Background
After previously disallowing deductions under section 162 for amounts paid by the taxpayers to purported captive insurance companies,2 the Tax Court in Patel considered whether the taxpayers were liable for penalties under section 6662(b)(6) for underpayments of tax attributable to transactions that the IRS claimed were lacking economic substance under section 7701(o), as well as an increased penalty under section 6662(i) for inadequately disclosing such transactions. Because its prior decision regarding the deductibility of the payments did not address whether the transactions lacked economic substance, the Tax Court began its analysis with section 7701(o). At issue was whether section 7701(o) required the Tax Court to first determine the economic substance doctrine was relevant to the taxpayers’ transactions before proceeding with the two-part test imposed by sections 7701(o)(1)(A) and (B).
Section 7701(o) imposes a threshold relevancy requirement
The Tax Court’s analysis centered on the statutory text of section 7701(o). The Tax Court explained that the opening text of section 7701(o)(1) states it applies to any “transaction to which the economic substance doctrine is relevant.” Additionally, the Tax Court observed that section 7701(o)(5), in turn, “expressly directs” courts to determine whether the doctrine is relevant, and “if that were not enough, the same provision explains how to make the determination.” Based on the statute’s plain language, the Tax Court “easily” concluded section 7701(o) “requires a relevancy determination” and looked to legislative history only to confirm its consistency with the Tax Court’s interpretation.
In reaching its conclusion, the Tax Court expressly disagreed with the decisions in Liberty Global, Inc. v. United States3—currently on appeal before the Tenth Circuit—and Chemoil Corp. v. United States4 and held the relevancy requirement is not co-extensive with the two-part (objective and subjective) test imposed by sections 7701(o)(1)(A) and (B). Rather, the Tax Court reasoned that “[c]onflating the relevancy determination with the two-part test would … deprive the statute's reference to relevance of independent meaning” contrary to the Tax Court’s duty to avoid surplusage.
The Tax Court next considered the content of the relevancy requirement, concluding Congress answered this question when it directed courts under section 7701(o)(5) to determine whether the economic substance doctrine is relevant “as if [the statute] had never been enacted.” Operating within the bounds of pre-codification economic substance doctrine cases similarly involving insurance transactions, the Tax Court concluded the doctrine was relevant in Patel without articulating a comprehensive standard for cases with facts not as readily traceable to common law. In doing so, the Tax Court emphasized the “parallels” between the Patels’ case and the precedent set by Malone & Hyde, Inc. v. Commissioner,5 noting it “perceive[d] no mitigating factors . . . that would argue for a different approach from the one [courts] have previously taken.”
Notably, the Tax Court considered and quickly dismissed the taxpayers’ argument that the economic substance doctrine does not apply where the taxpayer is “Congressionally induced” or “Congressionally incentivized” to engage in the transaction at issue. The Tax Court reasoned this argument fails for two reasons: (i) the economic substance doctrine applies to insurance arrangements (i.e., it is relevant), and (ii) the taxpayers could not identify any congressional inducement in this instance to claim deductions “for purported insurance that is not, in fact, insurance.”6 The Tax Court then applied the two-part test of section 7701(o)(1)(A) and (B) to conclude that the transactions lacked economic substance.
Section 6662(b)(6) imposes a 20% penalty, and section 6662(i) permits a penalty increase when a transaction is not adequately disclosed
After concluding the transactions lacked economic substance, the Tax Court confirmed a 20% penalty under section 6662(b)(6) applies if the “lack of economic substance” is “the cause of the disallowance of the claimed tax benefit.” Section 6662(i) increases the section 6662(b)(6) penalty to 40% for any portion of the underpayment attributable to one or more inadequately disclosed noneconomic substance transactions. The Court acknowledged that this was the first time it has been asked to consider what constitutes adequate disclosure under section 6662(i)(2). It recognized that, in other contexts, adequacy is a “factual question” and, for a disclosure to be adequate, the taxpayer’s return or statement to their return must provide the IRS sufficient information “to alert the Commissioner and his agents as to the nature of the transaction” so that they can make a “reasonably informed” decision as to whether to audit the return. The Court determined that there was no adequate disclosure here because the taxpayers “did not attach a statement to their returns, nor did they adequately disclose the relevant facts or provide sufficient information on their returns to enable respondent to identify the potential controversy involved.” The Tax Court did not accept the taxpayers’ penalty defenses as they did not have substantial authority, or act with reasonable cause and in good faith, for the positions they took, and the Tax Court sustained the increased penalty under section 6662(i).
The implications
Although the taxpayers in Patel were unsuccessful in challenging the penalties, the Tax Court confirmed that section 7701(o) includes a threshold relevancy requirement, which provides taxpayers a valuable tool for challenging applications of the economic substance doctrine to transactions—especially those transactions that have not been analyzed under the economic substance doctrine framework at common law. Moreover, the Tax Court’s imposition of the section 6662(i) penalty increase underscores the importance of providing sufficient disclosures either in the taxpayer’s return or attached thereto.
The Tenth Circuit’s decision in Liberty Global may address some of the same issues raised in Patel (including the threshold relevancy requirement) and will be one to watch.
1 165 T.C. No. 10 (2025).
2 See Patel v. Commissioner, T.C. Memo. 2024-34
3 1:20-cv-03501-RBJ (D. Colo. Oct. 31, 2023). See our previous client alert discussing Liberty Global, United States: Courts show changing attitudes towards anti-abuse doctrines - Baker McKenzie InsightPlus.
4 No. 19-CV-6314-LTS-JW (S.D.N.Y. Sept. 26, 2023).
5 62 F.3d 835 (6th Cir. 1995).
6 The Tax Court previously held the amounts paid by the taxpayers to purported captive insurance companies were not insurance premiums for federal income tax purposes and, thus, not deductible under section 162. See Patel v.. Commissioner, T.C. Memo 2024-34.
