Tax Court Addresses Economic Substance and Disclosure Penalties in Micro-Captive Case

The US Tax Court issued a reviewed opinion in Patel v. Commissioner, 165 T.C. No. 10 (Nov. 12, 2025), holding that the taxpayers' micro-captive arrangements lacked economic substance under Internal Revenue Code § 7701(o). The court also upheld accuracy-related penalties under § 6662(b)(6) and the enhanced 40 percent penalty under § 6662(i). 

Practitioners observing the case noted that the noneconomic substance penalty is a "strict liability" penalty, meaning the penalty applies without regard to the taxpayers' intent once the economic substance test is failed. They also noted that failure to adequately disclose the transaction increases the penalty rate by an additional 20 percent, resulting in a 40 percent penalty under § 6662(i). According to these practitioners, the opinion required the court to address preliminary statutory interpretation issues, including the scope of the relevancy determination under § 7701(o), which the court discussed at length.

Economic Substance

In the Patel case, the court noted that "[t]his is the Court's first opportunity to examine when the codified economic substance doctrine applies." A transaction lacks economic substance when it does not meaningfully change the taxpayers' economic position apart from tax effects and does not have a substantial nontax business purpose, as outlined in § 7701(o). After making the relevancy determination required by § 7701(o), the court held that the transactions did not meaningfully change the taxpayers' economic position apart from tax effects and did not have a substantial nontax purpose.

Premiums and Cash Flows

As outlined in earlier Patel findings, the court referenced the following.

• Premiums matched the § 831(b) limits
• The taxpayers continued to buy commercial insurance
• Funds moved in circular patterns through the Capstone arrangement

The opinion also noted that premium amounts were adjusted based on target amounts rather than actuarial determinations.

Disclosure and the 40 Percent Penalty

The court also stated that "[t]his is our first opportunity to consider what constitutes adequate disclosure under section 6662(i)(2)." The enhanced 40 percent penalty applies when a taxpayer fails to adequately disclose a transaction that the IRS later determines lacks economic substance. In this case, the court found that the taxpayers did not disclose enough information on their 2014 and 2015 returns to allow the Internal Revenue Service (IRS) to identify the potential issue.

According to the opinion, "the Patels did not attach a statement to their returns, nor did they adequately disclose the relevant facts or provide sufficient information … to enable respondent to identify the potential controversy involved." The court noted the returns did not reveal how funds moved among the entities, who was involved in the arrangements, how premiums were calculated, or how the Capstone pooling arrangement worked. Because of these omissions, the court upheld the application of the 40 percent penalty for those years.

The court also addressed an argument the taxpayers raised for the first time in a sur-reply footnote. In that footnote, the Patels contended that the invalidation of Notice 2016-66 and the use of Forms 1120-PC "negate Section 6662(i)." The court declined to consider the argument, noting it was not fully developed and that arguments raised only in footnotes or reply briefs are generally treated as waived.

Penalty Application

The court applied the penalties only for the years where earlier Patel rulings permitted them, noting that some years were excluded because the IRS had not secured timely supervisory approval under § 6751(b).