Tax Court Sustains 40% Penalty in Microcaptive Case

In Kadau v. Commissioner (T.C. Memo. 2026-37), the Tax Court upheld a 40% accuracy-related penalty against taxpayers involved in a microcaptive insurance arrangement.

Key Takeaways:

• Lacks Economic Substance: Applying the two-part test from Patel, the court found the arrangement failed both the objective and subjective prongs of IRC § 7701(o).

• No Meaningful Change: There was a "circular flow of funds" where the taxpayer never lost control of the money.

• No Nontax Purpose: Premiums were 2.5 to 3.5 times higher than commercial rates, suggesting the primary motivation was tax deductions, not insurance.

• Enhanced Penalty: Because the transaction lacked economic substance and was not properly disclosed on tax returns (missing Form 8275), the penalty was increased from 20% to 40% under IRC § 6662(i).

This serves as a critical reminder of the IRS’s continued success in challenging microcaptives and the high cost of nondisclosure.