Substantial Variance Doctrine for Informal Tax Refund Claims – Houston Tax Attorneys

Taxpayers often submit refund claims when they discover that they overpaid their taxes. Taxpayers usually do this by submitting a formal refund claim using the IRS’s prescribed forms. But this is not always required.

In many cases, taxpayers will submit so-called “informal refund claims” to the IRS during the course of an IRS audit. The IRS treats these informal claims as a refund claim as if the proper tax forms were filed. Given that the tax forms are often not used for informal claims, there may be less certainty as to what the taxpayer’s claim entails. The informal claim itself may just be various business records, complications, etc. or a myriad of other records that the taxpayer submits to the auditor.

This leads to the question as to whether the “variance doctrine,” which can prohibit taxpayers from litigating certain claims in court if they differ substantially from the taxpayer’s position on audit, applies to informal refund claims. The recent Express Scripts, Inc. v. United States, No. 4:21-cv-00035-HEA (E.D. Mo. Feb. 24, 2025) case provides an opportunity to consider this question.

Facts & Procedural History

The taxpayer in this case is a pharmacy benefit manager. It processes prescription drug claims for health plan sponsors and operates mail-order pharmacies.

During an IRS examination, the taxpayer submitted informal claims to the IRS auditor for Section 199 domestic production tax deductions that it omitted from its originally-filed tax returns.

As part of this process, the company provided the IRS with detailed workpapers and memoranda categorizing various revenue streams. These documents specifically identified certain “rebate” revenue and portions of their “mail claims” revenue (those manually entered into their system) as non-qualifying revenue streams that should be excluded from their Domestic Production Gross Receipts (“DPGR”) calculations. The taxpayer took the same positions in the formal administrative refund claims they later filed with the IRS for refunds for the years 2010, 2011, and 2012.

Nearly a decade after the initial claims, the taxpayer determined that both the rebate revenue and manually entered mail claims were qualifying for the Section 199 deduction. The taxpayer filed suit seeking refunds of federal income taxes for tax years 2010, 2011, and 2012, claiming it properly qualified for the Section 199 tax deduction for its rebate revenue and manually entered mail claims.

The government moved to dismiss the portions of the refund claims relating to rebate revenue and manually entered mail claims, arguing that the taxpayer was barred by the “substantial variance doctrine” from including revenue streams in tax litigation when they had specifically excluded them during the administrative claims process.

The Framework for Tax Refund Claims

Section 7422(a) allows taxpayers to sue the government for tax refunds. This is one of the permissible means to litigate a tax issue.

Section 7422 states that no suit for tax recovery can be maintained in any court “until a claim for refund or credit has been duly filed with the Secretary, according to the provisions of law in that regard, and the regulations of the Secretary established in pursuance thereof.”

This is the foundation for what courts often call the “pay first, litigate later” system for tax disputes. Under this framework, taxpayers must first pay the disputed tax, then file an administrative refund claim with the IRS, and only afterward can they pursue litigation if the IRS denies their claim or fails to act within six months.

The treasury regulations provide specific requirements for these administrative refund claims. Treasury Regulation § 301.6402-2(b) states that a claim “must set forth in detail each ground upon which a credit or refund is claimed and facts sufficient to apprise the commissioner of the exact basis thereof.” This regulation serves as the foundation for the substantial variance doctrine that limits what taxpayers can argue once they get to court.

What Is the Substantial Variance Doctrine?

The substantial variance doctrine operates as a jurisdictional limitation on tax refund litigation. As articulated in Lockheed Martin Corp. v. United States, 210 F.3d 1366, 1371 (Fed. Cir. 2000), which involved a research tax credit, a taxpayer is barred from presenting claims in a tax refund action that “substantially vary” the legal theories and factual bases set forth in the tax refund claim presented to the IRS.

The doctrine has two distinct branches: one addressing legal theories and another addressing factual bases. For legal theories, the rule states that “any legal theory not expressly or impliedly contained in the application for refund cannot be considered by a court in which a suit for refund is subsequently initiated.” This means taxpayers cannot pursue entirely new legal arguments in court that weren’t presented to the IRS.

The factual variance branch, which was at issue in the Express Scripts case, prohibits taxpayers from substantially varying the factual bases raised in their refund claims. This rule is not all that strict. Minor factual variations are permitted. Taxpayers cannot introduce entirely new factual elements that the IRS never had an opportunity to consider.

Why Does the Variance Doctrine Exist?

The substantial variance rule serves three primary purposes. First, it gives the IRS notice as to the nature of the claim and the specific facts upon which it is predicated. This notice function ensures that the IRS understands exactly what the taxpayer is claiming and why.

Second, it gives the IRS an opportunity to correct errors administratively. This purpose reflects the preference for resolving tax disputes at the administrative level rather than through costly litigation.

Third, it limits any subsequent litigation to those grounds that the IRS had an opportunity to consider and is willing to defend. This purpose helps ensure that courts aren’t faced with entirely new claims that the IRS never had a chance to review.

These purposes reflect the fundamental principle that tax litigation over refund claims is meant to be a review of the IRS’s administrative determination, not an entirely new proceeding where taxpayers can raise new issues.

Applying the Variance Doctrine to Informal Claims

Most refund claims follow the formal procedures outlined in IRS regulations, typically involving the filing of Forms 1040X for individuals, Forms 1120X for corporations, etc. However, courts have long recognized the “informal claim doctrine,” which allows taxpayers to satisfy the administrative claim requirement through less formal means.

An informal claim can suffice when it puts the IRS on notice that the taxpayer is seeking a refund, describes the legal and factual basis for the refund, and has some written component. IRS audits often provide opportunities for taxpayers to make these informal claims as part of the examination process.

The taxpayer in this case made its initial claims through informal claims during an IRS examination, providing detailed workpapers and memoranda. But does the variance doctrine apply differently to informal claims than to formal ones?

The answer is no. Courts have consistently held that the substantial variance doctrine applies equally to informal claims. In fact, the requirements for specificity can be even more important for informal claims, as the IRS must be able to determine from sometimes less structured submissions exactly what the taxpayer is claiming. This case is an example of the court applying the variance doctrine to informal claims.

Merely Additional Evidence of the Amount

The taxpayer argued that the variance doctrine did not apply as the inclusion of rebates and manually entered pharmacy claims merely represented “additional evidence” of the amount of their Section 199 deduction. They contended that because they were still seeking the same Section 199 deduction, there was no substantial variance in their legal theory.

The court rejected this argument, focusing on the fact that the taxpayer had “specifically excluded these amounts throughout the entire administrative claims period and indeed, through this action until it was asserted in the expert reports.” The court found that the taxpayer’s addition of this revenue “changes the facts upon which the IRS assessed Plaintiffs’ claims.”

The court emphasized that Express Scripts “specifically declined to include these items in its claim. As such, the IRS was not given the opportunity to review whether they were properly designated as gross receipts.” Because the IRS never had the opportunity to consider whether these additional revenue streams qualified for the deduction, the substantial variance doctrine barred their inclusion in the litigation.

What if the IRS Reviews the Position on Audit?

The taxpayer also argued that the IRS had waived the substantial variance doctrine by considering the allocation of DPGR. This approach reflects a strategy sometimes used in tax audits where taxpayers argue that the IRS has effectively waived technical requirements by addressing the merits of a claim.

The court rejected this waiver argument on factual grounds, noting that the taxpayer had “specifically exempted the rebates and manually entered mail pharmacy claims” from consideration, so the IRS “could not have considered the merits of these claims because they were not before the IRS for examination.”

The court’s reasoning highlights a critical point: taxpayers cannot claim waiver based on the IRS’s consideration of issues that were never actually presented to the IRS. The waiver argument can only work when the IRS actually considers facts or theories that were raised in the administrative claim.

The Takeaway

This case shows how important it is to provide clear detail and consistency when submitting tax refund claims to the IRS. This includes informal claims submitted to the IRS on audit. Taxpayers who specifically exclude certain factual bases from their administrative refund claims—whether formal or informal—may not be able to later include those bases in litigation, even if their legal theory remains unchanged. The substantial variance doctrine operates as a jurisdictional bar in these cases, which can serve to deny the taxpayer their day in court.

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Stephan Dorsey

Stephan is the sports journalist for the Maple Grove Report.

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FBAR Penalties Are Unconstitutionally Excessive – Houston Tax Attorneys

Most tax penalties follow a simple logic. The bigger the tax problem, the bigger the penalty.

For example, the civil fraud penalty is one of the most severe penalties in our tax code. This makes sense as fraud is the most severe thing that one can do wrong when it comes to taxes. The civil fraud penalty is 75% of the understated tax. This means it is effectively capped at about 26% of the underlying income (75% of the 35% maximum tax rate).

There are other penalties that are not tied to the tax loss to the government. Foreign Bank and Financial Accounts Report (“FBAR”) penalties are a prime example. FBAR penalties are based solely on unreported account balances. FBAR penalties can exceed 100% of the account value. This makes the FBAR penalties significantly larger than even the harshest traditional tax penalties. They can even greatly exceed the amount for the civil fraud penalty.

FBAR penalties often are excessive. Taxpayers have argued FBAR penalties are excessive. The courts have generally dismissed these challenges, however. This has recently changed with the United States v. Schwarzbaum, No. 22-14058 (11th Cir. Jan. 23, 2025) case.

Facts & Procedural History

The case involves a taxpayer who was born in Germany. He became a legal permanent resident of the U.S. in 1995 and obtained his U.S. citizenship in 2000. He then split his time between Costa Rica, Switzerland, and the United States.

The taxpayer’s wealth originated from his father’s successful textile and real estate ventures in Germany. In 2001, the father transferred an existing Swiss bank account to the taxpayer and continued making substantial gifts to the account through 2009. The funds were managed according to the father’s instructions by bankers, with the taxpayer never directing investments.

Between 2006 and 2009, the taxpayer maintained interests in 13 foreign accounts. This included 11 accounts in Switzerland and two in Costa Rica. The account balances were substantial:

One UBS account held over $8.6 million
Another UBS account contained more than $15 million
Multiple other Swiss accounts held between $2.6 million and $4.5 million each
One account (Aargauische) maintained a balance under $16,000

The taxpayer properly disclosed these accounts to his CPAs. However, the taxpayer’s CPAs incorrectly advised him that he had no duty to report these assets. Relying on this incorrect advice, the taxpayer filed incomplete FBARs. In 2007 he reported only one Scotiabank account. He filed no FBAR for 2008 until 2011. In 2009, he filed to disclose just three accounts out of the many he held.

In 2010, the taxpayer entered the IRS’s Offshore Voluntary Disclosure Initiative (“OVDI”). As part of this, the taxpayer disclosed 17 Swiss accounts and 4 Costa Rican accounts. The taxpayer later opted out of the program, which triggered an IRS audit.

The procedural history that followed was complex. The IRS initially calculated FBAR penalties at $35.4 million. This was reduced to $13.7 million after mitigation. The penalties were timely assessed in September 2016 under a tolling agreement.

In August 2018, the U.S. filed suit to collect the penalties. In March 2020, the district court found willful violations for 2007-2009. Multiple appeals followed regarding calculation methods. The IRS ultimately recalculated the penalties at $13.5 million. The government sought a final judgment of $12.5 million.

After an initial decision focusing on procedural issues, the Eleventh Circuit Court of Appeals granted a petition for rehearing, vacated its prior opinion, and addressed the constitutional question of whether FBAR penalties are so severe that they violate the Eighth Amendment’s prohibition on excessive fines.

About FBAR Penalties

U.S. citizens and residents have to file an FBAR to report financial interest in or signature authority over most foreign financial accounts.

The forms have to be filed if the accounts exceed $10,000 in total at any time during the calendar year. This is not an annual account balance test. If the combined accounts exceed $10,000 even for one day, the filing requirement is triggered.

The FBAR forms are not filed with the IRS. They are filed with the Treasury Department’s Financial Crimes Enforcement Network (“FinCEN”) through its BSA E-Filing System.

Unlike most tax penalties, FBAR penalties are not found in the tax code. They come from the Bank Secrecy Act of 1970, which was primarily designed to combat money laundering and other financial crimes. The IRS enforces these penalties even though they were not found in the tax law and not filed with the IRS.

Congress has created different tiers of penalties for FBAR violations. Non-willful violations are capped at $10,000 per violation. The courts have determined this is per account, not per year.

Willful violations trigger much steeper penalties. The IRS can assess the greater of $100,000, or 50% of the account balance at the time of the violation. This is the conjunctive “or” and not capped at $100,000.

The standard for “willful” violations in FBAR cases is surprisingly low. While criminal tax cases require proof that a taxpayer intentionally violated a known legal duty, civil FBAR cases only require recklessness. The courts have held that simply checking “no” on Schedule B of a tax return (which asks about foreign accounts) can be evidence of willfulness if the taxpayer has significant foreign accounts. Even failing to review tax returns carefully before signing them can constitute reckless conduct that triggers the larger willful FBAR penalties.

For willful violations, the penalties can stack year after year. Since the penalty is based on the account balance on the FBAR due date in each year, an account could theoretically be wiped out in just two years of penalties.

The Constitutional Framework

The Constitution gives Congress broad powers when it comes to taxes. Article I, Section 8 grants Congress the power to “lay and collect taxes.” The Sixteenth Amendment explicitly authorizes income taxes. Constitutional challenges to tax laws often focus on whether Congress acted within these enumerated powers, whether taxes are uniformly applied, or whether taxpayers received proper notice and hearings, or the taxpayer’s right to choose their own tax attorney.

FBAR penalties present a different constitutional question. Since these penalties originated in banking law rather than tax law, they raise issues under the Eighth Amendment’s Excessive Fines Clause. This clause states that “excessive fines shall not be imposed.”

While the Excessive Fines Clause originally targeted criminal penalties, the Supreme Court has extended it to civil penalties that serve punitive purposes. The key question is whether a penalty is solely remedial or serves even partly as punishment. If the penalty has any punitive aspect, it must not be “excessive” under the Eighth Amendment.

This creates an unusual situation. Congress has nearly unlimited power to impose taxes and traditional tax penalties. But when Congress creates penalties outside the tax code–like FBAR penalties–those penalties face constitutional scrutiny under the Excessive Fines Clause.

The Court’s Constitutional Analysis

The Eleventh Circuit had to first consider how FBAR penalties compare to traditional tax penalties. Most tax penalties are limited by being tied to the tax loss. The civil fraud penalty–one of the most severe penalties–is 75% of the understated tax. With our maximum tax rate of 35%, this means the civil fraud penalty cannot exceed 26% of the underlying income. FBAR penalties, by contrast, can exceed the entire value of the account.

With this context, the court found that FBAR penalties are subject to Eighth Amendment review because they serve punitive, not merely remedial, purposes. The court pointed to several factors for this:

The penalties are calculated without regard to government costs
The penalty structure focuses on culpability (higher for willful violations)
Congress explicitly designed the penalties for deterrence
The penalties can far exceed typical tax penalties

Applying this framework, the court found that $100,000 penalties on accounts holding less than $16,000 were “grossly disproportional” and thus unconstitutional. However, the court upheld larger penalties for the foreign accounts that held millions of dollars. This decision is particularly important as there are no administrative collection due process rights for FBAR penalties.

The court’s analysis raises fundamental questions about penalty proportionality. Most tax penalties are tied to the tax loss to the government. They are capped based on the tax rate. For example, the civil fraud penalty is 75% of the understated tax. With a maximum tax rate of 35%, this means the penalty cannot exceed 26% of the underlying income (75% x 35%).

As noted above, FBAR penalties work differently. They are based on account balances, not tax loss. They can exceed 100% of the account value. This leads to situations where the penalty amount may be thousands of times larger than any potential tax loss. The court acknowledged this disparity but concluded that hiding foreign accounts creates unique harms that justify larger penalties–at least for substantial accounts.

Differing Opinions for Now

This case marks a significant shift in how courts view FBAR penalties. In United States v. Toth, 33 F.4th 1 (1st Cir. 2022), the First Circuit had previously held that FBAR penalties entirely escape Eighth Amendment scrutiny. That court viewed these penalties as purely remedial, merely compensating the government for the costs of investigating foreign accounts.

The Eleventh Circuit explicitly rejected this view. It found that even if FBAR penalties serve some remedial purpose, they are at least partly punitive and thus subject to constitutional review. This creates a direct split between circuits on a fundamental question: whether there are any constitutional limits on FBAR penalties. Given the stakes involved and the frequency of FBAR cases, the Supreme Court may need to resolve this issue.

The Takeaway

This case preserved the IRS’s ability to impose significant FBAR penalties on larger foreign accounts. However, the case provides some grounds for taxpayers to make this type of constitutional argument when trying to defend against FBAR penalties. It suggests that penalties grossly disproportionate to account balances–like a $100,000 penalty on a $16,000 account–may be successfully challenged as unconstitutional.