What Does Increase in Tax Deficiency Mean?

An increase in tax deficiency occurs when the Internal Revenue Service (IRS) determines a taxpayer owes more tax than was originally reported on their tax return. The IRS arrives at this conclusion after a review or audit suggests the initial tax calculation was incorrect. The formal notification of this proposed increase marks the beginning of a specific process with defined timelines for a response.

Defining a Tax Deficiency

A tax deficiency is the specific amount by which the tax that the IRS calculates to be correct exceeds the tax amount shown on a taxpayer’s return. This shortfall is not a penalty itself, but rather the underlying amount of unpaid tax that serves as the basis for calculating potential interest and penalties.

The IRS identifies a deficiency by comparing the information on a filed return against data it receives from third parties, such as employers and financial institutions. For instance, if a W-2 from an employer shows higher income than what was reported by the employee, a deficiency is created. If no return was filed, the IRS can calculate a deficiency based on available income information, treating the reported tax as zero.

Common Causes for an Increased Deficiency

An increased deficiency often originates from an IRS audit or an automated review process. One of the most frequent causes is unreported income, which the IRS identifies by matching information returns, like Form 1099-NEC or Form 1099-K, against the income reported on an individual’s Form 1040.

Another reason for a deficiency is the disallowance of certain deductions or credits. During an examination, the IRS might determine that a taxpayer did not meet the specific eligibility rules for a credit they claimed. Similarly, deductions may be denied if the taxpayer cannot provide sufficient documentation to prove an expense or if the expense itself is not considered a valid business cost.

Clerical or mathematical errors on the original tax return can also lead to a notice of deficiency. These are often caught by the IRS’s automated processing systems. The IRS will correct these errors and propose changes to the return, which formally establishes the deficiency.

Understanding the Notice of Deficiency

The formal communication for a proposed increase in tax is the Statutory Notice of Deficiency, often called a “90-day letter.” This legal notice, a CP3219A or Letter 531, is sent by certified mail to the taxpayer’s last known address. Its arrival starts a strict 90-day period to challenge the IRS’s determination in U.S. Tax Court without first paying the disputed amount. This 90-day window cannot be extended.

The letter explains the reason for the notice, the specific adjustments the IRS has made, and how the deficiency was calculated. It will state the amount of the deficiency, the tax year in question, and the deadline for filing a petition with the Tax Court. If a taxpayer does not file a petition within the 90-day period, the IRS will assess the tax and send a bill for the deficiency, plus accrued interest and penalties.

Calculating the Total Amount Owed

The final amount due to the IRS is greater than the base tax deficiency because it also includes accrued interest and applicable penalties. Interest is charged on the underpayment from the original due date of the tax return until the tax is paid in full. The interest rate is set quarterly and is calculated as the federal short-term rate plus three percent, compounded daily.

Penalties are also added to the total bill. Common penalties include:

• An accuracy-related penalty, which may apply if the underpayment was due to negligence or a substantial understatement of income tax.
• A failure-to-pay penalty of 0.5% per month, up to a maximum of 25%, on the unpaid tax.
• A failure-to-file penalty of 5% per month, up to 25%, if the deficiency resulted from not filing a return on time.
• For returns filed more than 60 days late, the penalty is the lesser of $510 or 100% of the tax owed.

The IRS applies payments first to the tax, then to penalties, and finally to interest.

Your Response Options

One option is to agree with the IRS determination. You can sign the enclosed waiver form, such as Form 5564, and return it to the IRS. You will then receive a bill for the tax, interest, and penalties.

If you disagree with the proposed deficiency, you can file a petition with the U.S. Tax Court within the 90-day period. Filing a petition allows you to dispute the IRS’s findings before making any payment. You might also be able to request an audit reconsideration, which is an administrative process to have the IRS review the case with new information.