What is a substitute for return (SFR) and what should I do if the IRS files one for me?

September 15th, 2011

If you don’t file a tax return each year, the IRS will send you a notice reminding you to file your return.   If you fail to do so, the IRS will eventually prepare a substitute for return (SFR) for you using wage and other income information (such as 1099 income, interest, dividends and sale of stock) reported to the IRS for you in that particular tax year.  In preparing the SFR, the IRS will not take into consideration whether you were married filing jointly, had dependents you could claim for that year or whether you had any deductions or credits that could lower your taxes.  As a result, you could end up owing substantially more taxes based on the SFR than if you filed your own tax return.  If you fail to pay the taxes the IRS has assessed against you, the IRS will start collection proceedings to collect the taxes.  This could include issuing levies against your bank account or wages and filing liens against your property.

The first notice you will receive showing the IRS is preparing an SFR for you is a “Notice of Proposed Individual Tax Assessment” (Letter 2566), also known as the 30-day letter.  The letter will notify you that the IRS has no record of your individual tax return for a particular tax year and the IRS is proposing to assess taxes against you in a certain amount.  The IRS will also add interest and penalties to the amount of the proposed taxes.  The notice will show what income sources the IRS used in preparing the SFR.   You will then have 30 days to file your own tax return, agree to the IRS’s proposed assessment and collection of the taxes or dispute the IRS’s proposed assessment.

When you receive a 30-day letter, the best thing you can do is to call the IRS before the 30 days runs out and inform the IRS agent you talk to that you will be filing your own tax return.   If for some reason you cannot file your own tax return within the 30-day time period, you should request additional time to file it  from the IRS.  Once your own return is on file, the IRS will review the return and determine whether to accept and process it.

If you fail to respond to the 30-day letter, the IRS will send you a “Notice of Deficiency” (Letter 3219), also known as a 90-day letter.   The 90-day letter states the amount of tax you owe, plus penalties and interest.   The letter will notify you that within 90 days, you must submit your own tax return, agree to the IRS’s proposed assessment and collection of the taxes or dispute the IRS’s proposed assessment.  It also advises you that if you dispute the amount of the assessed tax, you have the right to appeal to the United States Tax Court by filing a petition no later than the 90-day deadline.  You do not have to file a petition with the Tax Court as long as you file your own tax return with the IRS within the 90 days.

Remember, you should always file your own tax return rather than letting the IRS prepare an SFR for you.  Once the IRS has prepared the SFR, you should still file your own return so that you can claim all exemptions, credits and deductions you are entitled to.  However, the IRS will examine your own return to determine whether to accept and process it in place of the SFR.  This examination could turn into a full blown audit of your own return if the IRS finds you have not included all income sources, or claimed credits or deductions you may not be entitled to.   The IRS could also ask for proof of any or all deductions you have claimed on Schedule A or C of your return.   If the IRS accepts and processes your own return, the IRS will adjust the numbers based on your own return.