Federal Tax Day - Current, J.2, Microcaptive Arrangement Lacked Economic Substance; Penalty Sustained (Kadau, TCM), (May 5, 2026)

A married couple and related entities were not entitled to deduct claimed insurance expenses because their microcaptive insurance arrangement lacked economic substance under Code Sec. 7701(o). The IRS challenged the deductions and asserted that the arrangement was a nondisclosed noneconomic substance transaction.

The Tax Court found that the arrangement did not meaningfully change the taxpayers’ economic position apart from federal income tax effects. Additionally, the Tax Court noted that the structure involved a circular flow of funds among related entities and that premiums were not actuarially determined. The Tax Court further observed that no claims were filed in early years and that later claims were controlled and approved by the taxpayer without independent review. Thus, the arrangement did not involve real insurance risk or economic consequences.

Further, the Tax Court concluded that the arrangement lacked a substantial non-tax business purpose, as premiums were excessive and designed to generate deductions. Accordingly, the Tax Court disallowed the deductions and sustained accuracy-related penalties under Code Sec. 6662(b)(6). The court further applied the increased forty percent penalty under Code Sec. 6662(i) because the taxpayers failed to adequately disclose the arrangement on the returns.

C.K. Kadau, TC Memo. 2026-37, Dec. 62,842(M)