The economic substance doctrine was codified in the Internal Revenue Code by the enactment of Code Section 7701(o) as part of the Health Care and Education Reconciliation Act of 2010. Code Section 7701(o) provides in relevant part:

“In the case of any transaction to which the economic substance doctrine is relevant, such transaction shall be treated as having economic substance only if – (A) the transaction changes in a meaningful way (apart from Federal income tax effects) the taxpayer’s economic position, and (B) the taxpayer has a substantial purpose (apart from Federal income tax effects) for entering into such transaction. . . . The term ‘economic substance doctrine’ means the common law doctrine under which tax benefits under subtitle A with respect to a transaction are not allowable if the transaction does not have economic substance or lacks a business purpose. . . . The determination of whether the economic substance doctrine is relevant to a transaction shall be made in the same manner as if this subsection had never been enacted”.

Patel v. Commissioner, 165 T.C. No. 10 (2025)

A recent case, decided by the United States Tax Court, that provides important authority regarding the application of the economic substance doctrine under Code Section 7701(o) is Patel v. Commissioner, 165 T.C. No. 10 (2025).

The key facts of the Patel case are as follows:

• Taxpayer Dr. Sunil Patel claimed deductions for amounts paid in connection with certain captive insurance companies. A captive insurance company generally is a company established to handle all or part of the insurance needs of the company’s shareholders or their affiliates;
• The Internal Revenue Service challenged these deductions, and, in a prior case, also decided by the United States Tax Court, Patel v. Commissioner, T.C. Memo 2024-34 (2024), the taxpayer’s captive insurance company deductions were disallowed; and
• The 2025 Patel case, which is the subject of this article, involved “accuracy-related” penalties applied by the Internal Revenue Service based on the taxpayer’s disallowed captive insurance company deductions. Code Section 6662(b)(6) provides a 20% penalty to “any underpayment which is attributable to . . . [a]ny disallowance of claimed tax benefits by reason of a transaction lacking economic substance (within the meaning of section 7701(o)) or failing to meet the requirements of any similar rule of law” (increased to a 40% penalty by Code Section 6662(i)(1) for “any portion of an underpayment which is attributable to one or more nondisclosed noneconomic substance transactions”).

In a unanimous, reviewed decision in the Patel case on November 12, 2025, the Tax Court first considered the term, “relevant”, under Code Section 7701(o). The Tax Court stated:

“This is the Court’s first opportunity to examine when the codified economic substance doctrine applies. Section 6662(b)(6) applies the accuracy-related penalty to any disallowance of claimed tax benefits by reason of a transaction lacking economic substance within the meaning of section 7701(o). . . . [S]ection 7701(o)(1) requires application of the economic substance doctrine ‘[i]n the case of any transaction to which the economic substance doctrine is relevant.’ (Emphasis added.) We will first address whether section 7701(o) requires a relevancy determination. . . .

The text before us is section 7701(o), which states in no uncertain terms that it applies to ‘transaction[s] to which the economic substance doctrine is relevant.’ [Section] 7701(o)(1). It further states that ‘[t]he determination of whether the economic substance doctrine is relevant to a transaction shall be made in the same manner as if this subsection had never been enacted.’ [Section] 7701(o)(5).

Faced with these provisions, we easily conclude that the statute requires a relevancy determination. To put it plainly–the statute says so, right there, on its face. First, section 7701(o)(1) signals that a determination is required by conditioning application of the doctrine on certain circumstances–namely, the doctrine applies if there is a transaction to which it is relevant. Next, section 7701(o)(5) expressly directs us to make the determination (whether the doctrine is relevant) and, if that were not enough, the same provision explains how to make the determination (as if the statute had never been enacted). In short, Congress could hardly have been clearer, at least on this narrow point.

This same text tells us that the relevancy determination is not coextensive with the two-part test set forth in section 7701(o)(1)(A) and (B). . . . Congress specifically provided in the introductory sentence of section 7701(o)(1) that the two-part test applies only ‘[i]n the case of any transaction to which the economic substance doctrine is relevant.’ Conflating the relevancy determination with the two-part test would ignore that direction and deprive the statute’s reference to relevance of independent meaning”.

Having concluded that a “relevancy determination” is required under Code Section 7701(o), the Tax Court in the Patel case next examined “the content of that requirement. There too Congress has answered the question by directing courts to the existing application of the doctrine”. The Tax Court continued, “[T]he economic substance doctrine has developed over the last 90 years. Our survey of caselaw revealed a variety of circumstances in which the doctrine has been applied. This includes, as relevant here, cases involving insurance transactions and, in particular, captive insurance transactions. See Malone & Hyde, Inc., & Subs. v. Commissioner, 62 F.3d 835 (6th Cir. 1995) (captive insurance), rev’g and remanding T.C. Memo. 1993-585”. The Tax Court focused on the Malone & Hyde case and stated:

“The parallels between Malone & Hyde and the cases before us are easy to draw. And we perceive no mitigating factors in these cases that would argue for a different approach from the one we and the courts of appeals have previously taken. Therefore, heeding Congress’s direction that we proceed in the same manner as if section 7701(o) had never been enacted–to determine whether the economic substance doctrine is relevant to a transaction–we conclude that the doctrine is relevant to these cases. . . . [T]he relevancy question is answered in the affirmative”.

The Tax Court in the Patel case then concluded that (1) the taxpayer’s captive insurance company transactions did not have economic substance under the two-part “economic substance doctrine” test of Code Section 7701(o)(1)(A) (“we hold that the transactions at issue did not meaningfully change the Patels’ economic position, aside from federal tax effects”) and (B) (“we cannot conclude that the Patels had a ‘substantial purpose’ for the transaction apart from federal income tax effects”), and (2) as the taxpayer’s captive insurance company transactions thereby were “transaction[s] lacking economic substance (within the meaning of section 7701(o))”, the taxpayer was subject to “accuracy-related” penalties pursuant to Code Section 6662(b)(6) (increased pursuant to Code Section 6662(i)) (as well as other “negligence and substantial understatement of income tax” penalties).

While these conclusions are important, it has been commented that the key aspect of the Tax Court’s decision in the Patel case as future authority may be how the Tax Court addressed the issue of the term, “relevant”, under Code Section 7701(o). The Patel case is authority that a “relevancy determination” should be completed first before the two-part “economic substance doctrine” test of Code Section 7701(o)(1)(A) and (B) is analyzed. As such, the “relevancy determination” can limit the scope of the economic substance doctrine under Code Section 7701(o); if the economic substance doctrine with respect to any transaction is not “relevant”, such transaction will not be subject to scrutiny under the economic substance doctrine under Code Section 7701(o).

The critical point is that not all transactions (specifically, transactions that are not “relevant”) are subject to scrutiny under the economic substance doctrine under Code Section 7701(o). This point was made in the Tax Court’s decision in the Patel case when it discussed the legislative history of Code Section 7701(o). The Tax Court stated:

“[T]he House report made clear that the economic substance doctrine does not apply to every transaction. . . . The House report stated that the codified economic substance doctrine applies ‘in the case of any transaction to which the economic substance doctrine is relevant’ and that ‘[t]he determination of whether the economic substance doctrine is relevant to a transaction shall be made in the same manner as if the provision had never been enacted.’ . . . The House report also confirms that ‘the provision does not change current law standards in determining when to utilize an economic substance analysis.’ . . . (emphasis added). Thus, the legislative history confirms that the codified economic substance doctrine is not intended to apply to every transaction and may be applied only when it is ‘relevant.’”

The Tax Court also referenced (without specifically listing) “a nonexhaustive list of transactions to which the doctrine does not apply” from the above-cited “House report” (“Report of the Committee on the Budget House of Representatives to Accompany H.R. 4872”, H.R. Rep. 111-443 (Volume 1, Division 1)). As additional helpful authority, this “House report” (on page 296) states, “The provision is not intended to alter the tax treatment of certain basic business transactions that, under longstanding judicial and administrative practice are respected, merely because the choice between meaningful economic alternatives is largely or entirely based on comparative tax advantages. Among . . . these basic transactions are (1) the choice between capitalizing a business enterprise with debt or equity; . . . (2) a U.S. person’s choice between utilizing a foreign corporation or a domestic corporation to make a foreign investment; . . . (3) the choice to enter a transaction or series of transactions that constitute a corporate organization or reorganization under subchapter C; . . . and (4) the choice to utilize a related-party entity in a transaction, provided that the arm’s length standard of section 482 and other applicable concepts are satisfied”.

In addition to serving as future authority that a “relevancy determination” should be completed first before the two-part “economic substance doctrine” test of Code Section 7701(o)(1)(A) and (B) is analyzed, the Tax Court’s opinion in the Patel case also could serve as future authority for how the “relevancy determination” should be completed. In the Patel case, the Tax Court essentially looked to see if the economic substance doctrine was “relevant” in prior cases similar to the Patel case; finding the Malone & Hyde case as a similar case in which the economic substance doctrine was “relevant”, the Tax Court held that the economic substance doctrine also was “relevant” in the Patel case.

An important question is how a ”relevancy determination” should be made for a transaction when there is no prior case law or other authority considering whether the economic substance doctrine should be “relevant” to such transaction. As the Patel case does not address this question, it will be interesting to follow how other cases answer this question in the future.

If you have any questions concerning the Patel case or the meaning of “relevant” under the economic substance doctrine, please discuss these issues with your advisers.

Note – The “$100,000 Payment” Rule for H-1B Visas

The H-1B nonimmigrant visa has been used by U.S. employers to hire foreign workers to work in the United States. However, the potential use of the H-1B visa was adversely affected when President Donald Trump issued a Proclamation, “Restriction on Entry of Certain Nonimmigrant Workers”, on September 19, 2025. As described in this Proclamation, and in subsequent releases from U.S. Citizenship and Immigration Services on September 21, 2025 and October 20, 2025, a $100,000 payment will now be a requirement of certain H-1B visa petitions. This “$100,000 payment” rule is applicable to new (and not renewal) H-1B visa petitions filed on or after September 21, 2025. In addition, there is an exception (although described by the U.S. Citizenship and Immigration Services as an “extraordinarily rare circumstance”) available to the “$100,000 payment” rule if the foreign worker’s presence in the United States as an H-1B visa worker is in the “national interest”, no American worker is available to fill the role to be taken by the foreign worker, the foreign worker does not pose a threat to the security or welfare of the United States, and requiring the petitioning U.S. employer to make the $100,000 payment on behalf of the foreign worker would significantly undermine the interests of the United States. If applicable, the $100,000 payment (which is to be made using pay.gov) is to made prior to filing of the H-1B visa petition. As at least two lawsuits have already been filed to challenge the “$100,000 payment” rule, it is uncertain whether the “$100,000 payment” rule will have long-term applicability. However, in the interim, until all litigation is fully resolved, U.S. employers relying on H-1B visa workers as part of their labor force will need to consider the “$100,000 payment” rule in making their hiring decisions.

If you have any questions concerning the “$100,000 payment” rule or H-1B visa petitions, please discuss these issues with your advisers.

If you wish to discuss any of the above, find Pen Pal Gary’s contact info here.

Disclaimer: please note that nothing in this article is intended to be, or should be relied on as, legal advice of any kind. Neither LHBR Consulting, LLC nor Gary Stern provides legal services of any kind.