What Is a Deficiency Assessment and What Should I Do?

A deficiency assessment is a proposal from the Internal Revenue Service (IRS) to increase a taxpayer’s liability when it determines the tax reported on a return is less than what is legally owed. It is not an immediate bill, but rather the IRS’s position based on an examination of the tax return and related information. The taxpayer is given a specific period to respond to this proposed adjustment before it becomes a formal assessment.

Common Triggers for a Deficiency Assessment

A primary catalyst for a deficiency assessment is a tax audit. The IRS conducts several types of audits, including correspondence audits by mail, office audits at an IRS office, and field audits at a taxpayer’s home or business. If any of these examinations conclude that tax was underreported, the auditor’s findings will form the basis for proposing a deficiency.

The IRS also uses automated systems to find discrepancies. The Automated Underreporter Program, for instance, compares information returns from third parties, like Form W-2s from employers and Form 1099s from banks, against the income reported on a tax return. If this process identifies unreported income, it generates a notice that proposes changes to the tax liability.

While simple math errors may result in a summary adjustment, more substantive mistakes can trigger a full deficiency process. These errors involve the incorrect application of tax rules. For example, miscalculating capital gains, using the wrong tax tables for a given filing status, or making a mistake in the computation of a tax credit could lead the IRS to propose a deficiency.

A proposed deficiency often results from the disallowance of deductions or credits. During an examination, an agent may determine a taxpayer does not meet the legal requirements for a specific tax benefit. This can include unsubstantiated business expenses, charitable contributions, or improperly claimed education credits. The denial of these items increases taxable income and results in a tax deficiency.

Dissecting the Notice of Deficiency

The formal document for a proposed deficiency is the Statutory Notice of Deficiency, commonly referred to as a “90-day letter.” This notice is not a bill, but a final administrative determination that gives the taxpayer the right to challenge the proposed amount in U.S. Tax Court without first paying it.

Upon reviewing the notice, you should locate the specific amount of additional tax the IRS believes is owed. This figure, often labeled as the “deficiency,” is the core of the proposed adjustment. The notice will clearly state the tax year in question and the proposed increase in tax liability for that period.

The notice will also detail any applicable penalties and interest. A common penalty is the accuracy-related penalty, which is 20% of the underpayment and can be applied for reasons such as negligence or substantial understatement of income tax. The letter also shows the interest that has accrued on the proposed deficiency from the original due date of the return, and these amounts will continue to accrue until the matter is resolved.

An important section of the 90-day letter is the explanation of adjustments, which provides the specific reasons for the IRS’s proposed changes. For example, it might state, “disallowed Schedule C travel expenses of $2,500 due to lack of substantiation” or “increased interest income by $300 based on Form 1099-INT from ABC Bank.” This section is the basis for any disagreement or challenge the taxpayer may wish to mount.

The Statutory Notice of Deficiency imposes a strict deadline. The letter grants the taxpayer 90 days from the date it is mailed to file a petition with the U.S. Tax Court. If the taxpayer’s address is outside the United States, this period is extended to 150 days. This deadline is absolute and cannot be extended, and missing it results in the forfeiture of the right to have the Tax Court hear the case before the tax is paid.

Procedural Options After Receiving a Notice

If the taxpayer agrees with the IRS’s adjustments, the simplest option is to consent to the assessment. This involves signing a waiver form, often provided with the examination report. Signing the waiver stops the accrual of interest and allows the IRS to bill for the agreed-upon tax and penalties.

If the taxpayer disagrees with the proposed deficiency, they have the right to challenge it in U.S. Tax Court before paying. This requires filing a formal petition, which initiates a legal case where the taxpayer can present evidence and arguments to contest the IRS’s determination. While taxpayers can represent themselves, the court’s formal rules and procedures must be followed precisely.

An alternative strategy is to pay the proposed tax and then seek a refund. The taxpayer first pays the full amount of tax and interest, then files a formal claim for refund with the IRS using Form 1040-X. If the IRS denies the claim or does not act on it within six months, the taxpayer can then file a lawsuit for a refund in a U.S. District Court or the U.S. Court of Federal Claims.

Ignoring the Statutory Notice of Deficiency has significant consequences. Once the period for petitioning the Tax Court expires, the IRS is legally authorized to assess the proposed tax, penalties, and interest, making it an enforceable debt. The IRS will then issue a formal bill, and if it remains unpaid, can begin collection actions like filing a federal tax lien, levying bank accounts, or garnishing wages.