What is a Notice of Deficiency?

A Notice of Deficiency is a formal notification by a revenue agency that a taxpayer has a currently outstanding balance in his or her tax account. This type of document is typically structured so that the taxpayer is also informed of various options regarding the amount due, including disputing the claim. In the United States, the Internal Revenue Service utilizes a Notice of Deficiency, along with a number of individual states that prepare documents that carry similar titles.

The main purpose of a Notice of Deficiency is to alert the taxpayer of an existing tax liability. In most cases, the liability refers to taxes due for previous periods, plus any penalties and interest that was applied up to the date of the notification. As part of the detail included in the document, the tax period associated with the balance due is noted. In the event that multiple periods have an outstanding tax debt, each of those periods and the appropriate balances are listed within the text.

Receiving a Notice of Deficiency is not necessarily an indication that some attempt at tax avoidance or evasion has taken place. The origin of the error could be something as simple as utilizing an outdated tax table, or even a minor error in addition or subtraction. In some situations, errors in calculating the taxes for a given period are discovered at a later date, requiring an adjustment. Should that adjustment mean that more taxes are due for that particular tax period, the notice is sent as a means of alerting the taxpayer to the situation, making it possible to avoid further accumulation of penalties.

Upon receiving a Notice of Deficiency, the taxpayer usually is presented with three options. One approach is to verify the amount stated on the document and pay the entire balance claimed by the revenue agency. Should the taxpayer feel the amount found on the notice is incorrect, he or she may follow specific procedures to dispute the balance and cite data that backs up his or her position.

A third alternative is to contact the revenue agency and work out some type of repayment plan, making it possible to retire the back taxes in monthly installments over a period of several months. This last option usually does mean that interest and penalties continue to accrue on the outstanding balance, but those penalties and interest may be competitive with the cost of taking out a loan to pay off the amount owed. When this is the case, working with the revenue agency is usually quicker and easier than going through a loan application process.