SFR – Substitute for return

IRS may prepare substitute returns in worker classification cases
Chief Counsel Advice 200822026


A Chief Counsel Advice (CCA) has concluded that, in employment tax cases where worker classification issues are present, revenue officers have authority under Code Sec. 6020(b) to prepare employment tax returns, but the requirements of Code Sec. 7436 must be met before assessment.

Background. Where there is an actual controversy involving a determination by IRS that one or more individuals performing services for the taxpayer are employees as part of an examination, Code Sec. 7436 gives the Tax Court jurisdiction to determine certain “worker classification issues” (i.e., the proper amount of the additions to tax, additional amounts, and penalties that relate to the employment tax with respect to determinations of worker classification and whether the taxpayer is entitled to relief under § 530 of the Revenue Act of 1978). To meet Code Sec. 7436 ‘s requirements, certain procedures must be followed before assessment of employment taxes. They are spelled out in Notice 2002-5, 2002-1 CB 320. For example, Notice 2002-5 provides generally that a taxpayer will first receive a “30-day” letter listing the proposed employment tax adjustments to be made and describing the taxpayer’s right either to agree to the proposed adjustments or to protest the proposed adjustments to the IRS’s Appeals function (Appeals) within 30 days of the date of the letter.

If the taxpayer does not respond to the “30-day” letter by agreeing to the proposed adjustments or by filing a protest to Appeals, the taxpayer will receive a Notice of Determination of Worker Classification (NDWC). The taxpayer may also receive the NDWC if the taxpayer files a protest with Appeals and the worker classification issues are not settled in Appeals. As indicated in Notice 2002-5, under Code Sec. 7436(d)(1), the mailing of the NDWC suspends the period of limitations for assessment of taxes attributable to the worker classification issues for the 90-day period during which the taxpayer can bring suit and precludes IRS from assessing the taxes identified in the NDWC before the expiration of the 90-day period during which the taxpayer may file a timely Tax Court petition.

If IRS erroneously makes an assessment of taxes attributable to the worker classification issues without first either issuing a NDWC or obtaining a waiver of restrictions on assessment from the taxpayer, the taxpayer is entitled to an automatic abatement of the assessment. However, under Notice 2002-5, once any procedural defects are corrected, IRS may reassess the employment taxes to the same extent as if the abated assessment had not occurred.

The amount of any tax imposed by the Code is to be assessed within 3 years after the return was filed, subject to certain specified exceptions. (Code Sec. 6501(a))

Under Code Sec. 6020(b), if a taxpayer fails to file a return when required, IRS may prepare a return based on its own knowledge and on information it obtains through testimony or other means. The failure-to-pay penalty under Code Sec. 6651(a)(2) applies to the amount of tax shown on the return, including, under Code Sec. 6651(g)(2) , any amount shown on a substitute return prepared by IRS. Absent the existence of a return under Code Sec. 6020(b), the Code Sec. 6651(a)(2) penalty doesn’t apply to a nonfiler. [For discussion of recently issued regs on substitute returns, see Federal Taxes Weekly Alert 02/14/2008]

Facts. The Chief Counsel was asked to review a memorandum which addressed the issue of whether a revenue officer has authority under Code Sec. 6020(b) to prepare employment tax returns on behalf of taxpayers who fail to file such returns in a case in which worker classification issues are present and where the revenue officer did not refer the case to the Employment Tax Program as required under the Internal Revenue Manual (IRM).

For the years at issue, the taxpayer took the position that certain workers were independent contractors for federal tax purposes. However, for prior years, the taxpayer had treated the workers as employees. After reviewing the facts of the case, the revenue officer determined that the workers should have been treated as employees and prepared Substitute for Returns (SFRs) under Code Sec. 6020(b).

The taxpayer objected to the preparation of the SFRs and requested an appeal. The appeals officer concluded that the worker classification issue was undeveloped and that “the revenue officer did not have the authority to prepare Forms 941 under Code Sec. 6020(b) procedures because the IRM requires the issue to be referred to the Employment Tax Program,” and recommended the government concede the case.

Analysis. The CCA observed that the taxpayer failed to file an employment tax return and did not submit evidence to establish that no employment tax return was due. The revenue officer determined that some of the taxpayer’s workers were employees and that an employment tax return should have been filed. The revenue officer prepared returns under Code Sec. 6020(b).

The CCA said that, because the revenue officer failed to meet Code Sec. 7436 ‘s requirements, an assessment of employment taxes based on the Code Sec. 6020(b) return prepared by him is improper. However, the CCA said that the facts do not indicate that the government is required to concede the case. The CCA said that, under Notice 2002-5 , once the procedural defects are corrected and Code Sec. 7436 ‘s requirements are met, employment taxes may be assessed.