How the IRS Can file a “Substitute Return” for those USCs and LPRs Residing Overseas

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The U.S. federal government has extensive “legal tools” at their disposal to help enforce the U.S. tax law overseas.  There are limits, both in practice and legally, of how they can effectively use those legal tools against USCs and LPRs residing outside the U.S.  See, U.S. Enforcement/Collection of Taxes Overseas against USCs and LPRs – Legal Limitations

Substitute 1040Although U.S. citizenship taxation has been the law in the U.S. since the Civil War, it has been a “de facto” residency based taxation system for the last 100 years, since the U.S. government did not have the means to collect information to identify assets, income and USC and LPR taxpayers outside the U.S.  Plus, based upon my experience, few USCs who lived almost all of their lives outside the U.S. had any idea of their obligation to file U.S. federal income tax returns, as U.S. “tax residents.”  IRS Form 1040.

This has changed with technology, the integrated worldwide financial system and FATCA which is now bringing a massive amount of financial data and information to the IRS.   See, Part 3 – Unintended Consequences of FATCA: Will Taxpayer (Individual’s) Personal Financial Data at IRS get “Snowdened”?

The IRS has a powerful tool to assess taxes against any taxpayer who does not file U.S. income tax returns, specifically including USCs and LPRs residing outside the U.S.  This tool is known as the “Substitute Return” and is explained well in a New York Times Article from Feb. 2012,  If You Don’t File, Beware the Ghost Return

The IRS provides a snippet of information below in their website:

What if you don’t file voluntarily

Substitute Return 

If you fail to file, we may file a substitute return for you. This return might not give you credit for deductions and exemptions you may be entitled to receive. We will send you a Notice of Deficiency CP3219N (90-day letter) proposing a tax assessment. You will have 90 days to file your past due tax return or file a petition in Tax Court. If you do neither, we will proceed with our proposed assessment. If you have received notice CP3219N you can not request an extension to file. 

If any of the income listed is incorrect, you may do the following:

  • Contact us at 1-866-681-4271 to let us know.
  • Contact the payer (source) of the income to request a corrected Form W-2 or 1099.
  • Attach the corrected forms when you send us your completed tax returns.

If the IRS files a substitute return, it is still in your best interest to file your own tax return to take advantage of any exemptions, credits and deductions you are entitled to receive. The IRS will generally adjust your account to reflect the correct figures.

The Internal Revenue Manual explains the Substitute Return and the so-called Automated Substitute for Return (ASFR) Program.

Based upon my experience, a Substitute Return for a non-resident taxpayer is necessarily terribly wrong and incorrect.  This is because it is typically based upon only a small sliver of information;  typically some item of income. It does not include a complete picture of the taxpayer.  There are never expense items that are available for a deduction, nor foreign taxes reflected available for a foreign tax credit, etc.  See,  USCs and LPRs Living Outside the U.S. – Key Tax and BSA Forms

I have never seen a Substitute Return which includes a foreign earned income exclusion calculation for the benefit of the individual.   See, The Foreign Earned Income Exclusion is Only Available If a U.S. Income Tax Return is Filed

I suspect that once the IRS collects information under FATCA (starting this year 2014) on the non-U.S. accounts and investments of millions of U.S. citizens and lawful permanent residents, they will begin to issue Substitute Returns in mass.  This will cause an entire “parade of horribles” such as the following:

  • The foreign addresses will often be incorrect or the regular mail service will simply not be able to effectively deliver the IRS correspondence to the non-U.S. address;
  • There will be mismatching of taxpayer identification numbers;
  • The IRS will mix up financial information, assets and accounts among Individuals with the same names (e.g., Juan Perez Gonzalez or Mary Johnson) who are living overseas, particularly since there is no global taxpayer identification number system, which will distort terribly the tax assessments the IRS makes;
  • The information and reports created by the IRS will be entirely in English, and then sent overseas to countries where English is not a first language and where the taxpayer may have little to no command over the English language;
  • Incorrect currency calculations, since most of the time the USC or LPR residing overseas will have their accounts in currencies other than U.S. dollars;
  • etc., etc. etc.

Finally, the last major disadvantage of the USC or LPR overseas in these cases, is that the law creates a “presumption of correctness” in favor of the IRS and their determinations (at least in the civil law context – which is where this part of the tax administration lies).  See an earlier post:

Indeed, when the Internal Revenue Service (IRS – the U.S. revenue authority) makes a tax assessment against an individual, the law generally carries with it a “presumption of correctness” in favor of the IRS.

This presumption of correctness was confirmed by the U.S. Supreme Court and therefore imposes the burden on the taxpayer of proving that the assessment made by the IRS is erroneous.

See and eariler post,  More on “PFICs” and their Complications for USCs and LPRs Living Outside the U.S. -(What if there are No Records?)

See, U.S. Supreme Court decision, Welch v. Helvering, 290 U.S. 111 (1933), stating that the Commissioner’s “ . . .ruling has the support of a presumption of correctness, and the petitioner [taxpayer] has the burden of proving it to be wrong . . . ” and further citing to another Supreme Court decision, Wickwire v. Reinecke,275 U. S. 101. 

At the end of the day, the USC or LPR residing overseas is at a terrible disadvantage as they need to identify U.S. tax law principles applicable to their case (which almost always means they need to hire a U.S. tax professional and incur those costs) and respond within a very short window of time to the IRS.  They also have to prove the IRS was wrong in its determinations made in the Substitute Return.


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