What Is a Deficiency?

A deficiency is the numerical difference between the amount of tax that a taxpayer, or taxpaying entity, reports on a tax return and the amount that the Internal Revenue Service (IRS) determines is actually owed. The term only applies to shortfalls and not to surpluses. Taxpayers are notified of deficiencies via deficiency letters.

Key Takeaways

  • When your reported income to the IRS is less than the income reported for you by employers or other sources, you will receive a deficiency notice.
  • Deficiency notices demand immediate action, and you cannot file for an extension when seeking to resolve the issue.
  • In case of deficiency due to identity theft, consult the IRS's identity theft website for more information.

Understanding Deficiency on Reported Taxes

A deficiency is located during internal audits conducted by the IRS that compare the various forms that have been submitted. Entities that report taxpayer liabilities include banks, employers, and other businesses.

A deficiency is assessed when the amount or tax liability reported to the IRS by the taxpayer is less than the amount reported by third parties. Third-party documents are an indication to the IRS that a form of income was received by the taxpayer.

Deficiencies can easily become back taxes if prompt action is not taken by taxpayers. A notice of deficiency does not automatically equate to an audit or disciplinary action, but it should be taken seriously. Taxpayers can use the contact information provided on the deficiency letter to contact the IRS for further information.

Deficiency notices are also not bills from the IRS. According to the IRS, "It is a proposal and informs you about the information we've received and how it affects your tax. It also provides you the option to agree, provide additional information for consideration if you disagree, or information for filing a petition with the U.S. Tax Court."

Examples of Events That Result in a Deficiency

A deficiency results when a W-2 submitted by an employer is not reported as income by the taxpayer. As the IRS reviews the documentation provided by employers, items are compared to those reported by the taxpayer. If the IRS locates a W-2 supplied by an employer, but not reported by the employee, a deficiency is assessed.

Deficiencies are also assessed due to inconsistent data. This includes when reported income on the W-2 and that reported on tax documents, such as a 1040, don’t match. Whether intentional or accidental, any additional liability is assessed as a deficiency. An official audit can also produce a deficiency. During an audit, the IRS will analyze all of the information and documentation as part of that particular tax year's return. If it is determined that additional taxes are owed, a deficiency results.

The IRS lists the following checklist to avoid being served a deficiency notice:

  • Keep accurate and full records.
  • Wait until you get all of your income statements before filing your tax return.
  • Check the records you get from your employer, mortgage company, bank, or other sources of income (W-2s, 1098s, 1099s, etc.) to make sure they're correct.
  • Include all your income on your tax return.
  • Follow the instructions on how to report income, expenses and deductions.
  • File an amended tax return for any information you receive after you've filed your return.

Addressing Notices of Deficiency

A form CP3219A, Notice of Deficiency, is sent after a first notice and Examination Report is sent and ignored. The notice, which is not a tax bill, specifies the inconsistencies between the taxpayer's reported tax liability and the liability assessed by the IRS.

Once the document is received if the taxpayer agrees that the deficiency indicated by the IRS is accurate, the taxpayer must respond within 90 days on Form 5564, Notice of Deficiency – Waiver. Should the taxpayer disagree with the assessment, they can choose to contest the deficiency by filing a petition with the U.S. Tax Court no later than the date shown on the notice. Please note the court can't consider your case if you file the petition late and there are no extensions.

There are several consequences if you ignore the Notice of Deficiency and do not pay your tax liability. The IRS can enforce and impose tax liens on your wages or bank account, tax levies by seizing your property or other assets, or even launch a criminal investigation, which could lead to jail time.  

Deficiency Due to Fraud or Identity Theft

If the deficiency is a result of fraud or identity theft, the taxpayer must report this information with the IRS by sending them Form 14039, Identity Theft Affidavit. 

Fraud may result if an incorrect amount is intentionally listed by the employer on the taxpayer's W-2. Identity theft may result if a person other than the taxpayer works while falsely claiming the taxpayer’s name and social security number as their own. A taxpayer will not be made liable for income tax on income they did not themselves earn.