The act of filing a return is central to tax administration. Section 6011 sets out the general requirement: “any person made liable for any tax imposed by this title” must file a return “according to the forms and regulations prescribed by the Secretary.” Section 6012 gets more granular and gives more specific requirements and exemptions from filing.
When a taxpayer fails to file a return, even after being reminded to do so, the IRS can simply send the taxpayer a Notice of Deficiency (NOD), and let the taxpayer either agree to the proposed tax liability or petition Tax Court. Or the IRS can follow the §6020 Substitute For Return (SFR) process whereby it creates a return for the taxpayer either with or without the taxpayer’s cooperation.
Regardless of how the IRS deals with the non-filer, an IRS employee first needs to create an account in the computer system for the relevant tax period. They do that by inputting the proper Transaction Code and preparing what is called a “dummy return” to support it. But there is one important difference between dummy returns used to set up the NOD process and dummy returns used to set up the SFR process: the §6651(a)(2) failure to pay penalties only apply to the failure to pay taxes shown on a “return.” Thus, the penalties do not apply to bare NODs. They do apply to SFRs. That’s why today’s lesson is useful.
In William T. Ashford v. Commissioner, T.C. Memo. 2022-101 (Sept. 29, 2022) (Judge Vasquez), we learn what to look for in the IRS files to see whether a dummy return used by the IRS leads to a proper SFR or not. We also learn why you cannot always trust the advice you see on the IRS website. Details below the fold.
The IRS has a choice of two ways to proceed when it determines a taxpayer has failed to file a required return: the §6020 SFR process or the §6212 deficiency process. Let’s take a quick look at both.
A. The §6020 SFR Process
Section 6020 has two subsections. Section 6020(a) permits the IRS to prepare the taxpayer’s return with the cooperation of the taxpayer. I call that the friendly SFR because that return will be treated as the return of the taxpayer for all purposes. For example, it starts the §6501 assessment limitation period. It counts as triggering the various bankruptcy discharge clocks. 11 U.S.C. §523(a) (flush language). It means the taxpayer cannot be tagged as a non-filer. That’s not really on the plate for today’s lesson, although the difference between what constitutes a 6020(a) and 6020(b) SFR is very interesting and not entirely intuitive. See Bryan T. Camp, “The Never-Ending Battle,” 111 Tax Notes 373 (Apr. 17, 2006).
Section 6020(b) is the unfriendly SFR. It provides that when the taxpayer does not cooperate, the IRS is authorized to “make such return from [its] own knowledge and from such information as [it] can obtain through testimony or otherwise.” Unlike §6020(a), §6020(b) SFRs are not always treated as returns of the taxpayer. Generally, it’s a heads-I-win, tails-you-lose proposition.
On the one hand, for example, almost all courts refuse to construe a §6020(b) SFR as the taxpayer’s return when to do so would permit the taxpayer to discharge of a tax liability in bankruptcy. See generally Ken Weil’s excellent post on the exception that proves the rule: “Rare Discharge in Bankruptcy for Taxpayers with a Return Filed After an SFR Assessment,” Procedurally Taxing Blog (May 22, 2022).
On the other hand, §6651(g) provides that such a return will count as the return of the taxpayer for purposes of computing the §6651(a)(2) penalty for failure to pay the tax owed. That’s an important point for today’s lesson. Until 1996, a §6020(b) SFR was not deemed to be a “return” within the meaning of §6651(a)(2). See generally Rev. Rul. 76-562, 1976-2 C.B. 430. That is because §6651(a)(2) imposes the failure to pay penalty only as to what is “shown as tax on any return.” Before 1996, both courts and the IRS interpreted that to mean the return of the taxpayer. That perverse situation rewarded obstreperous taxpayers and penalized cooperative ones. Congress fixed the problem (at the urging of the IRS and Treasury) by adding §6651(g). Section 6651(g) now properly aligns the consequences with the behavior.
Construing a §6020(b) SFR against a taxpayer this way makes sense, if you view it as a result of taxpayer noncompliance with the §6011 filing duty. To treat it the same as voluntary returns would undermine compliance. That is what happened before 1996 as to the §6651(a)(2) failure to pay penalties. But it is not always clear that a 6020(b) SFR results from bad-acting taxpayers, because the process is almost entirely automated and relies upon taxpayers responding to automated notices. As we all know, a notice properly sent is not always actually received. A taxpayer's failure to respond thus may or may not be due to bad faith.
The §6020(b) SFR process is pretty much run by computers with minimal human oversight in a system called the Automated Substitute for Return (ASFR) process. See generally IRM 5.18.1 (Automated Substitute for Return (ASFR) Program)(March 11, 2020). The ASFR draws from the Information Return Program (IRP) where the IRS collects and stores everything received on third party information returns such as W-2s and 1099’s. The ASFR creates an SFR package and sends it to the taxpayer’s last known address giving the taxpayer 30 days to respond. The 30-Day Letter package is fully automated. See generally, IRM 188.8.131.52.5, Letter 2566. If the taxpayer makes no response, the computers then generate an NOD, giving the taxpayer the usual time to petition Tax Court. For a more complete description of the ASFR process, see TIGTA Report 2017-30-078, “A Significantly Reduced Automated Substitute for Return Program Negatively Affected Collection and Filing Compliance,” (Sept. 29, 2017). Note too that the traditional TC 150 used to open a Tax Module using a dummy return seems to have now been changed to TC 971 with Action Code (AC) 143. Whenever you see a TC 971 on a transcript you have no idea what it means unless you look carefully at the associated AC because the TC 971 is the Swiss Army knife of transactions codes: it's used for a wide variety of situations unanticipated when the Automated Data Processing system was first constructed long, long, long ago.
Back to the SFR. If the IRS chooses to use the SFR process, it thus needs to be sure to create an SFR. Otherwise, the NOD it sends out will not be treated as resulting from an SFR but will instead be treated as arising from the second way the IRS can deal with non-filers. Let’s take a look at that first before we get to the lesson on how to tell whether the IRS has created an SFR.
B. The Deficiency Process
From 1862 to 1924, the SFR process was the only way for the IRS to deal with non-filers. And once it prepared the SFR it could immediately assess the tax. There was no deficiency process. See e.g. Revenue Act of 1913, 38 Stat. 114, at 178 (mandating immediate assessment).
The Revenue Act of 1924, 43 Stat. 253, 296 created the deficiency procedures now codified in §6211 et. seq. That worked a profound change in tax administration. While the law had long allowed taxpayers who disagreed with proposed increases to tax a right to conferences within the IRS, the 1924 Act now forbade the IRS from assessing an income, estate or gift tax against a non-consenting taxpayer until after the taxpayer had the chance for pre-payment review by an independent quasi-judicial body. That body started out as the Board of Tax Appeals (BTA) and morphed over time to its current status as the Tax Court.
In the early days the IRS tried to argue that it did not have to use the deficiency procedures to assess the tax it created on a §6020(b) SFR, but the BTA quickly rejected that position. See Taylor v. Commissioner, 36 B.T.A. 427 (1937) (requiring IRS to follow deficiency procedures when it had prepared return without consent or cooperation of the taxpayer).
Thus the IRS must issue an NOD even after it creates an SFR. But it does not have to create an SFR in order to issue an NOD to a non-filer. Courts have long rejected taxpayer arguments that the IRS was limited to the SFR process and that an NOD was invalid against a non-filer unless the IRS’s first prepared an SFR. See United States v. Harrison, 72-2 USTC ¶ 9573 (S.D.N.Y. 1972)(I cannot find free link, but Judge Weinstein gives an excellent discussion of legislative history); see also Hartman v. Commissioner, 65 T.C. 542, 545 (1975)(taxpayer’s failure to file a return and IRS decision not to prepare a substitute for the return under §6020 did not invalidate the NOD).
So the IRS can choose how to address a non-filer. However, even though the IRS has the option to forgo the SFR process, it generally chooses the SFR route, for several reasons. First, perhaps most importantly, encouraging and helping taxpayers prepare and file their own returns has long been recognized as an important part of the IRS mission. It makes sense administratively to use upstream resources to get as many taxpayers into compliance as possible before using downstream resources for enforced collection. See e.g. Policy Statement P-5-133, IRM 184.108.40.206.18 (08-04-2006). Before a taxpayer’s account goes into the ASFR program, the IRS will have sent the taxpayer at least two “soft” notices asking the taxpayer to file. Again, however, that sending does not ensure actual receipt.
Second, preparing a §6020(b) return betters serves compliance purposes because §6020(b) SFRs now trigger the §6651(a)(2) addition to tax for failure to pay the amount shown on the “return.” No such addition can be proposed if the IRS simply sends an NOD.
Finally, a §6020(b) SFR will almost always preclude the taxpayer from obtaining a discharge of the taxes in bankruptcy. See e.g. In Re: Payne, 431 F.3d 1055 (7th Cir. 2005), and cases cited therein.
In contrast to the SFR, if the IRS just sends out an NOD, the well-advised non-filer will promptly file returns to minimize penalties, set up a potential bankruptcy discharge, and start the §6501 limitations period running. I’m not saying that will always work, but the taxpayer certainly has a better shot than if the IRS has sent the NOD based on a §6020(b) SFR. See e.g. Mendes v. Commissioner, 121 T.C. 308 (2003) (Form 1040 reporting zero tax liability filed 48 months after receiving a notice of deficiency and 22 months after Tax Court petition was not a valid for §6654(d)(1)(B) safe harbor purposes).
C. The Dummy Return Problem: How To Tell Which Process The IRS Is Using?
So how do you tell whether the NOD being issued is based on an SFR or just a bare NOD? After all, both processes result in an NOD. And yet they have some very different consequences for taxpayers.
Part of the problem is that the IRS initiates both the 6020(b) process and the notice of deficiency process the same way: it opens what is called a Tax Module on the computer system in order to process documents and track the work done. Because of various and ancient computer design decisions dating back to the 1950's, the IRS employee who creates a Tax Module needs a return to do so. If there is no taxpayer-prepared Form 1040 to use (for income taxes), the employee will use what is basically a fake 1040 to support opening the module. That fake form is often called a “dummy return.” In the ASFR program, the Tax Module often opens before the IRS pulls enough information from third parties together to come up with a proposed tax liability.
But while that dummy return helps create the Tax Module it cannot, in and of itself, create an SFR. The Tax Court has held that dummy returns do not serve as a §6020(b) return. They need something more. Only when the IRS also creates records which support an assessment, properly associates those documents contemporaneously, and some authorized IRS employees signs off on the package will the dummy return caterpillar transform into a beautiful §6020(b) butterfly. Millsap v. Commissioner, 91 T.C. 926 (1988). For example, in Cabirac v. Commissioner, 120 T.C. 163 (2003), the Court denied the §6651(a)(2) failure to pay penalties because it decided that while the revenue agent’s report dated May 31, 2000, “contained sufficient information from which to calculate petitioner’s tax liability” it was not sufficiently contemporaneous with the dummy return used to open the Tax Module on February 23, 2000.
For years there was litigation over whether and when the IRS had properly created an SFR. In 2008 Treasury issued final regulations to try and create more certainty. See 73 Fed. Register 9188. As you might expect, the regulations make it pretty easy for the IRS. For example, while the regulations say that the SFR must be “signed” by an authorized official, they are very generous on what meets that requirement, providing that an SFR “may be signed by the name or title of an Internal Revenue Officer or employee being handwritten, stamped, typed, printed or otherwise mechanically affixed to the return” and that the “signature may be in written or electronic form.” Treas. Reg. 301.6020-1(b)(2) (emphasis supplied).
The regulations also give the IRS flexibility as to what documents to associate together in a package, but what the regulations also require is some form to forge the documents together into an SFR. Typically, the IRS will associate a Revenue Agent’s Report (often on a Form 886 series), and a Form 4549. But it seems that the key document to look for is "Form 13496, IRC Section 6020(b) Certification." That Form is what forges all those other documents into an SFR. See e.g. IRM 220.127.116.11.3.2 (07-08-2021)(“All SFRs having tax adjustments that follow deficiency procedures with the failure to pay (FTP) penalty applied under IRC 6651(g) must have a Form 13496, IRC Section 6020(b) Certification, completed.”). See generally IRM 18.104.22.168.2 (01-05-2010) (Form 13496 Certification Procedures). In fact, I would not be surprised if that Form—mentioned specifically in the regulation—becomes the bright-line test for the proper creation of an SFR, even though the regulation generously says it is not the exclusive form the IRS must use.
Facts and Lesson
The tax years at issue are 2013 and 2014. In those years Mr. Ashford received self-employment income for services provided to Aviation Managed Solutions, earning just about $90,000 in 2013 and $100,000 in 2014. Although he had filed returns for prior years, it appears that at some point in 2013 Mr. Ashford unintelligently came to believe that he was not required to file returns or pay taxes.
Eventually the IRS caught the error—likely through IRP—and sent NODs to Mr. Ashford in 2018. The NODs asserted taxes and failure to file penalties, and also asserted the §6651(a)(2) failure to pay penalty. Mr. Ashford petitioned Tax Court arguing, in part, that the NODs were not based on proper SFRs because the IRS had used dummy returns to open the Tax Module. He argued that the use of dummy returns resulted in no SFRs and that, in turn, invalidated both the asserted deficiencies and the asserted penalties.
As to the deficiencies, Judge Vasquez explains that the mere use of a dummy return does not affect the validity of the proposed deficiencies. Op. at 6. That is because the IRS has a choice in how to proceed against non-filers. It can issue its NOD based either on an SFR it prepares or simply on the basis of an examination.
As to the §6651(a)(2) penalties, however, is does matter whether the NOD was based on an SFR. Again, however, the use of dummy returns is irrelevant. Here, Judge Vasquez explains that the NODs in this case were indeed based on an SFR and recites how each one contained the magic Form 13496. Op. at footnote 9.
Bottom line: The IRS had properly transformed the dummy returns to create §6020(b) SFRs.
Comment: Misleading IRS Website? I am not clear on what soft Notices or Letters the IRS uses to ask for unfiled returns before it sends out a 6020(b) SFR package. It appears that if you or your client gets the CP2566, then you must really be careful to prevent an unfriendly SFR. The CP2566 is the 30-day letter sent out by the ASFR, as part of the 6020(b) SFR package. And the IRS takes the position that once a taxpayer is presented with that package, the taxpayer is helpless to prevent a 6020(b) SFR if the taxpayer simply signs the accompanying Form 4549. In a reversal of prior rulings, the IRS now says the taxpayer’s consent to the proposed deficiencies on Form 4549 does not result in a 6020(a) SFR. See Rev. Rul. 2005-59. For details and critiques on why this is one of the most inane Rev. Rules ever, see Bryan Camp, “The Function of Forms in the Substitute-for-Return Process,” 111 Tax Notes 1511 (June 26, 2006). But there it is. As best I can tell, it's only been discussed by one court, a bankruptcy court in Texas in 2017, where the debtor had many other problems.
But the IRS website ignores the Rev. Rule! It thus gives bad advice to taxpayers. It says that taxpayers who receive the CP2566 can either “File your tax return immediately” or “Accept our proposed assessment by signing and returning the Response Form.” Well, gosh, that’s pretty misleading if signing the forms included in the CP2566 create a §6020(b) SFR! That is definitely not the same as properly filling in a Form 1040, signing it and filing it! So it would be useful to know what CPs get issued before the taxpayer’s account gets loaded into the ASFR system and it becomes too late to create a friendly SFR. BTW, CP stands for “Computer Paragraph," meaning that any notice containing a “CP” before the number is a totally automated notice. I welcome any comments to address my confusion here.
Coda: There is some weirdness in this case. In 2019 Mr. Ashford received a notice from the Social Security Administration that it was reducing his 2013 self-employment income from the amounts reported on the Form 1099 to zero. That may have resulted from the IRS’s premature assessment of the deficiency while the case was pending in Tax Court, and then its abatement of that assessment. That’s kind of a rough justice for Mr. Ashford, especially if he was arguing to the effect that “I don’t have to pay self-employment taxes on the income but I still get to use it to generate Social Security benefits.” Now he’s got to figure out how to straighten out the SSA records.
Bryan Camp is the George H. Mahon Professor of Law at Texas Tech University School of Law. He invites readers to return to TaxProf Blog each Monday (or Tuesday, if Monday is a federal holiday) for another Lesson From The Tax Court.