Legal Definitions - notice of deficiency

A notice of deficiency is a formal letter sent by a tax authority, such as the Internal Revenue Service (IRS), to a taxpayer. This notice is issued when the tax authority has reviewed a taxpayer's return and determined that the taxpayer owes more income tax than originally reported. Essentially, it's the government's official way of saying, "We believe you owe more tax."

The notice of deficiency is a crucial step because it formally notifies the taxpayer of the proposed additional tax and typically provides them with a specific period (usually 90 days) to either agree to the changes or challenge the determination in Tax Court without first paying the disputed amount. It outlines the reasons for the proposed changes and the amount of the deficiency.

Here are some examples illustrating how a notice of deficiency might be issued:

• Example 1: Unreported Income
  Sarah, a freelance graphic designer, filed her annual tax return. A few months later, the IRS conducted a review of her return and cross-referenced it with payment records from a major client that had issued her a 1099-NEC form. The IRS discovered that Sarah had inadvertently forgotten to include income from one of her projects on her tax return. As a result, the IRS sent Sarah a notice of deficiency, detailing the additional income they believed she owed tax on and the resulting increase in her tax liability.

  This example illustrates the term because the IRS, after examining Sarah's return, determined she had a deficiency (owed more tax) due to unreported income and formally communicated this finding through the notice.

• Example 2: Disallowed Deductions
  The Millers, a married couple, claimed a substantial amount of business expense deductions for their home-based consulting firm. During an audit, the tax authority found that some of the expenses they claimed, such as personal travel and certain home improvements, did not meet the strict criteria for business deductions. After disallowing these items, the tax authority calculated that the Millers owed additional tax. They then issued a notice of deficiency to the Millers, explaining which deductions were disallowed and the resulting increase in their tax bill.

  Here, the notice of deficiency is used when the tax authority disagrees with the deductions a taxpayer has claimed, leading to a determination that more tax is due because the taxable income is higher than originally reported.

• Example 3: Incorrect Calculation of Capital Gains
  David sold a significant amount of stock during the year and reported a capital gain on his tax return. However, he mistakenly used an incorrect cost basis for some of the shares, which resulted in him reporting a lower taxable gain than he should have. After reviewing his brokerage statements and comparing them to his tax return, the tax authority identified this error. They then sent David a notice of deficiency, outlining the correct capital gain calculation and the additional tax he owed as a result of the initial miscalculation.

  This scenario demonstrates a notice of deficiency being sent when a taxpayer makes a computational error that leads to an underpayment of tax, and the tax authority identifies this discrepancy during their review.