What Is a Tax Deficiency and How Do You Respond?

A tax deficiency arises when the Internal Revenue Service (IRS) determines a taxpayer owes more tax than was reported on their return. This is a calculated discrepancy, not an accusation of wrongdoing. The IRS computes tax liability using information from third-party sources, like employers and financial institutions, and when this data indicates a higher tax obligation than what was paid, the difference is labeled a deficiency.

Common Causes of Tax Deficiencies

A primary cause of tax deficiencies is underreported income. The IRS uses an automated system to match information returns, like Form W-2 from employers and Form 1099 from clients, against the income reported on a tax return. When the system finds income paid to a taxpayer but not included on their Form 1040, it flags the return and proposes an adjustment. This can happen if a taxpayer forgets to include income from a freelance job or misplaces a 1099-INT for interest earned.

Another cause is the disallowance of tax deductions or credits. Taxpayers may claim deductions or credits for which they do not fully qualify according to tax law. For example, a person might claim an education credit without meeting enrollment requirements or a dependent who does not meet the residency or support tests. An IRS review can find these claims invalid, increasing the total tax owed and creating a deficiency.

Filing status errors also contribute to deficiencies. Choosing an incorrect status, such as Head of Household instead of Single, can alter the standard deduction and tax brackets. If an IRS review determines the taxpayer did not meet the legal requirements for their chosen status, it will recalculate the tax using the correct one. This recalculation often results in a higher tax liability and a deficiency.

Understanding IRS Deficiency Notices

The process often begins with a preliminary notice, most commonly the CP2000. This notice is not a bill but a proposal of changes to your tax return based on mismatched information. The CP2000 details the discrepancies the IRS found, like unreported income, and calculates the proposed additional tax, penalties, and interest. It provides an opportunity for the taxpayer to agree with the changes or disagree and provide supporting documentation.

If issues are not resolved at the preliminary stage, the agency will issue a Statutory Notice of Deficiency, also known as a “90-day letter.” This document is sent by certified mail and formally states the IRS’s determination of a deficiency. Its issuance begins a strict 90-day period (150 days if addressed outside the U.S.) during which the taxpayer can challenge the determination in U.S. Tax Court without first paying the disputed amount. Failure to respond within the timeframe results in the taxpayer forfeiting their right to petition the Tax Court, and the IRS will then assess the tax, making it a legally owed debt.

How to Respond to a Deficiency Notice

Responding if You Agree

When a taxpayer agrees with the findings in an IRS notice, the response depends on the type of notice received. For a preliminary notice like the CP2000, the taxpayer simply uses the enclosed response form to indicate their agreement.

If the deficiency is proposed after an audit, the IRS sends Form 4549, “Income Tax Examination Changes,” detailing the adjustments. Signing this form confirms agreement and typically closes the case without a formal Statutory Notice of Deficiency.

If you receive a Statutory Notice of Deficiency and agree, you can sign the enclosed waiver form, Form 4089-B. Signing this form waives the right to petition the U.S. Tax Court and allows the IRS to assess the tax.

In all cases of agreement, after returning the signed form, wait for an official bill from the IRS before sending payment. Payment options include paying from a bank account, using a debit or credit card, or applying for a payment plan.

Responding if You Disagree

If you disagree with a preliminary notice like the CP2000, you should not file an amended tax return (Form 1040-X), as this can complicate the process. Instead, complete the response form included with the notice, indicating your disagreement. You must attach a letter explaining why the IRS’s proposed changes are incorrect, along with copies of supporting documents like bank statements or corrected 1099s.

When disagreeing with a formal Statutory Notice of Deficiency, the procedure is time-sensitive. The only way to dispute the deficiency without first paying it is to file a petition with the U.S. Tax Court before the 90-day deadline expires. Missing this deadline means the opportunity to go to Tax Court is lost.

Interest and Penalties on a Deficiency

When a tax deficiency is determined, interest is charged on any underpayment of tax. This interest begins to accrue from the original due date of the tax return, not from the date the deficiency is identified, and continues until the tax is paid in full. The interest rate is set quarterly and is calculated as the federal short-term rate plus three percentage points, compounded daily.

The IRS may also impose penalties. The most common is the accuracy-related penalty, which is 20% of the underpayment attributable to negligence, disregard of the rules, or a substantial understatement of income tax. A substantial understatement occurs if the tax shown on the return is understated by the greater of 10% of the correct tax or $5,000.

While interest is difficult to have waived, penalties may be abated if the taxpayer can show they had reasonable cause for the error and acted in good faith. However, agreeing to the deficiency by signing a waiver form often means agreeing to the proposed penalties. It is important to address penalty relief as part of any response to the IRS.