The Dreaded Notice of Deficiency

An IRS Notice of Deficiency is a proposed increase in your taxes and a notice of your right to challenge that increase. It’s also called a CP3219A letter.

No one likes getting these notices. Who wants to be told by the biggest collection agency in the world, the IRS, that you owe them more money? Not me and not you.

The are a number of reasons for the IRS sending you this notice. The more common ones are claiming deductions the IRS won’t allow, a change in child tax credits, and penalties on early withdrawals from retirement accounts.

You need to be aware that this notice is under a 90 day time constraint, which begins on the notice date listed in your notice. If you miss the deadline, you will be in default and the changes will automatically be applied. The IRS will send you a bill for this new amount.

Let’s breakdown the notice. I will do my best to simplify it for you.

The first page gives you a summary of the proposed changes which includes the increase in tax (deficiency) and the penalties the IRS will assess. These proposed changes usually include a Substantial Tax Understatement penalty, a Failure To File penalty and interest charges.

The Substantial Tax Understatement penalty is 20% of the amount of the underpayment if the increase in your tax is greater than 10% of the amount you claimed, or $5,000.00, whichever is greater.

For example, let’s say you filed your tax return with a taxable income of $100,000.00. The IRS audits your return and finds that you have an additional $12,000.00 to add to your taxable income. This is more than 10% of $100,000.00 and more than a $5,000.00 adjustment. The penalty is then calculated by taking 20% of the $12,000.00 adjustment. So, the penalty is $2,400.00.

The Failure To File penalty is added because you did not claim the adjusted amounts the IRS is now claiming as due. This penalty is assessed at 5% of the adjusted amounts, per month for up to five months.

Using the example above, the Failure To File penalty would be 5% of the $12,000.00. This equals $600.00.

Interest charges are also accruing on the proposed adjusted amount. And it is calculated from the date the return is due, regardless of extensions.

You have three options to respond to the IRS’s proposed increases. They are:

  • agree to the proposed changes
  • contact the IRS directly and attempt to resolve it
  • file a petition with the U.S. Tax Court

The first option is to agree with the changes, pay the proposed amount due and be done with it. Or if you can’t pay it immediately, you can waive your rights by signing the Notice of Deficiency Waiver and returning it to the IRS. They will send you a bill and you will be obligated to pay it. If you don’t, then they will start collection action against you.

The second option is to contact the IRS directly and dispute the proposed changes. You will need to get your case together, explain the validity of your challenge, and fax or mail it to the IRS. The explanation needs to be signed by you, otherwise the IRS may not accept it.

The third option is to file a petition with the U.S. Tax Court. If you chose this route, it is imperative that you file your case before the 90 day date stated in your notice. Failing to file by the listed date, means you lose the right to be heard by the tax court. Going to court and pleading your case is a process. It can be done pro se, but I always recommend that you get an experienced tax attorney with tax court litigation experience to represent you.

Keep a copy of your notice because I will need to see it if you decide you want my help. It gives me the details of what the IRS is seeking from you.

Sources:

Understanding Your CP3219A Notice

Important Facts about Filing Late and Paying Penalties

Topic Number 653 – IRS Notices and Bills, Penalties, and Interest Charges

26 CFR § 1.6662-4 – Substantial understatement of income tax

26 U.S. Code § 6662. Imposition of accuracy-related penalty on underpayments

26 U.S. Code § 6651. Failure to file tax return or to pay tax