It’s a frequent call:

“Law Office.”

“Hi. I haven’t filed a tax return in X years. Now the IRS says I owe $Y. Can they do that? How do they know what I owe when I haven’t filed a tax return?”

Let’s look at those two questions:

1. Can they do that?

Yes, they can. It’s called a Substitute For Return, or SFR for short (hey, it gets wordy if you say it a lot). And it’s authorized by law – see 26 USC 6020(b)(1), which states:

If any person fails to make any return required by any internal revenue law or regulation made thereunder at the time prescribed therefor, or makes, willfully or otherwise, a false or fraudulent return, the Secretary shall make such return from his own knowledge and from such information as he can obtain through testimony or otherwise.

2. How do they know what I owe when I haven’t filed a return?

Truthfully, they don’t. What they DO know, however, is what some – not all – of your income is. And that’s enough to get started. For example, they know:

A. How much you made, if you’re an employee (from your W2);

B. How much interest you earned from your bank (from Form 1098);

C. The gross amount you made from stock sales (from Form 1098);

D. What you paid in mortgage interest (from Form 1098);

E. What non-employee income you have (from Form 1099-Misc);

F. How much your partnership or S-Corp earnings were (from K-1s);

G. How much pension (from Form 1099-R), Social Security, or Railroad Retirement Board income you had;

H. How much was withheld from your check (W2, again);

I. How much you paid in estimated taxes (from Form 1040-ES).

And that’s just for starters. The IRS has access to a lot of third-party provided information (unemployment, gambling winnings, etc.) which they can use to determine how much income you had in a given year. As bad as that seems, it’s not the worst part. It’s what they DON’T know that gets you.

For example, they don’t know:

What your filing status is – for an SFR, the IRS manual states that they are to use the filing status which results in the highest tax liability, so if you’re married, they will use Married Filing Separately (IRS agents have told me that they are not permitted to assume you’ll file a joint return). If you’re single, but qualify as Head of Household, you’ll be filed by the IRS as single.

What expenses you may be entitled to – a big problem for self-employeds, who generally gross considerably more than they net.

How many exemptions you may be entitled to – hey, it’s  not the IRS’ job to make sure you can still claim Junior, so they just assume you can’t.

What you paid for the stock or bond you sold – the general rule is that if you can’t prove basis, basis is zero. So since the IRS doesn’t know the basis, it’s zero.

As bad as that all may seem, it gets worse.

The SFR is not an official tax return. That’s right – it counts for nothing other than to provide a basis for collection efforts to begin. What does that mean for you, the taxpayer?

1. It cannot be used to discharge taxes in bankruptcy. Only an actual, filed, tax return – which represents a ‘tax assessment’ – can qualify for discharge. In order to discharge your taxes in bankruptcy, there are a number of qualifiers which must be present, and the first of the qualifiers is that it’s been at least 3 years since the tax was assessed. So if you file your 2006 tax return in 2010, then head over to your bankruptcy lawyer hoping to get the 2003 tax discharged, you’re out of luck – it wasn’t assessed until 2010.
2. It has no statute of limitations. The IRS has 10 years from the date of assessment to collect tax. And since the SFR doesn’t qualify as an assessment, it does not trigger the statute. The IRS can collect on this until the cows come home. Or later.
3. It can be used for levies, liens and garnishments. The IRS can, however, levy your bank account based on the tax shown in an SFR. And since the tax calculated by an SFR is almost always higher than the actual tax due, you’ll spend more than if you just hired a competent preparer to file the return.
4. You’ll lose out on important credits and benefits. For the most part, and SFR does not contemplate things such as Earned Income Credit, Child Tax Credit, and other benefits that you may be entitled to.

So if you haven’t filed a return, don’t think that you won’t eventually get a bill from the IRS. And it’s sure to be one that you won’t like. Before that happens, click here, and let me help you avoid a headache you don’t need.