PRACTICE CORNER FROM THE
Helping a Client Who Has a Substitute for Return
Substitute for Return What is a Substitute for Return
(SFR)? It’s the IRS’s way of getting the taxpayer’s attention when he or she fails to file a tax return! The IRS files an SFR when it believes there is tax due and the taxpayer is trying to shirk the responsibility of paying by not filing a legally required income tax return. NOTE: The Record of Account (ROA) may indicate that an SFR was filed. An SFR is filed by the IRS, not by the taxpayer. An SFR filing is a tax return that the IRS prepares and files on the taxpayer’s behalf. (You can determine if the return on file at the IRS is an original return filed by the taxpayer or an SFR just by knowing what to look for on the ROA.) The IRS assesses an SFR after it has repeatedly tried to get the taxpayer to file and has been ignored. Generally, the amount of tax penalty and interest due is MUCH greater than if the taxpayer actually filed his or her own original return. The reason for this is that the IRS uses the highest tax bracket for the taxpayer’s filing status (married filing separate), and the service only gives credit for one exemption and the standard deduction. The IRS ignores the actual filing status and number of dependents and does not allow for itemized deductions or expenses, such as home mortgage interest and property taxes, that the taxpayer might have actually paid. HowDoes the IRS File an SFR? If your client has an SFR on file, what this means is that the IRS uses the gross amounts of 1099-Misc or 1099-NEC income and 1099-B brokerage stock
sales when figuring the taxpayer’s taxable income, without any regard for the “basis” or cost of the stock, nor does the Service give credit for any business or self-employment expenses associated with the taxpayer’s 1099-Misc income. The IRS can take up to six years to file the SFR but generally files one within 2.5 years from the due date of the return. Once the SFR is assessed, the 10-year CSED applies unless when filing the original return there is additional tax due (than what the SFR reflects), as this will trigger a second CSED from the date of the recently filed original return. What to Do if Your Client Has an SFR The good news is that you can replace an SFR at any time by filing the original return! This, in and of itself, may greatly reduce what the IRS is claiming your client owes. I like to refer to this as an “SFR settlement” because in some instances, just filing the original returns will replace the SFRs and resolve the taxpayer’s account. I have seen SFR balances in the mid-six figures, and more, be reduced to $0. I’ve even seen, in some cases, where the client received a refund, all because they filed an original, accurate, and complete income tax return.
Another major reason to replace SFRs with original returns is generally, you cannot discharge SFRs in bankruptcy. You can discharge originally filed income tax returns, but there is a set of complex rules you must know and follow. Some practitioners think they don’t need to replace an SFR, as they are going to be doing an offer in compromise (OIC) anyway to reduce the amount owed. I think this may be a short-sighted strategy, as there is no guarantee that the OIC is going to get accepted in the first place. Better to reduce what’s owed first by simply replacing the SFR with an original return than go for the OIC or PPIA, etc. An SFR is usually bad news, and unless there is a compelling reason not to replace an SFR (e.g., filing the original return will result in more tax), you should generally always file original returns to replace SFRs. When your client has come into compliance by filing all required tax returns, you are ready to proceed with the resolution of the case!
–Michael Rozbruch
888.670.0303 • 3
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