According to tax law, the substitution for return principle allows the IRS to file a tax return on your behalf (the substitute) if you fail to do so for yourself. This is usually not a good thing because the substitute tax return is usually inaccurate and incomplete. This is why it is crucial for you to submit your tax return every year by the deadline.
Here’s how the substitution for return system works. Whether you are an employee or an independent contractor, your employer or principal will report to the IRS the compensation it paid to you during the tax year. In addition, if you drew income from other sources such as the sale of stocks and bonds, the ones who pay you those amounts are also required to report them to the IRS.
Hence the IRS would have a record of all your income reported to them in such ways. This record is what they will use to determine if your tax return is accurate. What the IRS does not have, however, would be records of your expenses (and therefore your actual profits or losses) and tax credits or deductions and claims for which you are eligible.
If you fail to submit a tax return of your own (that would contain a record of your expenses, tax credits, deductions and claims), then the IRS will send you several letters instructing you to file. If you still do not do so, the IRS has the right according to law to file a tax return on your behalf (the substitute) solely based on the records of income they receive. This will not augur well for you because the IRS has no way of knowing the deductions, losses or credits you may have had that would reduce that income. And, because you did not file, you cannot claim those credits or deductions.
There’s more bad news – once the substitute for return has been filed by the IRS, there is no customary 10 year statute of limitation (which normally applies to tax returns submitted by you). In other words, the IRS has forever to collect the amount (including penalties and interests) in the substitute tax return from you. And they will launch collection efforts once the substitute has been filed on your behalf.
The only way to get around a substitute for return is to file your own tax return which will be treated as a request for audit reconsideration by the IRS. Provided the audit reconsideration examiner accepts your return as filed, the IRS will replace the SFR with your voluntarily filed return. If not, then sorry, you have to pay the amount in the substitute for return.
So the best thing to do would be to pre-empt the substitute for return by filing your tax returns each year before the deadline.