In a unanimous, reviewed decision, the U.S. Tax Court held that the codified economic substance doctrine can only be considered when the doctrine is "relevant" to a transaction. Patel v. Commissioner, 165 T.C. No. 10 (Nov. 12, 2025) (Patel III). In reaching this conclusion, the court expressly disagreed with the controversial district court decision in Liberty Global that the codified economic substance doctrine does not require a "threshold" relevance inquiry (a decision now on appeal to the Tenth Circuit). The Tax Court's forceful affirmation of a threshold relevance requirement significantly diminishes the risk that routine transactions will be swept within the scope of the economic substance doctrine or that taxpayers will be required to defend such transactions from an economic substance challenge by the IRS. However, the scope of that relief remains to be seen, with the holding in Patel III providing only limited insight into the circumstances in which the doctrine will be relevant to specific transactions. 

Procedural Context 

At issue in Patel was the deductibility of insurance premium payments to captive insurance companies. In a 2024 decision, the court held that the captive insurance companies failed to provide insurance, so the purported premiums were not deductible as ordinary and necessary business expenses. Patel v. Commissioner, T.C. Memo. 2024-34 (Patel II). That opinion "was silent as to whether the transactions lacked economic substance as that determination was not necessary to resolve the disallowance of the deduction." Patel III, at 13, n.13. 

The IRS asserted accuracy-related penalties under section 6662 for all tax years at issue. For certain years, the IRS asserted the strict liability penalty in section 6662(b)(6), which imposes a 20 percent penalty on an underpayment of tax attributable to "[a]ny disallowance of claimed tax benefits by reason of a transaction lacking economic substance (within the meaning of section 7701(o))[.]" In addition, the IRS asserted the enhancement in section 6662(i), which increases the penalty to 40 percent for "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." Because the underlying decision on the merits had not required a decision on economic substance, the court requested briefing from the parties – and from amici – on two issues: (1) "[w]hether section 7701(o) requires a threshold relevancy determination;" and (2) if so, "the circumstance(s) in which the economic substance doctrine is 'relevant' within the meaning of section 7701(o)." Patel v. Commissioner, Docket Nos. 24344-17, 11352-18, 25268-18, Order (July 19, 2024).

Section 7701(o) Requires a Threshold Relevancy Determination

In 2010, Congress codified certain aspects of the common law economic substance doctrine in section 7701(o) of the Internal Revenue Code (I.R.C.). Section 7701(o)(1) provides that the federal income tax benefits with respect to certain transactions are not allowable unless the transactions satisfy an objective test (objective economic effect) and a subjective test (substantial business purpose). The opening clause of section 7701(o)(1) cabins the scope of the doctrine, stating that the conjunctive test is only applied "[i]n the case of any transaction to which the economic substance doctrine is relevant." In a paragraph designated as a "special rule," the statute specifies that "[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." I.R.C. § 7701(o)(5)(C). 

Based on the introductory clause in the statute and the "special rule," the court in Patel III "easily conclude[d] that the statute requires a relevancy determination." The court reinforced that conclusion with legislative history, which is "clear that the economic substance doctrine does not apply to every transaction" and includes a "nonexhaustive list of transactions to which the doctrine does not apply." It emphasized that the relevancy determination cannot be "coextensive with the two-part test" and that "[c]onflating the relevancy determination with the two-part test would ignore [Congress's] direction and deprive the statute's reference to relevance of independent meaning."

Applying the Relevance Requirement 

After concluding that section 7701(o) "right there, on its face" required a "relevancy determination," the court then applied the "content" of that requirement. Based on the statutory mandate to determine "whether the economic substance doctrine is relevant to a transaction… as if this subsection had never been enacted," the court reviewed pre-codification cases in which the economic substance doctrine had been applied to insurance and "in particular, captive insurance transactions." 

The court characterized a specific pre-codification case – Malone & Hyde, Inc. & Subs. v. Commissioner, 62 F.3d 835 (6th Cir. 1995) – as "the closest case to those before us." In Malone & Hyde, the Sixth Circuit applied the economic substance doctrine to disallow tax benefits arising from an insurance arrangement in which deductible amounts were substantially returned to the taxpayer through reinsurance transactions with an accommodation party. Based on "parallels" between Malone & Hyde and the captive insurance transactions at issue, as well as the absence of "mitigating factors," the Tax Court concluded that "heeding Congress's direction that we proceed in the same manner as if section 7701(o) had never been enacted," the doctrine must be relevant. In addition, the court dispensed with the taxpayer's contention that Congress sought to incentivize the taxpayer's transactions, based on the court's prior determination that the taxpayer's payments were not for insurance. 

Operating with judicial restraint, the court did not articulate a comprehensive approach to determining "relevance." Its approach of looking to pre-codification cases with similar facts may yield straightforward answers for transactions that can be readily connected to prior case law, an inquiry that will generally confirm that the doctrine is relevant where courts have previously considered it. However, that approach may offer less insight into the relevance (or irrelevance) of the doctrine to transactions that cannot be closely analogized to pre-codification precedent, putting taxpayers in the difficult position of proving a negative when the IRS seeks to apply the economic substance doctrine in a new or novel context. In 2022, the IRS Large Business & International Division issued guidance substantially relaxing its procedures for asserting the codified economic substance doctrine. That enforcement policy change is producing a pipeline of such novel cases for which it may be difficult to find close analogies in case law, which itself may be an indication of the irrelevancy of the doctrine.

Application of Conjunctive Test

In the span of four pages, the Tax Court concluded that the transactions failed both prongs of the economic substance doctrine: objective economic effect and substantial business purpose. With respect to the objective test, the court emphasized that the transactions resulted in a "circular flow of funds" and that the purported captive insurance did not reduce risk beyond the risk addressed through the taxpayer's commercial insurance. For completeness, the court also held that the taxpayers lacked a substantial non-tax business purpose, reciting extensive findings of fact from its 2024 decision. 

Enhanced Penalty for Inadequate Disclosure

To sustain the asserted economic substance penalty, the Tax Court held that the "claimed tax benefits" were disallowed under the economic substance doctrine, as an additional "alternative ground" to its prior holding in Patel II. 

The court then addressed whether the 20 percent penalty should be enhanced to 40 percent because "the relevant facts affecting the tax treatment [were] not adequately disclosed in the return nor in a statement attached to the return." Although the court announced that Patel represents its "first opportunity to consider what constitutes adequate disclosure" for purposes of section 6662(i), it ultimately did not select a standard. The court recited the disclosure standard for relief for penalties under former section 6661 ("sufficient information to enable the Commissioner to identify the potential controversy involved") while also invoking case law applying the less restrictive standard for preventing extension of the limitations period in section 6501(e) (an "adequate clue" that an error exists on the return). Based on the court's description, it appears the taxpayer's reporting would have been inadequate under either standard. Taxpayers should continue to evaluate the adequacy of their disclosures, consider whether amendments to existing disclosures are warranted (as permitted before "first contact"), and monitor developments in this sensitive area.

For more information, please contact:

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Jeffrey M. Tebbs, jtebbs@milchev.com, 202-626-1480

Samuel A. Lapin, slapin@milchev.com, 202-626-5807

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