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Substitute Tax Returns

If a taxpayer does not file an income tax return (IRS calls them non-filers), and the IRS deems that a tax return is due to be filed, the IRS will use the information it receives from third parties (employers, brokerage firms, mortgage lenders) and filed W/2 forms, Form 1099, Form 1098, and other similar income reporting forms, to prepare the missing tax return. The tax return is prepared by the substitute tax returns group at the IRS, which is connected to the audit group. The tax return is called by the IRS a Substitute For Return (SFR).

What to do if you owe taxes?When the IRS prepares your substitute tax return, they use the highest tax rate and do not include any tax credits you are entitled to. Therefore, the tax computed is higher than what it would have been if you prepared the tax return in most cases. They also treat married people as married filing separately, which also causes the tax rates to increase. They also exclude dependents, which causes a higher tax bill. 

When you don’t file an income tax return, there is no statute of limitations of when you or the IRS can file a tax return, or audit you. The typical rule is that the IRS can audit you for the last three years once you file a tax return, unless they find your income was materially under reported on a filed tax return and they can go back for the last six years. Once there is an assessment they have ten years to collect. The IRS however, under the Internal Revenue Manual sections 412.1.3, says in general they will only prepare substitute income tax returns for the last six years. The six-year rule also agrees with the IRS policy for non-criminal cases of only looking for taxpayers to file for the last six years if they did not file for a longer period of time.

The IRS does not file substitute tax returns in all cases when the taxpayer is a non-filer. The IRS looks at whether the taxpayer filed other income tax returns in the past, and just missed one year. This may be an indication that perhaps no income tax is owed if the taxpayer suffered a large loss, and decided they owed no tax. If the taxpayer missed multiple years the tax balance will typically be sufficient for the IRS to file the tax returns, and create a tax bill, and try to collect on it by issuing tax liens and levies through the normal IRS collection process (ACS). Therefore, high income taxpayers have a higher risk of having the IRS use this method. It can also happen if the taxpayer is self-employed and receives a Form 1099, since such income does not have withholding tax taken from it and you could owe taxes. The IRS also looks at whether you had illegal income that needs to be reported. This can happen if you use a check cashing business and do not report all your income by excluding cashed checks. Therefore, the IRS uses its judgment of when a SFR tax return will be prepared by them.

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