Judge rules doctor’s captive insurance setup had no real purpose
Patel, et al. v. Commissioner of Internal Revenue, 165 T.C. No. 10, November 12, 2025.
The Tax Court held that the Patels’ microcaptive arrangements lacked economic substance, triggering accuracy-related penalties and the 40% increased rate for non-disclosed transactions.
Holding
The court held that the Patels’ captive insurance transactions lacked economic substance under §7701(o).
As a result, the claimed premium deductions were disallowed for tax years 2013 through 2016, and accuracy-related penalties under §6662(a), including §6662(b)(6) and the increased rate under §6662(i), apply as limited by earlier rulings in Patel I.
Why It Matters
Confirms that microcaptive transactions remain subject to the codified economic substance doctrine, separate from the insurance analysis.
Highlights that failure to adequately disclose captive structures can trigger the 40% increased penalty rate.
Reinforces IRS scrutiny of premium calculations tied to §831(b) limits.
Adds a reviewed Tax Court opinion to the line of cases treating microcaptives as lacking risk distribution and business purpose.
Timeline
2011 to 2016: Patels form and operate Magellan and Plymouth microcaptives.
2013 to 2016: Premiums paid and deducted on business returns; IRS examinations begin.
2020: Patel I limits penalties for 2013 due to supervisory approval failures.
2024: Patel II holds that the arrangements did not constitute insurance for federal tax purposes.
2025: Court issues opinion resolving remaining penalty issues.
Key Facts
Dr. Patel formed two microcaptives after self-study and advisor introductions.
Premiums hovered near the §831(b) limit each year and were influenced by target amounts rather than actuarial analysis.
Commercial insurance policies remained in place and covered many of the same risks.
Captive arrangements used reinsurance pooling through Capstone, resulting in circular cash flows.
Total premiums paid to the captives exceeded $4.5 million over the years at issue.
IRS disallowed deductions and asserted penalties, including §6662(b)(6) and §6662(i).
Statutory or Regulatory Framework
The court applied §7701(o), which codifies the economic substance doctrine and requires both a meaningful change in economic position (apart from tax effects) and a substantial non-tax purpose.
§6662(b)(6) imposes a 20% penalty on underpayments attributable to transactions lacking economic substance. §6662(i) increases the penalty to 40% for non disclosed transactions.
Arguments
Taxpayer argued:
The microcaptive transactions were “congressionally induced” under §831(b).
Prior case law and revenue rulings supported their structure.
Penalties should not apply due to reliance on advisers and perceived uncertainty in the law.
IRS argued:
The structures lacked economic substance and business purpose.
Premiums were driven by tax considerations and were not actuarially determined.
Circular cash flows undermined claims of risk shifting and distribution.
Adequate disclosure was not provided, triggering §6662(i).
Court’s Reasoning
The codified economic substance doctrine requires a threshold relevancy determination, which applies here.
The captives did not change the Patels’ economic position in a meaningful way outside federal tax effects.
Premium pricing was driven by §831(b) limits rather than insurance needs.
Circular transfers through Capstone showed no substantive transfer of risk.
Emails and documentation demonstrated tax motivation, not business purpose.
Reliance on advisers did not establish reasonable cause because key advisers were promoters.
Disclosures on returns did not provide sufficient information to alert the IRS to the nature of the transactions.
Substantial understatement and negligence penalties are supported by the facts and apply where §6662(b)(6) does not.
Forward-Looking Implications
Reinforces the IRS approach to microcaptives.
Signals that courts will examine economic substance independently of the insurance analysis.
Highlights the importance of contemporaneous documentation showing real insurance needs and actuarial pricing.
Shows that nondisclosure carries significant penalty risk under §6662(i).
Result
Penalties under §6662(a) and (b)(6) apply for 2014 through 2016, including the increased 40 percent rate under §6662(i) for 2014 and 2015. Remaining accuracy-related penalties apply as limited by Patel I.
The Takeaway
Microcaptive structures tied to target premium amounts and circular reinsurance flows continue to face significant risk under §7701(o).
Lack of disclosure can convert a 20% penalty into a 40% one, and promoter involvement undermines reasonable cause defenses.
List of Citations
Gregory v. Helvering, 293 U.S. 465 (1935): Foundation for the economic substance doctrine.
Knetsch v. United States, 364 U.S. 361 (1960): Disallows transactions lacking economic reality.
Malone & Hyde, Inc. v. Commissioner, 62 F.3d 835 (6th Cir. 1995): Captive case applying economic substance analysis.
Avrahami v. Commissioner, 149 T.C. 144 (2017): Microcaptive risk distribution and penalty analysis.
§7701(o): Codified economic substance doctrine.
§6662(b)(6), §6662(i): Penalties for nondisclosed noneconomic substance transactions.
§831(b): Small insurance company tax regime at the center of the captive’s design.