What Is a Notice of Deficiency and How Should You Respond?

Receiving a Notice of Deficiency from the IRS can be unsettling for taxpayers. This formal notification highlights discrepancies in your tax return that may result in additional taxes owed. Understanding how to address this situation is crucial to ensure compliance and minimize complications.

Reasons for Issuance

A Notice of Deficiency is sent when the IRS identifies inconsistencies between a taxpayer’s return and the information it has on file. These discrepancies can stem from unreported income, incorrect deductions, or computational errors. For example, failing to report income from freelance work or overstating deductions can trigger such a notice. The IRS uses both automated systems and manual reviews to detect these issues, cross-referencing data from employers and financial institutions with your tax return. If discrepancies are found, the agency may conduct a more detailed examination under the authority of the Internal Revenue Code (IRC) and Treasury Regulations. IRC Section 6212 specifically authorizes the issuance of a Notice of Deficiency when additional taxes are deemed owed.

In some cases, a deficiency notice results from a taxpayer’s failure to respond to earlier IRS communications, such as requests for clarification or additional documentation. Ignoring such notices can escalate the issue. The IRS is required to explain the adjustments and the reasoning behind them, ensuring transparency.

Reviewing the Calculations

Upon receiving a Notice of Deficiency, your first step should be to carefully review the calculations provided by the IRS. Compare their figures with your original tax return to pinpoint specific discrepancies. The notice includes explanations for each adjustment, helping you understand the basis for the changes. For example, if the notice cites unreported income, confirm whether all sources were accurately reported by cross-checking with your financial records. Similarly, if deductions are disputed, ensure they meet the requirements outlined in the Internal Revenue Code for the applicable tax year.

Using financial software or consulting a tax professional can streamline the review process. These tools and experts can help recalculate tax liabilities and assess whether the IRS’s interpretation of the tax code aligns with current laws and precedents.

Response Deadlines

Timing is critical when responding to a Notice of Deficiency. Taxpayers have 90 days to respond, as outlined in IRC Section 6213. Missing this deadline allows the IRS to assess the proposed deficiency and may result in additional penalties. During this 90-day period, you can file a petition with the United States Tax Court if you disagree with the IRS’s findings. This option allows for judicial review without requiring payment of the disputed amount upfront. Consulting a tax attorney or enrolled agent can help navigate this process.

If you agree with the notice, paying the assessed amount within the 90-day window avoids further interest and penalties. Interest on unpaid taxes is calculated based on the federal short-term rate plus 3 percentage points. Confirm the current rate to accurately calculate any interest owed.

Potential Penalties

Failing to address a Notice of Deficiency can result in significant penalties. One common penalty is the accuracy-related penalty, amounting to 20% of the underpayment caused by negligence or disregard of tax rules, as detailed in IRC Section 6662. This underscores the importance of submitting accurate and complete tax returns.

Additionally, a failure-to-pay penalty may apply if the tax owed is not paid by the due date. This penalty accrues monthly at a rate of 0.5% of the unpaid taxes, up to a maximum of 25%, as described in IRC Section 6651. Penalties may be waived for reasonable cause, such as reliance on incorrect advice from a tax professional, provided supporting documentation is submitted.

Dispute and Appeal Channels

If you disagree with the IRS’s findings, there are options to dispute or appeal the proposed adjustments. Filing a petition with the United States Tax Court is a key avenue, provided it is done within the 90-day window. The Tax Court offers a pre-payment forum, meaning you are not required to pay the disputed tax amount before the case is resolved. Ensure your petition outlines the areas of disagreement and includes supporting documentation. A tax attorney or CPA experienced in litigation can strengthen your case.

Alternatively, the IRS Independent Office of Appeals offers an administrative resolution process. This office operates independently from the division that issued the notice, providing a neutral platform for negotiation. To initiate this process, submit a written protest detailing your objections and the basis for your position. Appeals officers consider both sides’ arguments, often leading to settlements.

Payment Arrangements

If you accept the IRS’s findings or lose a dispute, arranging payment for the assessed amount is the next step. The IRS offers various payment options to accommodate taxpayers’ financial situations. An installment agreement allows you to pay the liability over time. To request this, submit Form 9465, Installment Agreement Request, and propose a monthly payment amount. The IRS will evaluate your financial situation to determine whether the terms are acceptable. Interest and penalties will continue to accrue on the unpaid balance, so paying off the debt as quickly as possible is advisable.

For taxpayers facing financial hardship, an Offer in Compromise (OIC) may be an option. This program allows you to settle your tax debt for less than the full amount owed if you can demonstrate that paying in full would cause economic hardship or if there is doubt about the collectibility of the debt. To apply, submit Form 656, Offer in Compromise, along with detailed financial documentation. The IRS will calculate the minimum acceptable offer based on your income and assets. While the process is rigorous, it can provide relief for those who qualify.