Tax Court Strikes Down Microcaptive: The Patel Case Every Advisor Needs to Know

The recent Tax Court decision in Patel and McAnally Patel v. Commissioner (TCM 2024-34) delivers a decisive blow to aggressive microcaptive insurance tax planning. In this case, Dr. Sunil Patel and Laurie McAnally-Patel created two microcaptives and paid millions in premiums, claiming large deductions under IRC § 831(b).

What Went Wrong?

·         Premiums Set for Tax Advantage: The premiums paid to the captives far exceeded those for comparable commercial insurance and were calculated specifically to maximize deductions allowed under § 831(b)—not based on actuarial science or true risk.

·         Duplicative Insurance and Circular Flow: Despite setting up captives, Dr. Patel maintained ordinary commercial insurance and paid both sets of premiums, leading the court to find the captive arrangement had no meaningful economic effect aside from tax reduction.

·         Failed Economic Substance Tests: The arrangement failed both the objective and subjective prongs of the economic substance test. Objectively, there was no substantial change in the taxpayers’ economic position. Subjectively, emails and documents revealed a primary motive to reduce taxes rather than manage risk.

IRS Penalties Upheld

The IRS disallowed all deductions and imposed accuracy-related penalties. The court highlighted that the Patels did not have substantial authority for their treatment and could not defend their position by relying on promoters and advisors with a financial stake in the transactions.

Practice Takeaways

·         Tax-Favored Doesn’t Mean Safe: Even transactions explicitly incentivized by Congress (like microcaptives under § 831(b)) can be struck down if they lack economic substance.

·         Substance Over Form Prevails: Deductions for insurance premiums must reflect legitimate risk management, not simply an effort to lower income taxes.

·         Penalties Are Real: The IRS and courts will impose harsh penalties for arrangements they consider “too good to be true” and improperly disclosed on returns.

This decision should serve as a cautionary tale for taxpayers and advisors considering microcaptive insurance structures. Rigorous compliance with both tax law and the economic substance doctrine is the only way to ensure legitimate tax benefits.

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