Penalties under codified economic substance doctrine upheld

The Tax Court held that a Sec. 6662(b)(6) penalty and the increased rate for the penalty under Sec. 6662(i) applied to underpayments attributable to the disallowance of the taxpayers’ deductions from microcaptive insurance transactions that lacked economic substance under the Sec. 7701(o) codified economic substance doctrine.

Background

Sunil Patel is a medical doctor, the co–founder of an eye surgery center, and the founder of two medical research centers in West Texas. Beginning in 2011, Patel’s businesses supplemented their commercial insurance coverage by purchasing assorted policies from purported microcaptive insurance companies — Magellan Insurance Co. (Magellan) and Plymouth Insurance Co. (Plymouth) — that Patel controlled. Patel and his wife, Laurie McAnally–Patel, deducted the premiums paid to the microcaptives, which were substantially more than the premiums paid to the commercial insurers, creating substantial tax benefits for the Patels.

The IRS examined the Patels’ returns for 2013 through 2016 (the tax years at issue) and determined that the insurance premiums paid to Magellan and Plymouth were not deductible. Thus, it issued notices of deficiency (NODs) to the Patels that disallowed their deductions for the premiums. The NOD for 2013 disallowed the deductions for insurance expenses because of a lack of economic substance, while the NODs for 2014 through 2016 determined a disallowance of the deductions for reasons other than the economic substance doctrine.

The IRS also determined that the Patels were liable for Sec. 6662(a) accuracy–related penalties on the underpayments related to the disallowed deductions for the tax years at issue in the NODs. In the NOD for tax year 2013, the accuracy–related penalty was determined pursuant to Secs. 6662(a), (b)(6), and (i) and, in the alternative, pursuant to Secs. 6662(b)(1) and (b)(2). For tax years 2014 through 2016, accuracy–related penalties were determined pursuant to Secs. 6662(a), (b)(1), (b)(2), and (b)(6).

The Patels challenged the IRS’s determination in Tax Court. In its answers to the Patels’ petitions, the IRS asserted that the deductions for 2014 through 2016 were also disallowed because of the economic substance doctrine and, under Sec. 6662(i), increased the penalties for those years.

In Patel, T.C. Memo. 2020–133 (Patel I), the Tax Court granted in part the Patels’ motion for partial summary judgment related to the penalties. In relevant part, the court held that the IRS failed to satisfy the Sec. 6751(b)(1) supervisory–approval requirement with respect to the penalties under Secs. 6662(b)(2) and (b)(6), as well as the increased rate under Sec. 6662(i), for tax year 2013. In addition, the IRS conceded that the increased rate under Sec. 6662(i) did not apply in tax year 2016.

In Patel, T.C. Memo. 2024–34 (Patel II), the Tax Court held that for the tax years at issue, Magellan’s and Plymouth’s purported microcaptive transactions did not constitute insurance for federal income tax purposes because the microcaptives failed to distribute risk and did not operate as insurance companies in the commonly accepted sense. Accordingly, the court sustained the IRS’s disallowance of the deductions for the premiums paid as part of the transactions for the tax years at issue. The court, however, reserved on the issue of the penalties asserted by the IRS on the underpayments related to the disallowance of the deductions.

The NODs for the tax years at issue listed several alternative grounds for the IRS’s imposing the penalties, including that the transactions lacked economic substance within the meaning of Sec. 6662(b)(6). Thus, the Tax Court, in a third opinion in the Patels’ case, addressed the IRS’s determination that the transactions lacked economic substance and its assertion of accuracy–related penalties (as limited by Patel I) against the Patels on that ground.

In addressing whether the Patels were liable for the accuracy–related penalties, the Tax Court first addressed whether there is a threshold relevancy determination for the codified economic substance doctrine in Sec. 7701(o) and whether the economic substance doctrine was relevant in the Patels’ case.

Secs. 7701(o), 6662(b)(6), and 6662(i)

After years–long development in case law, Congress codified the economic substance doctrine in 2010 as Sec. 7701(o) in the Health Care and Education Reconciliation Act of 2010, P.L. 111–152. As relevant to the Patels’ case, Sec. 7701(o) provides:

Sec. 7701(o). Clarification of economic substance doctrine.

(1) Application of doctrine. In the case of any transaction to which the economic substance doctrine is relevant, such transaction shall be treated as having economic substance only if —

(A) the transaction changes in a meaningful way (apart from Federal income tax effects) the taxpayer’s economic position, and

(B) the taxpayer has a substantial purpose (apart from Federal income tax effects) for entering into such transaction….

(5) Definitions and special rules. For purposes of this subsection —

(A) Economic substance doctrine. — The term “economic substance doctrine” means the common law doctrine under which tax benefits under subtitle A with respect to a transaction are not allowable if the transaction does not have economic substance or lacks a business purpose.

(B) Exception for personal transactions of individuals. — In the case of an individual, paragraph (1) shall apply only to transactions entered into in connection with a trade or business or an activity engaged in for the production of income.

(C) Determination of application of doctrine not affected. — The determination of whether the economic substance doctrine is relevant to a transaction shall be made in the same manner as if this subsection had never been enacted.

(D) Transaction. — The term “transaction” includes a series of transactions.

The act also added Sec. 6662(b)(6), which imposes a 20% penalty on the portion of an underpayment of tax required to be shown on a return that is attributable to any disallowance of claimed tax benefits by reason of a transaction lacking economic substance within the meaning of Sec. 7701(o).

Sec. 6662(i) increases the Sec. 6662(a) penalty from 20% to 40% for any portion of an underpayment that is attributable to one or more nondisclosed noneconomic substance transactions under Sec. 6662(b)(6).

The Tax Court’s decision

The Tax Court held that the codified economic substance doctrine requires a relevancy determination within the meaning of Sec. 7701(o) and that the codified economic substance doctrine was relevant in the Patels’ case. It further held that the Patels were liable for penalties under the codified economic substance doctrine pursuant to Secs. 6662(a) and (b)(6) and the increased rate of tax for nondisclosed transactions under Sec. 6662(i). Finally, it determined that the Patels were liable for the Sec. 6662(b)(1) and (b)(2) accuracy–related penalties asserted by the IRS.

Relevancy determination

The Tax Court first addressed whether Sec. 7701(o) requires a determination that the economic substance doctrine is relevant to the transactions at issue. Sec. 6662(b)(6) applies the accuracy–related penalty to any disallowance of claimed tax benefits by reason of a transaction lacking economic substance within the meaning of Sec. 7701(o). Sec. 7701(o)(1) requires application of the economic substance doctrine “[i]n the case of any transaction to which the economic substance doctrine is relevant.” In deciding whether a relevancy determination was required, the court considered the statutory text of Sec. 7701 and its legislative history.

Statutory text: The Tax Court began by analyzing the text of Sec. 7701(o). As noted above, the text of Sec. 7701(o)(1) states that it applies to “transaction[s] to which the economic substance doctrine is relevant.” Sec. 7705(o)(5) further states, “The determination of whether the economic substance doctrine is relevant to a transaction shall be made in the same manner as if this subsection had never been enacted.”

The Tax Court stated, “Faced with these provisions, we easily conclude that the statute requires a relevancy determination. To put it plainly — the statute says so, right there, on its face.” The court explained that Sec. 7701(o)(1) signals that a relevancy determination is required by conditioning application of the doctrine on certain circumstances, i.e., if there is a transaction to which the doctrine is relevant. Also, Sec. 7701(o)(5) expressly requires a court to determine whether the doctrine is relevant and directs the court to make the determination as if the statute had never been enacted.

The Tax Court also concluded that the text of Sec. 7701 indicated the relevancy determination is not coextensive with the two–part economic substance test set forth in Secs. 7701(o)(1)(A) and (B). The introductory sentence of Sec. 7701(o)(1) states that the two–part test applies only in the case of any transaction to which the economic substance doctrine is relevant. In the court’s view, “Conflating the relevancy determination with the two–part test would ignore that direction and deprive the statute’s reference to relevance of independent meaning.”

Legislative history: Because Sec. 7701(o) was enacted in the Reconciliation Act of 2010, for the legislative history of the provision, the Tax Court looked to the House report for the act (H.R. Rep’t No. 111-443(I), 111th Cong., 2d Sess. (2010)). Based on the report, the court found that the legislative history of the codified economic substance doctrine is fully consistent with its interpretation that Sec. 7701(o)(1) requires a relevancy determination. According to the court, the explanation of Sec. 7701 in the House report made clear that the economic substance doctrine does not apply to every transaction and may be applied only when it is relevant.

Economic substance doctrine in the insurance context

To determine whether the economic substance doctrine was relevant in the Patels’ case, the court looked at how it had been applied in insurance cases decided before codification of the doctrine and, in particular, captive insurance transactions. Reviewing those cases, it found that Malone & Hyde, Inc., 62 F.3d 835 (6th Cir. 1995), rev’g and remanding T.C. Memo. 1993–585, was the closest to the Patels’ case.

In Malone & Hyde, a corporate taxpayer created a thinly capitalized Bermuda insurance subsidiary to reinsure certain risks. It then entered into primary insurance contracts with a third–party insurer (Northwestern National Insurance Co.). The taxpayer had Northwestern enter into reinsurance contracts with the Bermuda subsidiary. The taxpayer paid insurance premiums to Northwestern, which in turn paid a portion of the premiums to the Bermuda subsidiary. The taxpayer deducted the full amount of the premiums it paid to Northwestern, resulting in the taxpayer’s claiming deductions for amounts ultimately received by the Bermuda subsidiary as reinsurance premiums.

The IRS disallowed the taxpayer’s deductions for the portion of the insurance premiums Northwestern received and paid to the Bermuda subsidiary. The Sixth Circuit upheld the IRS’s determination, concluding that the arrangement lacked economic substance or a business purpose, and consequently, under the economic substance doctrine, the premiums paid to the subsidiary were not bona fide business expenses that entitled the taxpayer to a Sec. 162(a) deduction.

The Tax Court found that parallels between Malone & Hyde and the Patels’ case were “easy to draw” and that there were no mitigating factors in the Patels’ case that would “argue for a different approach” from that which it and the appeals courts had previously taken. The court stated that in the Patels’ case, “heeding Congress’s direction that we proceed in the same manner as if section 7701(o) had never been enacted — to determine whether the economic substance doctrine is relevant to a transaction — we conclude that the doctrine is relevant.”

Application of the Sec. 7701(o) economic substance test

Having held that the economic substance doctrine was relevant to the Patels’ microcaptive transactions, the Tax Court applied the two–part test for economic substance in Sec. 7701(o) to them. Under Sec. 7701(o)(1)(A), the court examined whether the microcaptive transactions changed the Patels’ economic position in a meaningful way other than federal income tax effects (the objective test) and, under Sec. 7701(o)(1)(B), whether the Patels had a substantial purpose, apart from federal income tax effects (i.e., tax avoidance), for entering into the transactions (the subjective test). The court found that the Patels did not meet either the objective or the subjective test, so it held that their purported insurance transactions carried out through their two microcaptive insurance companies lacked economic substance.

Objective test: With regard to the objective test, the Tax Court held that the Patels’ transactions did not result in a meaningful change in economic position with respect to insurance, aside from the federal tax effects. As the court had more fully described in Patel II, the Patels’ microcaptive transactions involved a circular flow of funds among Magellan, Plymouth, and a related reinsurance company. The court also noted that the Patels paid unreasonable and excessive premiums to Magellan and Plymouth up to the deductible amount allowed under Sec. 831(b), while maintaining insurance coverage with third-party commercial insurers.

Subjective test: With regard to the subjective test, the Tax Court also held that the evidence before it, as it had discussed at length in Patel II, demonstrated that the Patels entered into their microcaptive transactions to reduce their federal income tax bill, not for any business purpose. This evidence included, but was not limited to, the Patels and their entities paying excessively high premiums designed to maximize deductions; demonstrating through overwhelming contemporaneous emails and documents that the microcaptives served no legitimate business purpose; and maintaining commercial insurance during the tax years at issue for significantly lower premiums, which often covered the same risks as the microcaptives.

Application of Sec. 6662(b)(6)

The Tax Court next addressed whether the Sec. 6662(b)(6) penalty applied. After analyzing the text of the provision, the court determined that its natural reading is that a lack of economic substance must be the cause of the disallowance of the claimed tax benefit, which in the Patels’ case was the deductions for purported insurance premiums paid in the microcaptive transactions.

As discussed above, the Tax Court held that the Patels’ microcaptive transactions lacked economic substance. Thus, the court found the disallowance of the Patels’ claimed tax benefits were by reason of a transaction lacking economic substance within the meaning of Sec. 7701(o), and, accordingly, Sec. 6662(b)(6) applied. Therefore, the court sustained the IRS’s assertion of Sec. 6662(b)(6) penalties for tax years 2014 through 2016 on the ground that the transactions lacked economic substance.

Increased penalty under Sec. 6662(i)

Having determined that the Patels’ disallowed deductions were subject to the Sec. 6662(b)(6) penalty, the Tax Court then considered whether the increased penalty rate under Sec. 6662(i) applied. Sec. 6662(i) increases the Sec. 6662(a) penalty from 20% to 40% for any portion of an underpayment that is attributable to one or more nondisclosed noneconomic substance transactions under Sec. 6662(b)(6).

Under Sec. 6662(i)(2), “the term ‘nondisclosed noneconomic substance transaction’ means any portion of a transaction [lacking economic substance] with respect to which the relevant facts affecting the tax treatment are not adequately disclosed in the return nor in a statement attached to the return.” The Tax Court found that the Patels did not adequately disclose the relevant facts about the microcaptive transactions on their returns or in a statement attached to them. Therefore, it sustained the IRS’s imposition of the Sec. 6662(i) increased penalty rate in 2014 and 2015.

Negligence and substantial understatement of income tax

The IRS, after the Tax Court’s decision in Patel I, continued to assert that the Patels were liable for the accuracy–related penalty under Sec. 6662(b)(1) for negligence or disregard of the rules or regulations as the primary penalty for 2013. For 2014–2016, the IRS asserted that the Sec. 6662(b)(1) penalty or the Sec. 6662(b)(2) penalty for any substantial understatement of tax served as alternative grounds to sustain its penalty determinations.

Negligence or disregard of rules or regulations: Under Sec. 6662(c), for purposes of the accuracy-related penalties in Sec. 6662, “negligence” includes any failure to make a reasonable attempt to comply with the tax law, and the term “disregard” includes any careless, reckless, or intentional disregard. Regs. Sec. 1.6662-3(b)(1)(ii) provides that negligence is strongly indicated where a taxpayer fails to make a reasonable attempt to ascertain the correctness of a deduction, credit, or exclusion on a return that would seem “too good to be true” under the circumstances.

The court observed that while Patel was a highly educated man and described himself as a “savvy financial person,” the record did not show that he questioned or investigated the propriety of a microcaptive transaction, which the court described as “the type of ‘too good to be true’ transaction that should cause taxpayers to seek out competent advice from independent advisers.” Thus, the court found that Patel had failed to make reasonable attempts to comply with the tax law or to determine the correctness of deductions that should have seemed to him too good to be true. Accordingly, it held that the Patels were liable for the Sec. 6662(b)(1) penalty in the tax years at issue.

Substantial understatement of income tax: Under Sec. 6662(d)(1)(A), an understatement of income tax is “substantial” if it exceeds the greater of 10% of the tax required to be shown on the return or $5,000. In 2014, 2015, and 2016, the Patels’ understatements on their returns were over $5,000 and well in excess of 10% of the tax they were required to show on their return, so the Tax Court held that the Sec. 6662(b)(2) substantial understatement of income tax penalty applied to those years.

Reflections

In 2023, in Liberty Global, Inc., No. 20–cv–63501 (D. Colo. 10/31/23), the District Court for the District of Colorado came to the opposite conclusion of the Tax Court, finding that the prefatory clause of Sec. 7701(o) did not require a threshold relevancy determination before the application of the statute’s two–prong test for economic substance in Sec. 7701(o)(1). In a footnote to its opinion, the Tax Court stated, “In the light of the text [of Section 7701(o)], we respectfully disagree with other courts that have held that the relevancy requirement is coextensive with the requirements of section 7701(o)(1)(A) and (B).”

Patel, 165 T.C. No. 10 (2025)

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Contributor

James A. Beavers, CPA, CGMA, J.D., LL.M., is The Tax Adviser’s tax technical content manager. For more information about this column, contact thetaxadviser@aicpa.org.