Overview

A tax deficiency happens when the Internal Revenue Service (IRS) concludes that a taxpayer owes more tax than was reported on the original return. The IRS reaches that conclusion by reviewing reported income, deductions, credits, and payments, then recomputing tax liability using the correct tax code and available information. The result is an assessed deficiency plus any applicable penalties and interest. (IRS, “Understanding Your IRS Notice or Letter”, IRS.gov)

This article explains how those calculations typically work, common triggers, important deadlines and rights you can exercise to contest or resolve a proposed deficiency. The goal is practical — give you clear next steps if you receive a notice.

How the IRS arrives at a proposed deficiency

The IRS has several ways to discover differences between what you reported and information third parties provided: employer W-2s, bank or broker 1099s, Payers’ 1099s, and other informational returns. Here are the typical paths and adjustment types:

  • Information matching: The IRS matches amounts reported on third-party forms (W-2, 1099) against what you reported. Mismatches often generate automated notices (for example, CP2000 for proposed underreported income). (IRS, “CP2000 — Notice of Proposed Adjustment”, IRS.gov)
  • Mathematical corrections: Simple calculation or math errors can produce a corrected tax, commonly accompanied by an explanation. These are usually straightforward to correct.
  • Correspondence or field examinations (audits): If the IRS examines your return in more detail, it may disallow deductions, recharacterize income, or adjust basis in property.
  • Information from other filing returns or data analytics: Increased IRS data matching and analytics can flag unreported income or suspiciously large deductions.

Once the IRS determines an adjustment it thinks is appropriate, it recalculates tax this way:

  1. Recompute gross income by adding any unreported amounts.
  2. Recompute Adjusted Gross Income (AGI) after allowable adjustments.
  3. Apply the correct deductions or credits to calculate Taxable Income.
  4. Use the tax tables or tax rate schedules to compute the correct tax liability.
  5. Subtract credits and payments you already reported (withholdings, estimated taxes).
  6. The difference (if the tax liability is higher than your payments) is the proposed deficiency.
  7. The IRS then adds penalties and interest as applicable.

Every figure in this chain can be challenged with documentation — receipts, bank statements, invoices, logbooks, and contemporaneous records.

Common causes and examples

  • Underreported income: Forgot or didn’t receive a 1099, or personal use of business receipts were reported as business income.
  • Disallowed deductions: Home-office deductions, hobby vs. business issues, personal expenses claimed as business expenses, or excessive charitable deductions without contemporaneous receipts.
  • Basis errors on property sales: Wrong cost basis leads to overstated gain.
  • Incorrect credits: Child tax credit, education credits, or earned income credit claimed improperly.

Example calculation (simplified):

  • Reported tax after credits: $4,000
  • IRS adds $12,000 of unreported 1099 income → additional tax calculated at marginal rate = $3,000
  • New total tax = $7,000; payments and credits remain $4,000
  • Proposed deficiency = $3,000, plus penalties and interest if applicable.

Penalties and interest to expect

Penalties increase the dollar impact of a deficiency:

  • Accuracy-related penalty: generally 20% for negligence or substantial understatement (generally > 10% of correct tax or $5,000 threshold depending on context). (See IRS penalties guidance.)
  • Fraud penalty: up to 75% of the underpayment when fraud is proved.
  • Failure-to-pay: typically 0.5% per month on unpaid tax (up to a statutory limit).
  • Failure-to-file: generally 5% per month of the unpaid tax if you didn’t file when due.
  • Interest: Charged on unpaid balances compounded daily; rate set quarterly and tied to federal short-term rate plus a percentage (check IRS.gov for the current rate).

Because penalty rules are technical and fact-specific, consult a tax professional quickly if a penalty is proposed.

Statute of limitations

  • Assessment: The IRS usually has three years from the date you file to assess additional tax (26 U.S.C. § 6501).
  • Substantial understatement: Six years if you understate gross income by more than 25%.
  • No limit: If you never file a return or the return is fraudulent, there is no statute of limitations.

These time limits drive which years the IRS can go after when proposing a deficiency.

What to expect when you receive a notice

Notices differ by type. Common examples include CP2000 (proposed change from third-party info) and a Notice of Deficiency (often called a 90‑day letter) issued under the Internal Revenue Code that gives you the right to petition the U.S. Tax Court within 90 days (150 if you live outside the U.S.). Read the notice carefully; it explains the proposed change, which tax year is affected, and how long you have to respond. (IRS, “Understanding Your IRS Notice or Letter”, IRS.gov)

Important distinctions:

  • CP2000 is a proposed adjustment — it is not a formal assessment. You can agree and pay, or disagree and provide documentation.
  • Notice of Deficiency (IRS “90-day letter”) triggers a specific right to file a petition in U.S. Tax Court if you want to dispute the deficiency without first paying the tax.

If the IRS proposes a deficiency, you will normally be given a deadline to respond. Responding timely protects appeal and collection rights.

Practical steps to contest or resolve a proposed deficiency

  1. Read the notice carefully. Note the deadline and the errors claimed.
  2. Gather documentation that supports your return (receipts, contracts, canceled checks, bank statements, mileage logs, date-stamped invoices).
  3. If you agree with the math but need to amend, file Form 1040-X to correct your return (note: filing an amended return is separate from responding to an IRS notice).
  4. If you disagree, respond in writing with a point-by-point rebuttal and evidence. Use certified mail or the method described in the notice.
  5. If you can’t pay in full, consider payment options: installment agreement, Offer in Compromise (OIC), or temporarily delaying collection through a Collection Due Process hearing if collection actions start. Each option has eligibility rules. (See IRS appeals and collection programs.)
  6. If you want to litigate without paying first and you received a Notice of Deficiency, you may file a petition with the U.S. Tax Court within the deadline.
  7. Consider hiring a CPA, enrolled agent, or tax attorney — especially if large penalties or fraud allegations might apply. You can authorize a representative using Form 2848 (Power of Attorney).

If the IRS has opened an audit, see our practical checklists and document-packing guides for audits: Navigating the IRS Audit Process: What to Expect and How to Gather Records for an IRS Audit: A Step-by-Step Guide.

Appeal rights and dispute channels

  • Administrative appeal: You can appeal IRS audit adjustments within the IRS Office of Appeals. Appeals are an independent administrative review — often a cost-effective step before litigation.
  • Collection Due Process (CDP): If the IRS issues a lien or levy notice, CDP rights give you a hearing with the IRS Independent Office of Appeals. File Form 12153 to request a CDP hearing. (IRS, “Collection Due Process and Equivalent Hearing”, IRS.gov)
  • U.S. Tax Court: If you receive a Notice of Deficiency, you generally have 90 days to petition the Tax Court; this allows contesting the tax without first paying.
  • U.S. District Court or U.S. Court of Federal Claims: These venues typically require payment of tax first, then a refund suit.

Practical defenses and documentation that help

  • Third-party corroboration: 1099s, W-2s, and bank statements that support your position.
  • Contemporaneous records: logs, contracts, invoices, signed statements of work, photos, and receipts.
  • Reasonable cause: If errors arose from events beyond your control, you may avoid penalties with a reasonable cause showing.
  • Reconciliations: Bank reconciliations and detailed ledgers — especially for business owners — close the gap between reported and actual figures.

When to hire professional help

You should engage a tax professional when:

  • The deficiency is large or triggers large penalties.
  • Fraud or criminal exposure is alleged.
  • You need to file a timely petition in Tax Court or negotiate complex settlements like an Offer in Compromise.
  • You’d rather delegate communications to an authorized representative — file Form 2848 to do that.

If you’re preparing for an audit or need help negotiating an outcome, see our guide on Negotiating an Audit Resolution: Strategies and Documentation.

Quick checklist if you receive a deficiency notice

  • Read and calendar the deadline immediately.
  • Don’t ignore the notice — responding preserves rights.
  • Gather supporting records and create a concise rebuttal.
  • Contact a tax professional if the liability or penalties are material.
  • Explore payment or compromise options if you can’t pay in full.

Final notes and disclaimer

This guide is for educational purposes and summarizes common IRS procedures and taxpayer rights as of 2025. Tax situations are fact-specific; this is not individualized tax advice. For personal guidance, consult a qualified tax professional or attorney. Authoritative resources include IRS.gov (for notices like CP2000 and Notice of Deficiency), the Taxpayer Bill of Rights, and the Internal Revenue Code (26 U.S.C. § 6501 on assessment periods).