The IRS will sometimes prepare tax returns based on information they have in a taxpayer's file when an individual hasn't filed a return in a while. It's referred to as a substitute for a tax return. The IRS does this so they can assess tax and begin collection activities.
Example of a Substitute Return
Let's say that you're a self-employed graphic designer. You work for various companies as an independent contractor, and they 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 2017 and 2018 tax returns. The IRS computer will eventually 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, essentially saying that you owe X dollars based on the information the IRS had on hand.
What Are Your Options?
An individual faced with this situation has two possible courses of action:
- They can petition the Tax Court, which must be done within 90 days of receiving their statutory notice of deficiency.
- They 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 filed and processed within about the same amount of time that it would take to make an appearance before the Tax Court.
The Assessment Letter
Taxpayers usually find out that the IRS has prepared a substitute tax return because 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 and 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.
The IRS allows 30 days from the date of the letter for the taxpayer to take one of three actions. The taxpayer 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 they aren't required to file a tax return and why.
The taxpayer has 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 the taxpayer doesn't respond to the assessment letter within the allotted timeframe. This one is sent by certified mail, which requires that the taxpayer sign and acknowledge receipt.
The IRS mails this notice because they're going to proceed as though their proposed tax assessment detailed in the first letter is correct. They'll take whatever actions 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 gives you 90 days to take one of the following actions:
- File an original tax return.
- File a Consent to Assessment and Collection, which 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, and 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, but 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 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. For example, the filing deadline for individual returns for the tax year 2019 was July 15, 2020 after being extended from the usual April date due to the coronavirus. Three years from that date is July 15, 2023. Taxpayers have until that date to file an original return for tax year 2019 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 on another year. It can't apply the refund as an estimated payment to a future tax year. The money simply disappears.
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 finally-filed tax returns, according to Griffin. But they'll hold off on trying to collect the tax while they're doing so.
"As long as the IRS has received the original returns and they're being worked on, they'll 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, including:
- 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, and 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 me money, will I receive it?
- Should I mail in the tax returns or hand-deliver the returns to an IRS walk-in location?
- Who will be working with me 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, while others prefer email and still others 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, and it has no effect on the refund statute of limitations. It does begin the collections statute of limitations, however.
Signing the substitute return does start the audit statute of limitations, however, because this indicates that you've agreed with it.