Relevancy Reigns, But IRS Prevails: Tax Court Holds in Patel Case that Threshold Relevancy Determination Required Prior to Application of Codified Economic Substance Doctrine

On November 12, 2025, the Tax Court issued a reviewed opinion in Patel v. Commissioner holding in favor of the IRS that the taxpayers’ transaction lacked economic substance, and therefore the taxpayers were liable for penalties under the codified economic substance doctrine at the increased penalty rate, as well as accuracy-related penalties. The Court previously held in a separate opinion that the taxpayers’ purported captive transactions did not constitute insurance because they failed to distribute risk, and in the alternative, that the micro-captives did not act as an insurer commonly would. 

The Tax Court’s November 12^thopinion decided the remaining issues of whether (1) a relevancy determination is required to apply the economic substance doctrine, (2) the economic substance doctrine should be applied in this case, (3) the transaction passed the economic substance test, and (4) economic substance penalties should be upheld.  

Relevancy Determination is Required 

The Court began its analysis by determining that before the economic substance doctrine can be applied, there must be a determination as to whether the economic substance doctrine is relevant to a transaction. This has been a hotly disputed issue between the IRS and taxpayers and is at issue in other tax cases, including Liberty Global, which is on appeal to the 10^thCircuit.  

The Tax Court explained that codified economic substance doctrine under Section 7701(o) clearly requires a relevancy determination, because the statute states that it applies to “transaction[s] to which the economic substance doctrine is relevant” and “[t]he 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 opinion states that Congress “could hardly have been clearer” that a relevancy determination is required. The Court also pointed to the legislative history, which it held made clear that the economic substance doctrine is not relevant to every transaction and should only be applied after a relevancy determination has been made. 

The Court also explained that the relevancy determination is not coextensive and should be made before applying the two-part economic substance test. In a footnote, the Court states it disagrees with other courts that have held that the relevancy requirement is coextensive with the requirements to show that a transaction lacked economic substance, including the courts in Liberty Global and Chemoil Corp.  

The Court determined that it must look to the common law application of the economic substance doctrine to make the relevancy determination. The Court cited previous decisions involving captive insurance companies, in which courts first determined whether the insurance company was created for a legitimate business purpose or whether the captive was in fact a sham corporation before applying the economic substance doctrine. The Court concluded the taxpayers’ insurance company was not created for a legitimate business purpose and that the economic substance doctrine was relevant in this case. 

Transactions Failed the Economic Substance Test Under Section 7701(o)(1) 

After determining that the economic substance doctrine was relevant, the Court then examined the transaction under the two-part test in Section 7701(o)(1). A transaction is treated as having economic substance only if it satisfies both the objective and subjective tests:  

1. The transaction changes in a meaningful way (apart from Federal income tax effects) the taxpayer’s economic position [objective test], and  
2. The taxpayer has a substantial purpose (apart from Federal income tax effects) for entering into such transaction [subjective test].  
    
   The court concluded that under the objective test, the transactions at issue did not result in a meaningful change with respect to the insurance apart from federal tax effects for several reasons including that (1) the transaction involved a circular flow of funds, and (2) the taxpayer paid unreasonable and excessive premiums while maintaining his commercial insurance.  
    
   The Court concluded that while the taxpayers’ failure to meet the objective test alone was sufficient to conclude that the transactions at issue lacked economic substance, it would evaluate the transaction under the subjective test for completeness. The Court held that after considering the totality of the facts and circumstances in evidence, the taxpayer also failed the subjective test, because the Court could not find that the taxpayer had a substantial purpose for the transaction apart from the federal income tax effects. The Court found that the taxpayers operated the captive insurance companies without regard to insurance and business principles and that the record showed that the transactions occurred to maximize income tax deductions rather than for any legitimate business purpose.  
   

   Section 6662(b)(6) Underpayment Penalty and 6662(i) Increase in Penalty in Case of Nondisclosed Noneconomic Substance Transactions 

   After determining that the insurance transactions lacked economic substance, the Court looked to whether the Section 6662(b)(6) penalty applied. Under Section 6662(a) and (b)(6), a 20% accuracy-related penalty is imposed on the portion of an underpayment of tax attributable to the disallowance of claimed tax benefits by reason of a transaction lacking economic substance.   
    
   The Court held that the most natural reading of Section 6662(b)(6) is that the lack of economic substance must be the cause of the disallowance of the claimed tax benefit. Therefore, the Court said that it must be determine whether the claimed tax benefits were “by reason of” or “because of” a transaction lacking economic substance. The Court held that in this case, the disallowance of the claimed tax benefits was by reason of the transaction lacking economic substance, so Section 6662(b)(6) applied. 
   
   For some of the tax years at issue, the Commissioner’s Notices of Deficiency (NOD) did not list lack of economic substance as its reason for disallowance, but still applied the penalties for lack of economic substance in each of the NODs. The Tax Cout held that the IRS is permitted to assert the economic substance doctrine as a new ground upon which to disallow a claimed benefit in its answer, which it did in this case.  
    
   The next inquiry was whether the taxpayer was subject to an increased penalty under Section 6662(i), which increases the section 6662(a) penalty from 20% to 40% for any portion of an underpayment for transactions where the relevant facts affecting the tax treatment of a portion of a transaction lacking economic substance are neither adequately disclosed on the taxpayer’s return nor in the statement attached to the return. For a disclosure to be adequate, it must be sufficiently detailed to alert the Commissioner and his agents to the nature of the transaction so that the decision as to whether to select the return for audit may be a reasonable informed one. The Court found that the taxpayers in this case neither attached a statement to their returns nor did they adequately disclose the relevant facts or provide sufficient information on their returns to disclose the transaction. Therefore, the Court sustained the increased penalty rate.
   
   Lastly, the Court upheld accuracy related penalties for negligence and substantial understatements of income tax as alternatives to the Section 6662(b)(6) penalties (and as the primary ground for one of the tax years where the Court previously held that Section 6662(b)(6) did not apply). The Court rejected the taxpayers’ attempts to waive these penalties under the taxpayers’ substantial authority and reasonable cause relief arguments.

Conclusion

While taxpayers will be encouraged that the Tax Court held that a relevancy determination is required before the economic substance doctrine is asserted and that the economic substance doctrine does not apply to every transaction, it remains to be seen how high the bar is to meet the relevancy determination for other types of transactions. Taxpayers should closely watch for other court decisions on economic substance, including the Liberty Global case in the 10^thCircuit, where a decision is expected soon. 

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