund statute of limitations. It does begin the collections statute of limitations, however.
Signing the substitute return starts the audit statute of limitations and indicates that you've agreed with it.