In Patel v. Commissioner,¹ the Tax Court held for the first time that the economic substance doctrine, codified under IRC Section 7701(o), requires a relevancy determination.

Case history

The case concerns the IRS disallowance of deductions for premiums paid to two microcaptive insurance companies formed by a doctor. The IRS issued notices of deficiency for tax year 2013 based on lack of economic substance and for 2014 through 2016 based on based on lack of substantiation, among other things, and assessed penalties.

This case addresses whether the petitioners are subject to accuracy-related penalties of (1) 20% under IRC Section 6662(a) and (b)(6) for underpayment of tax attributable due to a transaction lacking economic substance under IRC Section 7701(o) and (2) 40% under IRC Section 6662(i) for underpayment attributable to nondisclosed noneconomic substance transactions.

Analysis

According to the Tax Court, this is the first time it has examined when the IRC Section 7701(o) economic substance doctrine applies.

IRC Section 7701(o) states that the doctrine applies in "the case of any transaction 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."

"Faced with these provisions, we easily conclude that the statute requires a relevancy determination. To put it plainly — the statute says so, right there, on its face," the court said. The court first examined the legislative history of IRC Section 7701(o)(1), citing the House Committee report to support its finding. The court also looked to case law involving insurance transactions, particularly captive insurance transactions, to find that the economic substance doctrine was relevant to this case.

The court then applied the test in IRC Section 7701(o)(1), under which there is economic substance if: (1) the transaction changes, apart from federal income tax effects, the taxpayer's economic position in a meaningful way; and (2) the taxpayer has a substantial purpose (apart from federal income tax effects) for entering into the transaction.

The court found that (1) the transactions at issue did not meaningfully change the Patels' economic position beyond federal tax effects; and (2) the evidence demonstrated that the Patels entered into the microcaptive transactions primarily to reduce their federal income tax bill, not for any business purpose.

Concluding that the transactions lacked economic substance, the court upheld the IRS's penalties for 2013 through 2016.

Implications

The Tax Court's opinion in Patel v. Commissioner establishes that a relevancy determination is required before applying the economic substance doctrine under IRC Section 7701(o). It is the highest level of Tax Court opinion — a reviewed opinion — meaning the court believed it involves a sufficiently important legal issue or principle, and it was reviewed (and, here, agreed) by all Tax Court judges.

This opinion directly conflicts with Liberty Global Inc. v. United States, No. 1:20-cv-03501-RBJ (D. Colo. Oct. 31, 2023), where the U.S. District Court for the District of Colorado ruled that no threshold "relevance" inquiry was required under IRC Section 7701(o) in a case concerning the dividends-received deduction under IRC Section 245A (see Tax Alert 2023-1857).

More recently, the U.S. District Court for the Western District of Michigan rejected the IRS's assertion of the economic substance doctrine under IRC Section 7701(o) for the first time in a transfer pricing case (W.D. Mich. Sept. 25, 2025) (see Tax Alert 2025-2161).

These recent cases indicate growing scrutiny under the economic substance doctrine and its extension into the transfer pricing space. Taxpayers should monitor this area of case law and ensure they are considering the appropriate precedent when performing economic substance doctrine analyses.