Taxpayers who get into a dispute with the IRS often assume that good faith will protect them. They relied on professionals. They read the materials. They believed the deduction was allowed at the time. So even if the deduction is later denied, they expect the penalty to go away because they were not careless and they were not hiding anything.
That assumption holds for many tax penalties. It does not hold for one of them. The tax code carries a penalty that applies even when the taxpayer acted in complete good faith and even when there was real authority for the position. There is no reasonable cause defense. There is no substantial authority defense. And the rate doubles if the taxpayer did not check a box on the return.
This raises a question worth asking before you ever claim an aggressive deduction. When does the IRS get to impose a penalty that no amount of good faith can defeat? The U.S. Tax Court took up that question in Patel v. Commissioner, 165 T.C. No. 10 (2025). The case gives us a chance to look at the economic substance penalty and the strict liability that comes with it.
Facts & Procedural History
The taxpayer is a physician. He has practiced medicine in Texas since the late 1990s. He holds both a medical degree and a doctorate in immunology. He runs his own surgical practice along with two clinical research companies. He describes himself as a savvy financial person.
After reading books on asset protection and insurance, the taxpayer decided to form a captive insurance company. A captive is an insurance company owned by the same people it insures. Used correctly, it can be a legitimate risk management tool. Used incorrectly, it becomes a way to move money out of a profitable business, deduct it on the way out, and pull it back later at favorable rates.
The taxpayer formed his captives and paid them what he called premiums. He then claimed deductions for those payments as ordinary and necessary business expenses under Section 162 for the 2013 through 2016 tax years. A related entity purported to reinsure part of the risk.
On audit, the IRS disallowed the deductions. The agency took the position that the payments were not insurance premiums at all. In a prior round of this same litigation, the U.S. Tax Court agreed that the amounts paid to the captives were not insurance premiums for federal tax purposes. The IRS then determined accuracy-related penalties under Section 6662. The penalties included the penalty tied to the economic substance doctrine, and the IRS sought the increased 40% rate for two of the years. The taxpayer petitioned the U.S. Tax Court to contest the penalties.
What Is the Accuracy-Related Penalty?
Start with the broad rule. Section 6662(a) imposes a penalty equal to 20% of the portion of an underpayment that is attributable to certain conduct. The most common triggers are negligence, a substantial understatement of income tax, and a substantial valuation misstatement. This is the workhorse penalty. The IRS asserts it in a large share of audits that produce additional tax.
The 20% accuracy-related penalty has a built-in escape hatch for most of its triggers. If the taxpayer had substantial authority for the position, the penalty can be avoided. If the taxpayer acted with reasonable cause and in good faith, the penalty can be avoided. These defenses appear in Sections 6662(d) and 6664(c). They are the reason a taxpayer who relied on a competent advisor, or who took a position supported by real law, can often beat the penalty even after losing on the underlying tax.
This is not a new framework. It has been the structure of the accuracy-related penalty for decades. Taxpayers and their advisors plan around it. The expectation is simple. If you lose the issue but you were reasonable, the penalty should fall away.
How the Economic Substance Penalty Is Different
Now narrow down. In 2010, Congress added a new trigger to the accuracy-related penalty. Section 6662(b)(6) applies the penalty to any underpayment attributable to a transaction that lacks economic substance within the meaning of Section 7701(o). Section 7701(o) is the codified version of the economic substance doctrine, a court-made rule that denies tax benefits to transactions that have no real business purpose beyond tax savings.
Here is the part that catches taxpayers off guard. The economic substance penalty is a strict liability penalty. Section 6664(c)(2) provides that the reasonable cause and good faith defense does not apply to the portion of an underpayment attributable to a transaction lacking economic substance. The substantial authority defense does not save it either. The U.S. Tax Court said as much in this case. Neither defense applies to penalties resulting from the codified economic substance doctrine.
Think about what that means in practice. A taxpayer can hire the best advisors. The taxpayer can get a formal opinion letter. The taxpayer can have a genuine, documented belief that the transaction was proper. None of that matters once a court decides the transaction lacked economic substance. The good faith that defeats an ordinary negligence penalty is irrelevant here. The penalty attaches automatically.
Why Did the Penalty Apply Here?
The taxpayer raised the kinds of arguments that usually work against penalties. He suggested that Congress had encouraged the formation of captives. He pointed to uncertainty in the law when the captives were formed. He argued that he should not be punished for taking a position that seemed defensible at the time. These are the same points a taxpayer might raise in tax litigation over an ordinary penalty.
Those arguments go to substantial authority and to reasonable cause. And for the ordinary accuracy-related penalty, they might have had some traction. But the court explained that those defenses simply do not reach the economic substance penalty. The taxpayer was arguing on a field that the statute had already closed off. The court did consider the defenses for the other penalties at issue, and it found that the taxpayer did not have substantial authority because no prior case supported deducting payments that were not actually made for insurance. But for the economic substance portion, the defenses were beside the point from the start.
Does the Doctrine Apply to Every Transaction?
There is one gate the IRS still has to clear, and it is worth understanding because it is the taxpayer’s best line of defense. The economic substance penalty only applies if the economic substance doctrine is relevant to the transaction in the first place.
This was the heart of the court’s opinion. Section 7701(o) applies, by its own terms, only to a transaction to which the economic substance doctrine is relevant. The statute further says that the determination of whether the doctrine is relevant is made in the same manner as if the subsection had never been enacted. The court read that language to mean what it says. Before the penalty can apply, there must be a separate threshold finding that the doctrine is relevant to the transaction at hand. The court could hardly have been clearer that this relevancy determination is a real and required step, not an afterthought.
So naturally there is an argument here for taxpayers. The economic substance doctrine is not relevant to every transaction. It generally targets transactions that produce tax benefits Congress did not intend. A straightforward business decision that happens to be tax-efficient is not automatically subject to the doctrine. If the IRS cannot first show that the doctrine is relevant, the penalty never gets off the ground. In this case, the court found the doctrine was relevant because the so-called insurance arrangement had no real purpose beyond the tax deduction. But the relevancy gate is where a better-structured transaction might survive.
When Does the Penalty Double to 40%?
The last layer is the rate. Section 6662(i) increases the economic substance penalty from 20% to 40%. The increase applies to any portion of the underpayment attributable to a nondisclosed noneconomic substance transaction. The word that matters is nondisclosed.
A transaction is nondisclosed for this purpose when the relevant facts affecting its tax treatment are not adequately disclosed on the return or in a statement attached to the return. This was the first time the Tax Court squarely addressed what counts as adequate disclosure under this provision. The court explained that disclosure has to be detailed enough to alert the IRS to the nature of the transaction so the agency can decide whether to take a closer look. A vague entry buried in a return does not cut it.
The practical effect is harsh. A taxpayer who claims an aggressive deduction and says nothing extra on the return faces a 40% penalty if the transaction is later found to lack economic substance—and no good faith defense to soften it, by the way. A taxpayer who discloses the same transaction in detail faces 20%. The disclosure does not make the deduction correct. It just cuts the penalty in half. For transactions that carry economic substance risk, that is a meaningful reason to disclose.
The Takeaway
Most tax penalties leave room for a good faith taxpayer to escape. The economic substance penalty does not. Once a court decides a transaction lacked economic substance, the penalty applies as a matter of strict liability. Reasonable cause will not help. Substantial authority will not help. The rate starts at 20% and climbs to 40% if the taxpayer did not adequately disclose the transaction. The lesson from this case is twofold. The IRS must still prove the doctrine is relevant before the penalty applies, so that threshold is worth fighting on. And if you are claiming a deduction that could draw an economic substance challenge, disclose it on the return. Disclosure will not save the deduction. It can cut the penalty in half.