Substitute Returns
When a taxpayer fails to file their own tax return, the IRS has the
authority under Section 6020(b) of the Internal Revenue Code to prepare a tax
return on behalf of the taxpayer. The IRS can base its computations on
documents received from payers (like W-2 forms, 1099s, etc) as well as using
industry standards and other sources.
These returns - referred to as "Substitute Returns" - generally reflect
a larger tax liability than would be owing if the taxpayer filed their complete
return. That is because the IRS will not give the taxpayer credit for
deductions or exemptions that the taxpayer may be able to claim on their own
prepared return – such as mortgage interest, property taxes, contributions, and
so forth. Generally, it is to the taxpayer's advantage to prepare their
original (albeit delinquent) return after the IRS has prepared a substitute
return just to lower the tax liability for that tax year.
The other consideration for married taxpayers is that the IRS never
prepares Substitute Joint Returns. Filing jointly is an election that can
only be made by the husband and wife. Often by filing a delinquent joint
return (and getting the benefits of joint filing rates and credits only
available to married taxpayers if they file jointly - like child care), the
taxpayer will reduce their total liability.
There are restrictions on filing a delinquent joint return, however.
If either spouse had previously filed a separate return, the election to file
jointly must be made within 3 years of the original due date (without
extension). If neither spouse filed their own return, then the joint
return election can be made at any time regardless if the IRS prepared a
substitute return.
Failing to timely file a return can result in a significant civil
penalty of 5% of the tax liability (the amount of tax due minus withholding
and estimated tax payments) up to a maximum of 25%.
That is why I advise clients that even if they cannot
pay the tax liability that will be due, they should at least file the return and
avoid the accrual of the hefty late filing penalty! Further, if
the taxpayer was due a refund (the tax withheld plus any estimated tax payments
exceed the total tax liability), the taxpayer will forfeit a refund if an
original return is not filed within 3 years of the due date.
If the taxpayers fails to file a return and the IRS prepares a
substitute return, that substitute return tax assessment is generally NOT
eligible for bankruptcy discharge.
Most all state income tax agencies have a similar authority to prepare a
substitute return for a delinquent taxpayer.
The process/procedures and penalties likely differ from
those of the IRS.
Here is a link to
a Chief Counsel Memorandum that provides a good discussion of the IRS's
substitute return program, and the opportunities taxpayers have to replace the
IRS prepared return with their own.