The Tax Times

Monday, May 11, 2026

Kadau Case Alert: How “Insurance” Planning Turned Into a 40% Tax Disaster

The Tax Court’s memorandum decision in Kadau v. Commissioner, T.C. Memo. 2026-37 (May 4, 2026) is the latest warning shot at taxpayers using microcaptive insurance structures that do not hold up as real insurance arrangements with genuine economic substance. For practitioners, Kadau is useful not just as another “bad microcaptive” case, but as a clear illustration of how courts are applying the economic substance doctrine and the 40% penalty under section 6662(i) in this context.

The Structure: Microcaptive + Life Insurance

In Kadau, the taxpayers owned and operated a metal alloy coating business. To manage their risks—and, as the IRS argued, primarily to manage their taxes—they participated in a microcaptive insurance arrangement using a Nevis-based captive insurer, Risk & Asset. The business paid premiums to this captive, which purported to insure various business risks. Those premium payments then helped fund life insurance investments and other related-party benefits that largely inured back to the insured owners.

On paper, this looked like an insurance program qualifying for favorable tax treatment under the small insurance company regime. In practice, the court concluded it was nothing of the sort. Premiums were set at levels roughly 2.5 to 3.5 times prevailing commercial rates, and the flow of funds resembled a circular financing arrangement more than an arm’s-length insurance relationship with real risk transfer.

Economic Substance: Failing Both Prongs of § 7701(o)

The Tax Court evaluated the transaction under section 7701(o) and the economic substance doctrine, which requires:

1. A meaningful change in the taxpayer’s economic position (objective component), and

2. A substantial non-tax purpose (subjective component).

Kadau failed both tests.

On the objective side, the court found that the microcaptive structure did not materially change the taxpayers’ economic position. Premiums were grossly inflated relative to commercial market rates, and the captive’s assets and activities were effectively under the taxpayers’ control. The supposed insurance risk was largely illusory because the arrangement was designed so that funds could be recycled to benefit the owners (including through life insurance), with little genuine risk distribution or exposure to third-party claims.

On the subjective side, the court was not persuaded that the taxpayers had a substantial, non-tax business purpose. While they cited risk management and estate planning goals, the evidence showed that the dominant driver was tax reduction: large deductions for premiums paid to a related insurer that would be taxed lightly (if at all) within the captive, followed by access to those funds through other channels. The disparity between premium levels and commercial coverage also undermined any claim of bona fide insurance pricing.

Against the backdrop of cases like Avrahami, Reserve Mechanical, and a prior Kadau-related opinion (T.C. Memo. 2025-81), the court treated this as part of a familiar pattern of microcaptive structures that nominally follow the form of insurance but lack real substance.

The 40% Accuracy-Related Penalty

Perhaps the most painful aspect of Kadau for taxpayers is the 40% accuracy-related penalty under section 6662(i) for transactions lacking economic substance. Once the court concluded the arrangement failed under section 7701(o), it applied the heightened 40% penalty (rather than the usual 20% under section 6662(b)) because there was no adequate disclosure and no reasonable cause.

Key penalty points from the opinion:

· The microcaptive was treated as a transaction lacking economic substance, triggering the potential for the 40% penalty.

· The taxpayers did not adequately disclose the transaction (for example, through Form 8275 or other robust disclosure), which foreclosed the reduced penalty rate.

· The court found no substantial authority and no reasonable cause/good faith defense. Reliance on promoters or on opinions that merely accepted the taxpayer’s assumptions about risk, pricing, and structure was insufficient.

For advisors, Kadau reinforces that once the court characterizes a transaction as lacking economic substance, the default expectation is a 40% penalty unless the taxpayer has very strong disclosure and reasonable cause facts.

Practical Lessons for Microcaptive and Estate Planning Work

Kadau is another data point in the IRS’s continuing campaign against abusive microcaptive arrangements, but it also offers practical takeaways for structuring legitimate risk management and estate planning strategies.

Some key lessons:

· Risk transfer and distribution must be real. Courts will look closely at whether the captive is truly bearing risk, whether risks are pooled or diversified, and whether claims experience is consistent with genuine insurance.

· Premiums must be at arm’s length. Overpriced policies (multiples of commercial coverage) scream tax-motivated structuring and undermine both economic substance and insurance characterization.

· Avoid circular cash flows. If money effectively goes from the operating company to the captive and then back to the owners via loans, life insurance, or thinly disguised distributions, expect scrutiny.

· Document non-tax purposes rigorously. If there are real, quantifiable business reasons—unique risks, gaps in commercial coverage, regulatory requirements—those should be substantiated with contemporaneous analysis and third-party input.

· Take disclosure seriously. Kadau illustrates the cost of inadequate disclosure in a post-§ 7701(o) world: the difference between a 20% and a 40% penalty can be enormous.

For estate and business succession planning, the opinion also underscores that using insurance and captive structures to support wealth transfer is not inherently problematic, but when those structures are driven primarily by tax arbitrage and lack real insurance economics, they are highly vulnerable in litigation.

Have an Micro Captive Tax Problem?

Contact the Tax Lawyers at

Marini & Associates, P.A.

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or Toll Free at 888 8TAXAID (888-882-9243)

Sources:

1. https://www.vitallaw.com/news/microcaptive-arrangement-lacked-economic-substance-penalty-sustained-kadau-tcm/ftd01cc82c15a2e6d43f1a916fea85b407597

2. https://substack.com/@mceowenaglawandtax/note/c-255724370

3. https://www.captivatingthinking.com/kadau-v-commissioner-captive-insurance-that-wasnt/

4. https://www.currentfederaltaxdevelopments.com/blog/2025/7/31/microcaptive-arrangements-under-scrutiny-yet-again

5. https://news.bloombergtax.com/daily-tax-report/microcaptive-case-warrants-harsher-tax-penalties-court-says

6. https://www.currentfederaltaxdevelopments.com/blog/2026/4/17/taxation-of-terminated-life-insurance-policies-an-analysis-of-constructive-receipt-and-investment-interest

7. https://www.ca5.uscourts.gov/opinions/pub/23/23-20480-CV1.pdf

8. https://taishofflaw.com/author/taishofflaw/

9. https://texastaxsection.org/Content/Classroom/20241204_First_Wednesday_Tax_Update_Outline.pdf

10. https://www.irs.gov/irb/2026-07_IRB

11. https://www.irs.gov/pub/irs-irbs/irb24-43.pdf

12. https://kpmg.com/kpmg-us/content/dam/kpmg/taxnewsflash/pdf/2024/10/tc-memo-2024-100.pdf

13. https://www.ul.com/resources/global-market-access-regulatory-news-update

14. https://www.fire.org/sites/default/files/2025/12/Supplemental En Banc Brief - Spectrum WT v. Walter Wendler.pdf

15. https://steinsperling.com/february-federal-tax-update-4/

16. https://www.currentfederaltaxdevelopments.com/blog/2026/3/31/taxation-of-customer-funded-facility-expansions-a-technical-review-of-thermal-circuits-inc-v-commissioner

17. https://www.facebook.com/vgcpapc/posts/1652320313206225/

18. https://www.forbes.com/sites/jayadkisson/2026/05/09/microcaptive-investing-in-life-insurance-gets-40-penalty-in-kadau/

19. http://www.smbiz.com/sbtc26.html

20. https://news.bloombergtax.com/daily-tax-report/u-s-tax-court-memorandum-decision-upholds-irs-deficiency-ruling-penalty-on-unreported-property-sale-gains

21. https://klasing-associates.com/micro-captive-insurance-under-intensified-irs-attack/

22. https://www.llulegacy.org/?pageID=134&docID=1016

23. https://www.facebook.com/groups/1771941169693583/posts/4582881818599490/

24. https://www.facebook.com/vgcpapc/photos/tax-court-hits-microcaptive-arrangement-with-40-penalty-kadau-v-commissioner-202/1652319173206339/

25. https://www.pwc.com/us/en/services/tax/library/pwc-tax-court-analyzes-application-of-economic-substance-doctrine.html

26. http://federaltaxprocedure.blogspot.com

27. https://www.vitallaw.com/news/microcaptive-arrangement-lacked-economic-substance-penalty-sustained-kadau-tcm/ftd01cc82c15a2e6d43f1a916fea85b407597

28. https://substack.com/@mceowenaglawandtax/note/c-255724370

29. https://news.bloombergtax.com/daily-tax-report/microcaptive-case-warrants-harsher-tax-penalties-court-says

30. https://www.captivatingthinking.com/kadau-v-commissioner-captive-insurance-that-wasnt/

31. https://www.forbes.com/sites/jayadkisson/2026/05/09/microcaptive-investing-in-life-insurance-gets-40-penalty-in-kadau/

32. https://www.currentfederaltaxdevelopments.com/blog/2025/7/31/microcaptive-arrangements-under-scrutiny-yet-again

https://klasing-associates.com/micro-captive-insurance-under-intensified-irs-attack/

Thursday, May 7, 2026

Taxpayers Need to Consider Documenting Business Purpose After Liberty Global

In a highly anticipated and long awaited decision, on April 21 the U.S. Court of Appeals for the Tenth Circuit ruled in favor of the IRS in Liberty Global Inc. v. U.S. The court held that Liberty Global's disputed transactions lacked economic substance and that the economic substance doctrine did not require a threshold relevancy determination to be applied.

Setting the stage: why Liberty Global matters

For years, the codified economic substance doctrine in section 7701(o) sat atop an already muddled common‑law landscape, with courts disagreeing on when the doctrine is “relevant” and how intrusive it should be in evaluating tax‑motivated planning. Congress tried to clarify, not replace, existing doctrine in 2010, expressly limiting section 7701(o) to “any transaction to which the economic substance doctrine is relevant,” but never defining what “relevant” means. Initially, the IRS imposed internal executive‑level approval requirements before agents could assert economic substance and the strict‑liability penalties under sections 6662(b)(6) and 6662(i), but those approvals were lifted in 2022 following TIGTA criticism that the Service was under‑using the doctrine in large corporate and partnership cases. Since then, exam teams have invoked economic substance with increasing frequency, often against complex corporate restructurings and cross‑border plans that formally comply with Code mechanics but generate eye‑catching tax benefits.

The Liberty Global transaction and holding

Liberty Global’s “Project Soy” was a four‑step cross‑border restructuring designed to exploit a timing mismatch among the GILTI, Subpart F, and section 245A regimes to transform approximately 2.4 billion dollars of gain into a dividends‑received deduction. In the district court, Liberty Global conceded that the first three steps of the plan failed the two‑prong economic substance test—no meaningful non‑tax economic change and no substantial non‑tax purpose—leaving on appeal only whether section 7701(o) was even “relevant” to Project Soy. A divided Tenth Circuit affirmed the District of Colorado, holding that the codified economic substance doctrine applies even when the taxpayer has mechanically followed the literal terms of the Code, so long as the resulting tax benefit is not one Congress can reasonably be thought to have intended. The majority further rejected the argument that common M&A elements or ordinary business steps are categorically immune from economic substance review, emphasizing that section 7701(o)(5)(D) permits courts to analyze an integrated series of steps as a single transaction even when individual pieces resemble routine business moves.

U.S. Circuit Judge Allison Eid dissented, reading section 7701(o)’s “relevant” language as demanding a threshold inquiry before courts can apply the doctrine, and warning that skipping this step invites economic substance into ordinary‑course transactions Congress did not mean to police in this way. Her dissent provides a roadmap for further litigation, including a possible en banc request in the Tenth Circuit or a future certiorari petition that squarely asks the Supreme Court to define “relevant” for purposes of section 7701(o).

How Liberty Global fits with Patel and Perrigo

Recent cases underscore that Liberty Global is part of an emerging split on the scope of the doctrine and the role of the relevancy requirement.

· In Patel v. Commissioner, a reviewed 2025 Tax Court decision involving microcaptive insurance arrangements, the court held that Congress “could hardly have been clearer” that the economic substance doctrine is only relevant to certain transactions. After expressly conducting a relevancy inquiry under section 7701(o), the Tax Court concluded the microcaptive structure lacked both meaningful non‑tax economic change and substantial non‑tax purpose, disallowing the deductions and sustaining 20% and 40% strict‑liability penalties. Patel is now on appeal to the Fifth Circuit, which will have an opportunity to endorse or refine the Tax Court’s articulation of the relevancy requirement.

· In Perrigo Co. v. United States, the Western District of Michigan rejected the government’s attempt to invoke common‑law economic substance and related sham doctrines to disregard an intercompany assignment of contract rights to a controlled Israeli affiliate. The court found the restructuring had genuine business drivers and declined to treat economic substance as a catch‑all anti‑abuse tool where section 482 and other specific provisions already provided a tailored framework. Although Perrigo addressed the uncodified doctrine rather than section 7701(o), it signals judicial skepticism toward using economic substance to override transactions that fit cleanly within detailed statutory and regulatory regimes.

Taken together, Patel and Perrigo stand in tension with the Tenth Circuit’s willingness in Liberty Global to treat “relevance” as essentially satisfied whenever a taxpayer uses Code mechanics to achieve a result courts view as inconsistent with congressional intent. That divergence increases the odds that the appellate courts—and eventually the Supreme Court—will be asked to draw clearer lines around when economic substance can and cannot be deployed.

Different judicial approaches at a glance

Case	Court / Circuit	Doctrine applied	Approach to “relevance” or scope	Outcome for taxpayer
Liberty Global	10th Cir. (appeal from D. Colo.)	Codified §7701(o)	Majority treats doctrine as relevant to mechanical use of Code to obtain unintended benefits; no separate threshold carve‑out for ordinary‑looking steps.	Government win; 2.4B dollar benefit denied.
Patel	Tax Court (appeal to 5th Cir.)	Codified §7701(o)	Explicit relevancy inquiry; emphasizes that doctrine is limited to “certain transactions” and not universal.	Government win; microcaptive deductions disallowed; penalties sustained.
Perrigo	W.D. Mich. (appeal to 6th Cir.)	Common‑law economic substance and sham doctrines	Treats doctrine as inapplicable where detailed rules (e.g., section 482) fit better and transactions show real business substance.	Taxpayer win; intercompany assignment respected; substantial refund allowed.

Implications for planning, exams, and penalties

The Liberty Global majority opinion is likely to embolden the IRS to assert economic substance more aggressively in cases where taxpayers have exploited timing, hybrid entities, or structural asymmetries in the Code to achieve large deductions or deferrals. Tax advisors can expect exam teams to cite Liberty Global when challenging cross‑border restructurings that are technically compliant but difficult to square with a principled reading of congressional intent, especially in the GILTI, Subpart F, section 245A, and related international regimes. Because section 7701(o) carries strict‑liability penalties—40 percent for undisclosed transactions and 20 percent with adequate disclosure—the risk calculus around “mechanical” planning has shifted further in the government’s favor, particularly in the Tenth Circuit and in cases likely to influence national guidance.

At the same time, Perrigo offers a counter‑narrative for taxpayers arguing that economic substance should not be used as a blunt instrument where more precise tools like section 482 already exist and where transactions have clear commercial rationales. Patel demonstrates that courts are capable of conducting a disciplined relevancy analysis and still reaching a government‑favorable result, which could appeal to appellate judges concerned about unchecked judicial anti‑abuse doctrines. If the Fifth and Sixth Circuits embrace Patel’s and Perrigo’s more bounded views, the split with the Tenth Circuit’s Liberty Global framework will become sharper and potentially ripe for Supreme Court review.

Practical takeaways for taxpayers and advisors

From a practical standpoint, Liberty Global reinforces that taxpayers cannot safely rely on formal compliance with Code text alone when the economic outcome appears tax‑driven and disconnected from business realities. To mitigate audit and litigation risk:

· Elevate business purpose: Ensure that every major step in a transaction can be tied to a concrete business objective—operational efficiency, market access, regulatory requirements, financing needs—supported by contemporaneous evidence. Advisors should help clients articulate these rationales in clear, non‑tax‑centric terms.

· Build a cohesive documentary record: Maintain a consistent story across board materials, internal slide decks, tax memos, external opinions, emails, and press releases; inconsistencies or “tax‑only” project names create fertile ground for an economic substance challenge. Contemporaneously document alternative structures considered, why they were rejected, and how the chosen path better addressed the underlying business problem.

· Preserve key transaction artifacts: Keep detailed reorganization plans, financial projections pre‑ and post‑transaction, valuation reports, legal opinions, and operational integration documents readily accessible for a future exam. Identifying a clear business “owner” for each transaction—someone who can credibly explain commercial motivations—is often as important as the written record.

· Rethink penalty posture and disclosures: Given the strict‑liability penalties and the Tenth Circuit’s expansive reading of “relevance,” taxpayers should carefully evaluate whether protective disclosures are warranted for significant tax‑motivated restructurings, especially those involving legislative gaps or timing mismatches. Opinions should analyze not just literal statutory compliance but also how a court might view economic substance in light of Liberty Global, Patel, and Perrigo.

Liberty Global is unlikely to be the last word on economic substance, but it meaningfully re‑weights the balance between taxpayer reliance on statute text and judicial anti‑abuse authority.

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