Are Substituted Tax Returns Considered a “Filed” Tax Return So That Unpaid Income Tax Can Be Discharged in Bankruptcy?

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In order for your tax debt to be dischargeable in bankruptcy you need to meet all these criteria: 1) the taxes need to be due more than three years ago, 2) filed at least two years prior to filing bankruptcy, 3) the taxes need to be assessed more than 240 days (8 months) ago, and 4) no filing of fraudulent returns or willful attempts to evade or defeat a tax. If you meet those 4 requirements, your unpaid income taxes can be dischargeable in your bankruptcy case. Today we are going to focus on Internal Revenue Service policies and whether a substituted tax return filed by a taxing authority on behalf of a taxpayer is considered a “filed” tax return to satisfy number two listed above.

What is a substituted tax return? A substitute for return (“SFR”) is a tax return the Internal Revenue Service (“IRS”) files on your behalf if you fail to do so. The IRS gathers all the information submitted to them (W-2s, 1099s, etc.) and the taxing authority prepares your return on your behalf. Keep in mind that the SFR is most likely not going to include all the deductions, exemptions, and credits that you may be entitled to so the tax assessment may be higher than what you actually owe. The IRS will send you a Notice of Deficiency and provide you with a proposed assessment and give you 90 days to file a return or a petition in Tax Court. If you do not respond the IRS will proceed with the assessment and for all intents and purposes the SFR will be considered a valid return for tax assessment and interest and penalties will accrue. Now just because the IRS filed an SFR for you does not mean that you cannot file your own tax return. In fact it is encouraged that you still file your own return because as indicated previously, the IRS does not take into account all the deductions, credits, and exemptions that you may be entitled to. By filing your own return you can reduce your tax liability if not eliminate it altogether. You may even be due a refund. If you do not file your return within 3 years of the date the return is due you risk losing your refund and your right to claim tax credits. Make sure your bankruptcy attorney or you obtain an account transcript from the IRS to verify your tax history and verify that a SFR was filed on your behalf.

Now that you know what a SFR is the next step is to determine if the SFR acts as a filed tax return if the IRS prepares the SFR. The short answer is a resounding NO! Please see IRS Chief Counsel Notice CC-2010-016 and Internal Revenue Code §6020(b). The SFR does not count as a filed return and therefore if you owe taxes pursuant to the SFR it is not dischargeable in bankruptcy. If you prepare and file your own tax return after a SFR was prepared by the IRS, taxes are assessed and file it with the IRS and meet all the criteria of a dischargeable tax debt, then only the portion of the tax that was not previously assessed would be dischargeable. If you end up owing no taxes or a decrease in taxes owed, those taxes would not be dischargeable.

After the IRS prepares a SFR and assesses taxes owed from the SFR you can still prepare and file your own tax return. Once you file your own tax return and if your unpaid income tax meets all the criteria for the taxes to be dischargeable, only the portion that was not previously assessed from the SFR would be dischargeable. If it turns out that you do not owe as much as the IRS claims, whatever amount remaining owed to the IRS from the taxes assessed by the SFR is not dischargeable.

For example:

Let’s look at an example to help you picture this rule. Let’s say you want to file for Chapter 7 bankruptcy in November 2014 and you ask your bankruptcy lawyer if your taxes are dischargeable. You owe taxes for the 2008 tax year but you never filed a tax return for this year and the IRS filed an SFR on your behalf and assessed the taxes in 2010 and the SFR indicated you owed $15,000 for the 2008 tax year. Even though you meet all the other criteria to have your taxes discharged, the $15,000 is not dischargeable because you did not technically file a return since SFRs do not count as a valid return. Now let’s say you immediately go to a CPA to file the 2008 tax return and you were assessed an additional $5,000. That $5,000 would be dischargeable in bankruptcy once it meets the other discharge rules. If the CPA helps you file the tax return and you end up lowering your tax liability from the $15,000 the IRS assessed from the SFR to only $3,000, your tax liability will only be $3,000. This is good news since you only owe $3,000 rather than $15,000, but the bad news is that the entire $3,000 is not dischargeable no matter how long you wait to file for bankruptcy.

The harsh effect of the SFR should encourage you to file your taxes on time in the event you know you are going to owe income taxes. Not filing a return and the Internal Revenue Service filing a substituted return could make any otherwise dischargeable income tax not dischargeable. So no, substituted tax returns are not considered a “filed” tax return so that unpaid income taxes can be discharged when filing bankruptcy.