Unfiled Tax Returns Can Lead To An IRS Action That Costs You Money

With tax filing season in full swing, it’s important to understand what might happen if you do not file a U.S. income tax return. The IRS can, and often will, file a “substitute” return for you and generally, it won’t be favorable. Taxpayers living and working abroad face greater risks with a SFR.

The IRS Automated Substitute for Return program is a powerful tool designed to enforce tax compliance for individuals who fail to file their federal income tax returns. For U.S. taxpayers abroad, understanding the ASFR program and its implications is crucial, given the unique challenges they face in navigating U.S. tax obligations.

Taxpayers living and working overseas face greater challenges if they get caught up in the ASFR program. In addition to the increased tax complexities and challenges of communicating with the IRS, maintaining a valid U.S. passport is essential for taxpayers living abroad. Falling into the ASFR program, in which the IRS automatically calculates tax debt, can lead to the IRS notifying the State Department of the outstanding liability. This, in turn, may result in the denial or revocation of the taxpayer’s U.S. passport.

What Is A SFR?

A Substitute for Return is a tax return prepared by the IRS on behalf of a taxpayer who has failed to file their own return. In preparing the SFR, the IRS relies on information it has received from third parties, such as Forms W-2, 1099, and other income reporting documents. While this might seem convenient, taxpayers should be aware that an SFR is often incomplete and highly unfavorable.

An SFR does not include deductions, credits, or exemptions that the taxpayer might be entitled to. For example, the standard deduction, itemized deductions, foreign earned income and housing exclusions, or foreign tax credits for U.S. taxpayers abroad are typically omitted. Consequently, the IRS’s calculation often results in a higher tax liability than if the taxpayer had filed their own return.

How The ASFR Program Works

The ASFR program automates the process of creating and assessing a SFR. Here’s how it typically works:

1. Identification of Non-Filers: The IRS identifies taxpayers who have failed to file returns by cross-referencing income reporting forms against filed returns.
2. Notice to Taxpayer: The IRS sends a series of notices informing the taxpayer of their filing requirement and potential liability.
3. SFR Preparation: If the taxpayer does not respond or file a return, the IRS prepares a SFR using the available third-party information.
4. Assessment: The SFR will lead to a tax bill, which if unpaid will trigger the IRS collection process, to recover the amount due. Once the IRS assesses the tax liability based on the SFR, taxpayer inaction means IRS may initiate levies on wages or accounts or place a federal tax lien on property.

A Temporary Suspension Of The ASFR Program

In the time frame 2015-2019, the ASFR program was temporarily suspended, offering taxpayers an opportunity to address their non-filing issues. This pause aimed to encourage compliance while reducing the IRS’ administrative burden and its budget constraints.

Whether the ASFR program might be suspended again is uncertain. Given the recent IRS staff lay-offs, it could happen, but taxpayers should not rely on such suspensions as a strategy. Proactively addressing non-compliance is always the safest course of action and there may be a window of opportunity to correct late filings given reduced IRS staff.

Special SFR Considerations For U.S. Taxpayers Abroad

U.S. taxpayers living abroad often have complex tax situations that make them particularly vulnerable if a SFR is filed for them by the IRS. Key points to consider include:

1. Exclusions and Credits: U.S. taxpayers abroad may qualify for the foreign earned income and housing exclusions and foreign tax credits. These provisions can significantly reduce or eliminate their U.S. tax liability, but they are not automatically included in an SFR. Failure to claim these benefits could result in an artificially high tax liability.
2. Filing Extensions and Exceptions: Taxpayers abroad are generally granted an automatic two-month extension (to June 15) to file their returns, with the option to request additional time. However, this extension does not exempt them from penalties and interest if taxes are owed.
3. Information Reporting Requirements: U.S. taxpayers abroad often have additional reporting obligations, such as filing the FBAR (FinCEN Form 114) or Form 8938 (Statement of Specified Foreign Financial Assets). Failure to meet these requirements can result in severe penalties, compounding their issues with the ASFR program.
4. Address and Communication Challenges: Notices sent by the IRS may not reach taxpayers abroad in a timely manner, leading to missed deadlines and a greater likelihood of an SFR being prepared. Ensuring the IRS has an up-to-date address on file is critical.
5. Passport Revocation:  A taxpayer’s U.S. passport can be denied, revoked, or not renewed if the taxpayer has “seriously delinquent tax debt.” This is a threshold amount adjusted annually for inflation (currently $64,000 in 2025). In addition to the tax due, it includes penalties and interest and it becomes quite easy to meet the threshold. Overseas taxpayers are particularly vulnerable when it comes to loss of the U.S. passport.

How To Avoid Or Resolve SFR

To avoid the consequences of a SFR, taxpayers should:

1. File Returns Promptly: Even if you cannot pay the full amount due, filing a timely return can mitigate penalties and prevent the ASFR process from starting.
2. Respond to IRS Notices: If you receive a notice, respond promptly to provide the requested information or file the missing return.
3. Leverage the Streamlined Procedures: For taxpayers abroad who have fallen behind on their U.S. tax filings, the IRS offers the Streamlined Filing Compliance Procedures. This program allows eligible taxpayers to become compliant without facing penalties.
4. Seek Professional Help: Navigating the ASFR program can be daunting, especially for taxpayers abroad. Consulting a tax professional experienced in international tax law can help ensure compliance and minimize tax liability.

Conclusion

The ASFR program underscores the importance of timely and accurate tax filing for all U.S. taxpayers, including those living abroad. While the program’s automation allows the IRS to address non-filing efficiently, SFR rigid calculations often lead to inflated tax liabilities. By understanding the implications of a SFR and taking proactive steps to file and respond to IRS communications, taxpayers can avoid the program’s pitfalls and ensure their tax obligations are met accurately and fairly.

Posted  March 20, 2025

This post first appeared in Forbes March 10, 2025