Distributions From Forfeited IRA are Not Taxable – Houston Tax Attorneys

You commit a crime, you are convicted, and you do your time. Then the IRS steps in to collect taxes. The IRS takes your assets to pay the tax that arose from your criminal activity.

As part of this, the IRS seizes your IRA funds. Are you responsible for paying income taxes on the IRA distribution–even through you never received the money and you did not have control over the IRA at the time the funds are withdrawn?

The recent Sixth Circuit decision in Hubbard v. Commissioner, No. 24-1450 (6th Cir. Mar. 19, 2025), considers whether a taxpayer must pay income tax on IRA funds that were forfeited to the government following a criminal conviction.

Facts & Procedural History

The taxpayer in this case was a pharmacist who owned and operated a pharmacy in eastern Kentucky. His business generated substantial income, allowing him to acquire multiple homes, luxury vehicles, a boat, jet skis, and establish an IRA. By 2017, his IRA had nearly $500,000 in untaxed money.

The source of the taxpayer’s wealth, however, was illegal. He operated what courts described as a “pill mill,” selling large quantities of oxycodone to those addicted to the drug and supplying pseudoephedrine to methamphetamine manufacturers. Following criminal proceedings, a jury convicted the taxpayer of drug and money-laundering offenses. This resulted in a 30-year prison sentence. Importantly, there were no tax fraud charges.

As part of the criminal case, prosecutors invoked criminal forfeiture laws to seize the taxpayer’s assets acquired with proceeds from his illegal activities. The district court ordered the forfeiture of specific property—his homes, vehicles, watercraft, and financial accounts, including his IRA—to the IRS.

In 2017, the IRS seized the nearly $500,000 from the taxpayer’s IRA. The IRS treated this seizure as a taxable distribution to the taxpayer. While the taxpayer was in prison, the IRS sent him a notice of deficiency claiming he owed nearly $300,000 in combined in income taxes, early withdrawal penalty, and interest and penalties for failing to file a tax return.

The taxpayer challenged this notice in tax court

The taxpayer challenged this notice in tax court. He argued that the tax liability “should be paid by [the] feds” since his account “was forfeited to” them. Although the IRS conceded that the taxpayer shouldn’t have to pay the early withdrawal penalty, it maintained that he still owed income taxes. The tax court sided with the IRS, finding that the taxpayer owed taxes and penalties. This appeal followed, which reversed the tax court.

Understanding Criminal Forfeiture

Criminal forfeiture laws allow the government to seize property connected to illegal activity to “ensure that crime does not pay.” While English common law permitted authorities to confiscate all of a convicted defendant’s property, American forfeiture laws typically target only “specific assets” with a connection to the crime.

The Sixth Circuit explained that there are two general types of forfeitures in our legal system, i.e., a specific property forfeiture and a personal money judgment forfeiture. The tax implications are not the same for each type.

What is a Specific Property Forfeiture?

The first type of forfeiture identifies “specific property” that the defendant must relinquish. The government becomes the owner of this property upon conviction.

Some forfeiture laws incorporate a “relation back” doctrine that treats the government as having ownership rights in the property dating back to when the crime was committed.

This type of forfeiture resembles an “in rem” judgment because it permits the government to seize only the identified “tainted property” rather than the defendant’s other assets.

What is a Personal Money Judgment Forfeiture?

The second type of forfeiture is a personal money judgment. This type of forfeiture allows courts to impose a “personal money judgment” identifying a sum that the defendant must pay.

With this type of forfeiture, the court calculates this amount based on the value of the forfeitable property involved in the crimes.

This type of forfeiture resembles an “in personam” judgment because the government may collect the debt from any of the defendant’s current or future assets.

Which Type Applied In Hubbard’s Case?

This case involved a specific property forfeiture. The district court identified specific property subject to forfeiture—including his IRA—and ordered the IRS to seize only these assets. The court did not enter a personal money judgment against the taxpayer.

The order stated that the forfeited assets “shall be forfeited to the United States and no right, title, or interest in the property shall exist in any other party.” This meant that the government became the IRA’s owner at the time of the order.

Distributions from Forfeited IRAs, Generally

Questions about gross income start with Section 61(a) of the tax code. Section 61(a) says that “gross income means all income from whatever source derived.” This broad language is intentional. It reflects Congress’s intent to exercise its full constitutional taxing power under the Sixteenth Amendment. The Supreme Court has consistently interpreted this provision broadly, holding that it covers “all economic gains” not specifically exempted by statute. The breadth of Section 61(a) extends beyond direct cash receipts to include just about all forms of economic benefit.

Beyond this general definition, Section 408(d)(1) specifically addresses IRA distributions, stating that “any amount paid or distributed out of an individual retirement plan shall be included in gross income by the payee or distributee, as the case may be.” This language is key here because it identifies who bears the tax burden—the “payee or distributee” of the funds.

These provisions would clearly apply if the taxpayer owned the IRA at the time of the distribution. But the taxpayer did not own the IRA at the time of the distribution. The government owned the IRA.

This ownership question was central to the court’s analysis. The Sixth Circuit had to determine whether the taxpayer remained the “payee or distributee” for tax purposes despite no longer owning or controlling the IRA when the funds were withdrawn.

The court concluded that once the IRS became the owner of…

The court concluded that once the IRS became the owner of the IRA through the forfeiture order, the agency—not the taxpayer—became the “[o]ne to whom money [was] paid or payable” and the “beneficiary entitled to payment” under ordinary definitions of these terms.

Thus, the Sixth Circuit Court held that the broad language of Section 61(a) did not cause the distribution to be taxable income to the taxpayer.

Distribution from Forfeited IRA as Discharge of Debt Income

Since Section 61(a) did not work, the IRS had to find some other rationale for including this in income. The IRS argued that Subsection 61(a)(12) made the distribution income for income tax purposes.

This subsection specifically identifies “income from discharge of indebtedness” as a form of gross income. This principle, sometimes called “cancellation of debt” income, recognizes that when a taxpayer’s financial obligation is satisfied by a third party or otherwise canceled, the taxpayer has realized an economic benefit equivalent to receiving cash and using it to pay the debt.

The seminal case interpreting discharge of indebtedness as income is Old Colony Trust Co. v. Commissioner. In that case, the Supreme Court held that when an employer paid an employee’s tax obligations directly to the government, this payment constituted additional taxable income to the employee. The Court reasoned that the “discharge” of an “obligation” was economically equivalent to a “receipt” of the same sum of money.

Courts have since applied this principle to numerous situations, including involuntary distributions from retirement accounts. For example, the tax court has held that when IRA funds are garnished to pay child support (Vorwald v. Commissioner), to satisfy tax debts (Schroeder v. Commissioner), or to pay restitution (Rodrigues v. Commissioner), the IRA owner must still pay taxes on the distributions despite never receiving the funds directly. This is even true if the debt that is cancelled is exceedingly old.

The question in this case was whether the criminal forfei…

The question in this case was whether the criminal forfeiture of the taxpayer’s IRA created a “debt” that was discharged when the IRS seized the funds. The Sixth Circuit answered this question by examining the specific type of forfeiture involved.

The court reasoned that had the district court entered a …

The court reasoned that had the district court entered a “personal money judgment” against the taxpayer, that judgment might have created a debt. In that case, the withdrawal of IRA funds might have created a tax obligation by reducing a debt the taxpayer owed.

However, since the district court instead granted the IRS ownership of the “specific property” (the IRA), the IRS did not withdraw the funds to “discharge” an “obligation” that the taxpayer owed. Rather, the IRS withdrew the funds because it owned them. As the court noted, “if the forfeiture order created a debt merely by transferring ownership of the IRA from Hubbard to the IRS, why wouldn’t the order have created a debt in Hubbard’s homes and cars too?” The court concluded that Section 61(a)(12)’s discharge of indebtedness provision did not apply because no debt was being discharged—ownership of the asset itself had changed hands through the specific property forfeiture.

As such, the Sixth Circuit Court concluded that there was no debt and the distribution from the IRA did not create cancellation of debt income.

The Takeaway

This decision highlights the distinction between different types of forfeitures and their tax consequences. When the government obtains ownership of specific property through forfeiture (rather than imposing a money judgment), the former owner may not be liable for taxes on subsequent transactions involving that property. For IRA accounts specifically, this means that when the government becomes the owner through forfeiture, it—not the former account holder—becomes the “payee or distributee” responsible for any tax consequences from withdrawals.

The IRS may not be able to distinguish between the types of forfeited IRAs, as the custodians will likely just issue Forms 1099R and that will start the IRS assessment process. Those who have been assessed tax on forfeited IRAs in the past and those that will likely continue in the future should consider their options based on this case, which may include filing refund claims, or challenging the IRS on this issue as the taxpayer did in this case.

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Stephan Dorsey

Stephan is the sports journalist for the Maple Grove Report.

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Recent Reviews

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.