By Michael Rude, Enrolled Agent
Learn more about Michael on NerdWallet’s Ask an Advisor
If you fail to file income tax returns with the Internal Revenue Service and the appropriate state tax agency (in states that have income tax), you may be subject to a procedure by the IRS and/or the state tax agency to file a tax return on your behalf. If you ignore the situation, the tax agency will assess tax and subsequently collect.
This process is referred to as a Substitute for Return, or SFR. The IRS uses a variety of methods to determine if an SFR assessment is appropriate. IRS computer systems gauge whether there is sufficient income reported on various required documents, such as W-2s, 1099-MISC, 1099-INT, and so on, and tax is computed based on your reported income minus any withheld taxes. If the computation results in a tax amount due, the IRS will mail notices requesting that the tax return be filed.
If you don’t respond, the IRS will move forward with a proposed SFR assessment.
The IRS can use additional methods to arrive at a tax amount due, including investigations conducted by IRS revenue officers, revenue agents and by special agents in cases of criminal tax matters. Summonsed bank records and information gathered from third parties are common sources of information used as a basis for SFR assessments in these investigations.
Upon assessment of the tax, the IRS will notify the appropriate state tax agency. This typically results in the state agency assessing an SFR assessment for state taxes if the taxpayer has not filed a state income tax return. Once the tax has been assessed, the tax agency proceeds with collecting the assessed liabilities.
Case study: failing to file
I had a client who did not file an original tax return for 2006, and he and his former spouse had sold their personal residence that year, resulting in no taxable gain. However, because they did not file for a tax return for that year, the IRS completed an SFR assessment based upon the gross sale proceeds from the sale of the house.
IRS assessed tax, penalties and interest, totaling more than $349,000, and then kept my client’s tax refunds for 2011 and 2012, totaling more than $34,000, to apply toward the SFR assessment.
I completed the original tax return for the 2006 year, filed it with the IRS and went on to get the SFR assessment adjusted accordingly. I then submitted a claim to get my client’s 2011 and 2012 tax refunds returned to him. These efforts resulted in my client owing no tax and receiving his refunds of more than $34,000.
Since state tax agencies also receive income information, they may initiate SFR assessments independent from any actions taken by the IRS. In the state of California, the Franchise Tax Board (FTB) can assess tax based solely on income averages by occupation. The FTB has a program in place that identifies all people who hold occupational licenses—for instance, real estate, contractors, attorneys, and so forth. Even if sufficient income documents don’t exist, the FTB can use the average income reported by occupation and assess tax based upon that figure, irrespective of how much the person may have earned.
Where to go for help
What to do if you’re hit with an SFR assessment? In many cases, the assessment is substantially reduced or abated in full on the basis of the subsequent filing of the original tax return(s). However, trying to contact the appropriate person at the IRS or state tax agency and then navigating the various procedures can be a daunting task for anyone without knowledge of the processes involved.
If you have been subject to SFR procedures by the IRS and/or a state tax agency, consider retaining a tax professional to help you through the process of filing original tax returns, getting the SFR assessments adjusted accordingly, and preventing or stopping enforcement actions by the tax agency.
But be aware, not all “tax preparers” are allowed to represent you before the IRS in collection matters. Practice before the IRS in collection matters is limited to Enrolled Agents (EAs), CPAs and attorneys. Many of these professionals, however, do not specialize in collection matters. Find a tax professional who does specialize in collections to assist you with complete tax resolution.