Bloomberg (James Matheson), Tax Group Calls Economic Substance Doctrine a ‘Dangerous Tool

Courts must first determine the economic substance doctrine’s relevance to a transaction before the IRS can raise a challenge under it, a nonprofit taxpayer advocacy organization told the Fifth Circuit, warning of the government’s current “regulation by litigation” approach.

The National Taxpayers Union Foundation asked the US Court of Appeals for the Fifth Circuit to partially affirm and partially reverse a 2025 Tax Court decision regarding the economic substance doctrine codified in IRC Section 7701(o). The common-law doctrine disallows tax benefits when a transaction lacks economic substance or business purpose, which is a dangerous tool that should only be used when relevant, NTUF said in a brief filed Monday.

Contrary to a requirement Congress explicitly wrote into the statute, the IRS has refused to define through formal rulemaking when it considers the doctrine relevant, instead litigating the question case-by-case and burdening taxpayers with litigation costs and clogs in federal courts, the union added.

“This freewheeling approach to the doctrine, untethered from the text of § 7701(o), is untenable,” NTUF said.

In 2025, the Tax Court held Sunil Patel and Laurie McAnally-Patel were liable for about $397,000 tax penalties for using a micro-captive insurance program that was disallowed because it lacked economic substance. The IRS correctly used the economic substance doctrine to determine that the $1.74 million the Patels paid in premiums to micro-captive insurance companies they controlled for their 2013 to 2016 tax years were generated for tax benefits, not to provide insurance coverage, the Tax Court said in it’s decision.

The Tax Court correctly required a relevancy determination before applying Section 7701(o) to the Patels, NTUF argues, and that ruling should be affirmed. However, the Tax Court went too far when it broadly declared all insurance arrangements presumptively suspect under the doctrine — creating an automatic application on other insurance arrangements that is contradictory to congressional intent, the brief said.

That portion should be reversed, and the matter remanded for formal notice-and-comment rulemaking by the IRS, NTUF said.

“Taxpayers need guidance, before the government starts asking questions, on how to comply with the law and avoid § 7701(o),” the brief said. “The answer cannot be ‘do not use captive insurance,’ for that disallows what Congress blessed already in the Code.”

Taxpayers shouldn’t be penalized simply for using tax benefits and incentives Congress deliberately created, the brief added.

“But a free-wielding IRS applying the economic substance doctrine at will threatens these incentives, and taxpayers risk real harm if the IRS applies the doctrine,” the brief said.