What Is a Notice of Deficiency and What Should You Do About It?
Understand the Notice of Deficiency, its implications, and learn how to effectively respond and challenge it to ensure compliance.
Receiving a Notice of Deficiency from the IRS can be an unsettling experience. This official document indicates potential discrepancies in your tax return, which may result in additional taxes owed. Understanding the notice and addressing it promptly is crucial to resolving the issue effectively and minimizing financial impact.
Causes of the Notice
A Notice of Deficiency typically arises from discrepancies identified during the IRS’s review of a tax return. These discrepancies may result from unreported income, incorrect deductions, or calculation errors. For instance, failing to report income from freelance work or a side business can trigger a notice, as the IRS cross-checks taxpayer data with third-party information, such as Form 1099. Similarly, claiming deductions without proper documentation or exceeding allowable limits can prompt scrutiny.
The IRS employs the Automated Underreporter Program to compare taxpayer submissions with information from employers, financial institutions, and other entities. For example, if mortgage interest deductions reported by a taxpayer do not align with the lender’s records, the system may flag the return for further review. Additionally, changes in tax laws can lead to discrepancies if taxpayers are unaware of updated regulations.
Computational errors, such as miscalculations of taxable income or credits, can also result in a Notice of Deficiency. Similarly, deductions or credits disallowed after an audit—such as personal expenses claimed as business deductions—may lead to additional tax liability.
Information Within the Notice
A Notice of Deficiency outlines the IRS’s proposed changes to your tax return, including the specific discrepancies identified. These changes might involve unreported income, disallowed deductions, or other adjustments, with references to relevant IRS codes and regulations. For example, if business expenses are disallowed, the notice will cite the sections of the Internal Revenue Code governing allowable deductions.
The notice also specifies the additional tax liability, including any interest and penalties accrued since the original due date of the return. Detailed calculations provide insight into how the IRS arrived at these figures, which can help you determine if there are grounds for dispute. For instance, if penalties for substantial understatement of income tax are included, you may need to assess whether you qualify for reasonable cause exceptions.
Finally, the notice explains your rights and options, including the ability to challenge the findings by filing a petition with the U.S. Tax Court. It also sets clear deadlines—typically 90 days from the date the notice is mailed, or 150 days for taxpayers outside the U.S.—to respond and avoid automatic assessment and collection actions. Acting within these timeframes is critical to preserving your rights.
Response Deadlines
The IRS enforces strict deadlines for responding to a Notice of Deficiency. The response period begins the day the notice is issued, not the day it is received. Taxpayers generally have 90 days to respond, or 150 days if the notice is sent to an address outside the U.S. During this period, you can either agree with the IRS’s findings and pay the additional tax or dispute the notice by filing a petition with the U.S. Tax Court. These deadlines are non-negotiable, making timely action essential.
Steps to Challenge the Notice
Challenging a Notice of Deficiency begins with a careful review of the document. Compare the IRS’s claims against your own records to identify any errors or misunderstandings. Gather all relevant documentation—such as receipts, bank statements, and financial records—to support your case.
Consulting a tax professional or attorney with expertise in tax law can be invaluable. They can help interpret complex tax codes, assess the strength of your position, and craft a strong argument. For example, if disputing a disallowed deduction, they can determine whether past tax court rulings support your claim.
After preparing your documentation and legal strategy, file a petition with the U.S. Tax Court. This document should clearly outline your disagreement with the IRS’s findings, supported by facts and legal arguments. Following the court’s procedural rules is essential to ensure your petition is accepted.
Implications of Non-Compliance
Failing to respond to a Notice of Deficiency within the prescribed timeframe can result in serious financial and legal consequences. Once the deadline passes, the IRS will assess the proposed tax liability, making it legally enforceable. This allows the IRS to initiate collection actions, such as placing liens on property or garnishing wages, which can significantly impact your financial stability and creditworthiness.
Non-compliance also leads to accruing interest and penalties. Interest on unpaid taxes, compounded daily under Internal Revenue Code Section 6601, is calculated at the federal short-term rate plus 3%. Penalties, such as the failure-to-pay penalty under IRC Section 6651(a)(2), add 0.5% of the unpaid tax per month, up to 25%. These additional costs can quickly escalate the total amount owed.
Ignoring the notice also limits your legal options. Once the tax is assessed, you lose the ability to dispute the liability in Tax Court. Instead, you would need to pay the tax in full and file for a refund, a more complex and time-consuming process. Acting promptly is essential to protect your rights and minimize financial exposure.
Tax Court Proceedings
Filing a petition with the U.S. Tax Court is the primary method for disputing a Notice of Deficiency. The Tax Court allows taxpayers to challenge IRS findings without requiring upfront payment of the disputed tax. However, filing a petition requires strict adherence to procedural rules and submission within the 90- or 150-day deadline.
After filing, the IRS will respond with an “Answer” outlining its position. Both parties may engage in discovery to exchange evidence and clarify arguments. Many cases are resolved during this stage through settlement negotiations, often facilitated by the IRS Office of Appeals. For instance, providing additional documentation may lead the IRS to reduce or eliminate the proposed tax liability.
If the case proceeds to trial, the Tax Court evaluates the evidence and legal arguments presented. The burden of proof typically lies with the taxpayer, except in cases involving fraud allegations. The court’s decision is binding, though taxpayers can appeal to a U.S. Court of Appeals if dissatisfied with the outcome. Given the complexities of tax law and court procedures, engaging a qualified tax attorney is highly advisable.