Tax Court applies 40% economic substance penalty to microcaptive insurance arrangement

The Tax Court held that a microcaptive insurance arrangement lacked economic substance under Sec. 7701(o) and sustained the enhanced 40% accuracy-related penalty under Secs. 6662(b)(6) and (i) for nondisclosed noneconomic substance transactions for tax years 2012 through 2015. In a prior opinion, the court had determined that the arrangement did not constitute insurance and disallowed the premium deductions. Addressing the reserved penalty issue following supplemental briefing, the court found the arrangement failed both prongs of the economic substance test and that the taxpayers had not adequately disclosed the transaction.

Facts: Curtis K. Kadau was the sole shareholder and president of Surface Engineering & Alloy Co. Inc., an S corporation engaged in the production and sale of metal alloys during tax years 2012 through 2017. Surface Engineering maintained commercial insurance policies with conventional carriers. In 2012, Kadau was referred to the RMC Group, a consortium of companies that promoted microcaptive insurance arrangements. An actuary retained by the RMC Group, Marn Rivelle, conducted a feasibility study and recommended annual premium funding of approximately $1.2 million for various lines of coverage. Based on this study, Risk & Asset Protection Services Ltd. (the captive insurer) was incorporated in the Caribbean island of Nevis in October 2012. Kadau was Risk & Asset’s sole shareholder, having contributed $50,000 in capital, and served as its chair, president, and corporate secretary.

Risk & Asset issued policies to Surface Engineering covering excess business interruption, collection risk, and directors’ and officers’ liability. Surface Engineering simultaneously purchased excess layer coverage from RMC Property & Casualty Ltd. for the same types of policies and periods. The premiums paid to RMC Property were then transferred to Risk & Asset, less a retained 2% to 2.5% fee. More than half of Risk & Asset’s available funds by 2017 were invested in a $6 million life insurance policy on Kadau, chosen specifically to cover “all [of Mr. Kadau’s] mortgages to protect his family in the event of his death.” Tax-free withdrawals from an annuity, which was the only other investment in Risk & Asset’s portfolio, were used to pay the premiums on that life insurance policy.

The IRS contended that the arrangement did not provide actual insurance and that Kadau could therefore not deduct those amounts paid. The IRS also contended that Kadau was liable for the 40% accuracy-related penalty for a transaction lacking economic substance or, in the alternative, a 20% penalty. The IRS issued Kadau a notice of deficiency for tax years 2012 through 2014 and another for tax years 2015 through 2017. Kadau petitioned the Tax Court for a redetermination.

In Kadau I, T.C. Memo. 2025-81, the Tax Court held that the payments made by Surface Engineering were not premiums for insurance in the commonly accepted sense or for federal income tax purposes. The court found that the premiums were 2.5 to 3.5 times higher than comparable commercial policies and that Rivelle’s actuarial report “was prepared in a matter of days and after a single phone call with Mr. Kadau.” Furthermore, Kadau did not provide RMC Group or Rivelle with any information about Surface Engineering. The court further determined that the contracts issued by Risk & Asset and RMC Property were not insurance contracts and that the policies, which the court determined required unreasonable premiums, did not have a legitimate business purpose. The court disallowed the premium deductions under Sec. 162 and sustained 20% accuracy-related penalties for all six tax years. It reserved the question of whether the enhanced 40% penalty under Secs. 6662(b)(6) and (i) applied for tax years 2012 through 2015, pending the court’s decision regarding the “relevancy” issue under Sec. 7701(o) — see below — in another microcaptive insurance case, Patel, 165 T.C. No. 10 (2025). The IRS had conceded the 40% penalty for tax years 2016 and 2017 before trial.

Issues: The issue was whether the microcaptive arrangement lacked economic substance under the codified economic substance doctrine of Sec. 7701(o) and, if so, whether the underpayments for tax years 2012 through 2015 were attributable to nondisclosed noneconomic substance transactions warranting the enhanced 40% penalty under Secs. 6662(b)(6) and (i). The deficiencies and asserted penalties were: $135,858 and $54,343, respectively, for 2012; $31,371 and $12,236 for 2013; $89,100 and $35,640 for 2014; and $180,633 and $72,253 for 2015.

Sec. 7701(o)(1) states that the codified economic substance doctrine of Sec. 7701(o) is applicable to “any transaction to which the economic substance doctrine is relevant” and provides a conjunctive two-prong test for economic substance. Under it, a transaction has economic substance only if (1) it changes the taxpayer’s economic position in a meaningful way apart from federal income tax effects (the objective prong) and (2) the taxpayer has a substantial purpose apart from federal income tax effects for entering into the transaction (the subjective prong).

The Tax Court followed its recent decision in Patel concerning the threshold “relevancy determination” in economic substance cases, i.e., a finding that the economic substance doctrine is relevant to a transaction for the application of Sec. 7701(o). In Patel, the Tax Court held as a matter of first impression that “the statute requires a relevancy determination. To put it plainly — the statute says so, right there, on its face” (Patel, 165 T.C. at 188). The court further held that the determination was distinct from the two-prong economic substance test. Kadau conceded in a supplemental briefing that the economic substance doctrine was relevant to his microcaptive arrangement, so the court proceeded directly to the two-prong analysis.

On the objective prong, the court framed the inquiry as whether the transaction either caused real dollars to meaningfully change hands or created a realistic possibility that they would do so, and it concluded that the arrangement did not meaningfully change Kadau’s economic position. Risk & Asset received no claims during the first four tax years at issue (2012 through 2015). The claims filed in 2016 and 2017 were exclusively under a collection risk policy issued by Risk & Asset. Kadau personally determined and assessed all three claims, served as the sole payment authorizer, and decided there was no need for an adjuster, granting payment for each in full without an independent adjuster’s review. The court determined that “[i]f one were to disregard the federal tax benefits, [Kadau] would have been in the same position economically had [he] simply put the amounts claimed as premiums in a bank account to be drawn upon in the event of losses.”

Further, the transactions involving RMC Property, Surface Engineering, and Risk & Asset resulted in a near-circular flow of funds after fees, and the court concluded that “Mr. Kadau never lost control of his money.” Citing Patel, the court found that “a circular flow of funds among related entities does not result in a meaningful change to economic position.”

On the subjective prong, Kadau argued that he “formed the captive primarily to reduce Surface’s insurance costs and to build reserves that could ultimately replace expensive commercial coverage.” The Tax Court found this unpersuasive, noting that “the high costs of insurance premiums are not unique to Mr. Kadau and Surface Engineering” and that “no evidence in the record reflects that Mr. Kadau ‘identified additional risks'” that were unavailable or prohibitively expensive from third-party insurers. As in Patel, the court found the premiums were not actuarially determined and that “an insurance purchaser would want to negotiate lower instead of higher premiums.” The premiums for the captive coverage were 2.5 to 3.5 times higher than the premiums for Surface Engineering’s commercial coverage, which the court stated supported the “conclusion that Surface Engineering was motivated to pay higher premiums to increase its corresponding deductions” (Kadau I). The court also pointed to the $6 million life insurance policy, which it described as evidence that “Risk & Asset’s investments were nothing more than a structural shell for Mr. Kadau’s estate planning rather than effective means of investing premiums to hedge against risk.”

On the penalty rate, Sec. 6662(i) increases the accuracy-related penalty from 20% to 40% for any underpayment attributable to a “nondisclosed noneconomic substance transaction” — defined as 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.” Adequate disclosure, the court stated, “must be sufficiently detailed to alert the [IRS] as to the nature of the transaction so that the decision as to whether to select the return for audit may be a reasonably informed one.” Surface Engineering’s Forms 1120S, U.S. Income Tax Return for an S Corporation, for 2012 through 2015 did not reflect any connection to Risk & Asset or to RMC Property, and none included a Form 8275, Disclosure Statement; an addendum; or any schedule identifying the microcaptive arrangement. The court held that “the mere declaration of a deduction does not entitle taxpayer to a reduced penalty” (Accardo, 942 F.2d 444, 453 (7th Cir. 1991), aff’g 94 T.C. 96 (1990)) and that Kadau failed to provide sufficient information to enable the IRS to identify that the deducted premiums were part of a microcaptive arrangement.

Holding: The Tax Court sustained the 40% accuracy-related penalties under Secs. 6662(a) and (b)(6), at the increased rate prescribed by Sec. 6662(i), for tax years 2012 through 2015. The court also continued to sustain the 20% accuracy-related penalties for tax years 2016 and 2017, as determined in Kadau I.

The court held that Kadau’s microcaptive arrangement lacked economic substance under Sec. 7701(o), failing both the objective prong and the subjective prong of the economic substance test of Sec. 7701(o)(1). The enhanced penalty rate applied because the microcaptive arrangement lacked economic substance and Kadau had failed to adequately disclose it on his returns. The decision follows Patel, which established the framework for Sec. 7701(o) analysis and the determination of whether microcaptive insurance arrangements are adequately disclosed for purposes of the enhanced penalty under Sec. 6662(i). Together, the cases represent the Tax Court’s continued scrutiny of captive structures that follow the form of insurance but lack genuine risk distribution, arm’s-length pricing, and economic substance.

• Kadau, T.C. Memo. 2026-37

— Thomas Godwin, CPA, CGMA, Ph.D., and John McKinley, CPA, CGMA, J.D., LL.M., are both professors of the practice in accounting and taxation in the SC Johnson College of Business at Cornell University in Ithaca, N.Y. To comment on this column, contact Paul Bonner, the JofA’s tax editor.