Loss of deduction and a 40% penalty. Ouch!

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We now rejoin the Kadau microcaptive case already in progress. This case was last discussed in my article, IRS Wins Two More Microcaptive Tax Shelter Cases In Kadau And CFM (Aug. 12, 2025). There, the U.S. Tax Court held that a risk-pooled captive insurance company that made the 831(b) election was not an insurance company for tax law purposes.

In a nutshell, and like nearly all the rest of these microcaptive tax cases, the risk pool was merely a recirculation vehicle without any real risk for the premiums to go from the taxpayer’s operating business back to the taxpayer’s captive, the insurance policies were inadequate and unreasonable, and the insurance premiums were not properly calculated.

What made the Kadau case stand out is that the captive insurance company invested primarily in life insurance policies issued on the taxpayers. This indicated to the tax court that the true purpose the captive arrangement was to dodge taxes, not to provide anything like a true enterprise risk management vehicle which is the entire purpose of a captive arrangement.

When that opinion came out, which is now known as “Kadau I“, the tax court deferred the determination of penalties. Either the 20% inaccuracy penalty or the 40% gross valuation misstatement penalty would apply. In this opinion, which is “Kadau II“, the tax court answers the penalty question.

The tax court noted that the economic substance doctrine has two necessary elements. First, the transaction changes the taxpayer’s economic position in a meaningful way. Second, the taxpayer has a substantial purpose for entering into the transaction, other than federal income tax effects. The prove that a transaction has economic substance, the taxpayer must prove that both elements were present.

As to the first element, the tax court noted that a “circular flow” of funds does not change the taxpayer’s economic position in a meaningful way. Here, the tax court determined that the captive transaction did not change the taxpayer’s economic position. For the first four years, the captive had no claims from the taxpayer’s operating business. When a couple of claims finally materialized, the taxpayer personally acted as the claims adjustor and approved and paid the claims. This was no different than if the taxpayer had put the premiums into a bank account to pay claims.

Moreover, the tax court held that the premium payments were a circular transaction that did little more than funneled those payments right back to the taxpayer. “Mr. Kadau chose and paid for policies with unreasonable premiums which had no legitimate business purpose and were not deductible.” Thus, the captive transaction did not materially change the taxpayer’s economic position.

The next element was whether the captive transaction had a substantial nontax business purpose. The tax court thought not. The premiums charged were not actuarially determined, similar insurance options were available more cheaply on the open insurance market, the premiums were not negotiated at arm’s length, and the taxpayer’s operating business was motivated to pay higher premiums so as to realize greater deductions.

That the captive invested in life insurance also belied a nontax purpose. The life insurance policy was about half of the captive’s investment portfolio and was designed to cover the taxpayer’s mortgages in the event of his death. The other major investment of the captive was an annuity, and tax-free withdrawals from the annuity were used to pay the premiums on the life insurance policy. ” This created a cyclical flow of funding, leaving the impression that Risk & Asset’s investments were nothing more than a structural shell for Mr. Kadau’s estate planning rather than effective means of investing premiums to hedge against risk.”

For all these reasons, the tax court held that captive transaction did not have a substantial nontax business purpose. Thus, both of the elements of the economic substance doctrine failed and the only remaining issue was the penalties to be assessed.

The tax court held that the taxpayer did not make an adequate disclosure of the captive transaction. None of the tax returns filed by the underlying business indicated the connection to the captive transaction.

The tax court then assessed the 40% lack of economic substance penalty for tax years 2012 through 2015, and the 20% accuracy-related penalties for tax years 2016 and 2017.

ANALYSIS

My article, Life Insurance and the 831(b) Captive Insurance Company – Wait For The Test Case Before Signing Up (April 20, 2014), and similar articles warned that the use of life insurance inside microcaptives was bound to come to grief. Twelve years later, this case illustrates why.

A captive insurance company, large or small, is an enterprise risk management tool. In this role, the captive takes in premiums against the enterprise’s future claims and sets aside reserves to pay those claims. The premium amounts paid should roughly match up to the amount of the anticipated claims plus the expenses of the captive. Because all of these reserves are used to back the payment of future claims, they need to be kept relatively liquid.

Life insurance is not a liquid asset. Although one may borrow against the cash value of a life insurance policy, that typically will operate to kill the policy and thus destroy its value. Thus, life insurance is not the type of asset that is suitable for a captive. That then belies that the captive insurance company is a bona fide enterprise risk management tool but is instead a tax shelter. Thus, a microcaptive that has life insurance as its primary investment is basically dead-on-arrival at the U.S. Tax Court.

Life insurance was not, of course, the only reason the captive arrangement here resulted in the 40% penalties. As discussed in my previous article about this case, the captive was a total mess and really just a captive in name only. The only real question is why the taxpayer in this case decided to appeal, since there was basically no chance of winning against the IRS.

In retrospect, the taxpayer should have just paid the back taxes and penalties and moved on.