Tax Court Sustains Penalties in Microcaptive Insurance Case

(Parker Tax Publishing November 2025)

The Tax Court held that the owner of a medical practice who formed a microcaptive insurance company which was previously held by the Tax Court not to constitute insurance for tax purposes was liable for a penalty under Code Sec. 6662(a) and (b)(6) on underpayments of tax attributable to a transaction lacking economic substance within the meaning Code Sec. 7701(o) (the codified economic substance doctrine). The court further held that the codified economic substance doctrine requires a relevancy determination and that the doctrine is relevant in cases involving captive insurance transactions. Patel, et al. v. Comm'r, 165 T.C. No. 10 (2025).

Background

Dr. Sunil Patel has practiced medicine in Texas since 1997. He has an extensive education as well as an extensive business background. Dr. Patel formed multiple medical-related businesses, including Ophthalmology Specialists of Texas (OST), Integrated Clinical Research, LLC (ICR), and Strategic Clinical Research Group, LLC (SCR). Dr. Patel described himself as a "savvy financial person."

In 2011, Dr. Patel formed Magellan Insurance Co. (Magellan), a captive insurance company. Assisting him in the formation of Magellan was Christopher Fay, a financial planner, Sean King of CIC Services, LLC (CIC Services), and James Coomes, a tax attorney who focused his practice on captive insurance. Coomes prepared a business plan for Magellan, outlining proposed insurance coverages. An actuary, Allen Rosenbach, priced the premiums for Magellan's policies based on applications he received from Dr. Patel. No person associated with Magellan completed a feasibility study to determine the costs and merits of a captive arrangement, and neither Dr. Patel nor his advisers explored the cost or feasibility of the same policies on the commercial market.

In 2016, Dr. Patel formed a second captive insurance company called Plymouth Insurance Co. (Plymouth). He did so even though his accountant had been contacted by the IRS about Magellan, several captives formed by Coomes were being examined by the IRS, and a family member had told him that the IRS was focusing its compliance efforts of captive insurance arrangements.

During 2013 through 2016 (the tax years at issue), Magellan Plymouth issued direct written policies to OST and ICR, and SCR. However, Dr. Patel continued to purchase insurance coverage with third-party commercial insurers for each of his entities. Such policies insured many of the same risks as the captive policies. Commercial premiums ranged between approximately $68,000 and $106,000 per year for the three entities. In contrast, during the same years, Dr. Patel's businesses paid premiums to the microcaptives totaling just over $4.5 million. Dr. Patel never placed his medical malpractice insurance coverage with his captives.

Magellan and Plymouth participated in a purported risk pool through Capstone Reinsurance Co., Ltd. (Capstone), a company formed by Coomes. Participants in the purported risk pool paid 51 percent of their premiums into the pooling arrangement as part of the reinsurance agreement. And in less than a year, they received a significant percentage of funds back as part of the quota share agreement. Premium pricing for Magellan and Plymouth was developed to facilitate favorable income tax treatment, not for business purposes. Although Rosenbach was retained to provide actuarially determined premium pricing, he did not do so. Instead, he was flexible in determining premium pricing, changing the premium amounts when requested to do so. Dr. Patel provided target premiums he wanted to pay. Rosenbach was aware that under Code Sec. 831(b), a $1.2 limit exclusion limit applied; the limit was later increased to $2.2. million. The final pricing he prepared for Coomes's clients from 2011 to 2016 never exceeded $1.2 million, the maximum deductible amount in those years.

The IRS audited the joint tax returns filed by Dr. Patel and his wife and issued notices of deficiency (NODs). The NOD for 2013 disallowed the deductions for insurance expenses because of a lack of economic substance, while the NODs for 2014 through 2016 determined a disallowance of deductions for lack of substantiation or because the expenses were not ordinary and necessary. The IRS also determined various penalties under Code Sec. 6662. In Patel v. Comm'r, T.C. Memo. 2024-34 (Patel II), the Tax Court held that Magellan's and Plymouth's purported captive transactions did not constitute insurance because they failed to distribute risk. The Patels' liability for accuracy-related penalties for 2013 through 2016 was decided separately by the Tax Court.

Code Sec. 6662(a) and (b)(6) imposes a penalty on the portion of an underpayment of tax attributable to the disallowance of claimed tax benefits by reason of a transaction lacking economic substance within the meaning of Code Sec. 7701(o), which codifies the economic substance doctrine. Economic substance is a common-law doctrine that was codified in 2010 in Code Sec. 7701(o). The statutes provides: "In the case of any transaction to which the economic substance doctrine is relevant," the transaction will be treated as having economic substance only if (1) it changes the taxpayer's economic position in a meaningful way (apart from federal income tax effects) and (2) the taxpayer has a substantial non-tax purpose for entering into the transaction. Under Code Sec. 7701(o)(5)(C), the determination of whether the economic substance doctrine is relevant must be made in the same manner as if Code Sec. 7701(o) had never been enacted.

This case was the Tax Court's first opportunity to examine when the codified economic substance doctrine applies. The court framed the issues before it as (1) whether Code Sec. 7701(o) requires a relevancy determination and (2) if so, whether the economic substance doctrine was relevant to this case. The court also considered whether the increased rate for inadequate disclosure under Code Sec. 6662(i) applied, as well as the Patels' liability for accuracy-related penalties for negligence and substantial understatements of income tax for 2013 under Code Sec. 6662(b)(1) and (2).

Analysis

The court easily concluded that Code Sec. 7701(o) requires a relevancy determination given that the text of the statute states that the economic substance doctrine applies if there is a transaction to which it is relevant. In addition, the court concluded that the economic substance doctrine applies in the insurance context. Proceeding in the same manner as if Code Sec. 7701(o) had never been enacted, the court examined the development of the economic substance doctrine over the last 90 years and found that it has been applied in a variety of circumstances, including cases involving captive insurance transactions.

Next, the court applied Code Sec. 7701(o) and found that the transactions at issue lacked economic substance because Dr. Patel entered into them to maximum tax deductions, not for any business purpose. In the court's view, the transactions did not result in a meaningful change in economic position, given that the reinsurance transaction involving Capstone, Magellan, and Plymouth involved a circular flow of funds. The court also noted that Dr. Patel paid unreasonable and excessive premiums, up to the amount allowed by Code Sec. 831(b), while maintaining his commercial insurance coverage. Having found that the transactions at issue lacked economic substance, the court concluded that the disallowance of the claimed tax benefits was by reason of a transaction lacking economic substance within the meaning of Code Sec. 7701(o), and thus Code Sec. 6662(b)(6) applied.

The court then considered whether the Patels were subject to an increased rate of. 40 percent under Code Sec. 6662(i) for any portion of an underpayment that was attributable to one or more nondisclosed noneconomic substance transactions under Code Sec. 6662(b)(6). The court noted that this was its first opportunity to consider what constitutes "adequate disclosure" under Code Sec. 6662(i)((2). In Estate of Fry v. Comm'r, 88 T.C. 1020 (1987), the Tax Court held in a different context that for a disclosure to be adequate, it 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. Applying this standard, the court found that the Patels 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 the IRS to identify the potential controversy involved.

The court also held that the Patels were liable for accuracy-related penalties for negligence and substantial understatements of income tax for 2013. The court found that, despite Dr. Patel's education he did not investigate whether it was proper for him to drastically reduce his tax liabilities in the manner he chose. The court thought that this was exactly the type of "too good to be true" transaction that should cause taxpayers to seek out competent advice from independent advisers. Moreover, Dr. Patel decided to move forward with forming a second captive in 2016, despite being on notice that the IRS was examining the captive arrangements formed by Coomes. Under the circumstances, the court concluded that Dr. Patel was negligent in that he failed to make reasonable attempts to determine the correctness of deductions that should have seemed to him too good to be true. The court also sustained the IRS's imposition of substantial understatement penalties after finding that each of the understatements at issue clearly exceeded $5,000 and was greater than 10 percent of the tax required to be shown.

For a discussion of captive insurance arrangements, see Parker Tax ¶92,730. For a discussion of penalties relating to transactions lacking economic substance, see Parker Tax ¶99,740. For a discussion of accuracy-related penalties, see Parker Tax ¶262,120.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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