More on the Economic Substance Doctrine (ESD) and Relevancy in § 7701(o) (5/5/26)

In Kadau v. Commissioner, T.C. Memo. 2026-37 (5/5/26), referred to as Kadau II, TC Case # 286-21 here at #216; GS here [to come], the Court held that the taxpayer’s microcaptive insurance arrangement failed under the Economic Substance Doctrine (“ESD”) in § 7701(o) and was subject to the 40% penalty in § 6662(b)(6) and (i). Given the facts in Kadau II and its earlier opinion in Kadau v. Commissioner, T.C. Memo. 2025-81 (referred to as Kadau I), at # 198 and GS here, the result is not surprising. The arrangement was smoke and mirrors to appear as a transaction with magic tax benefits.

Kadau II drew my attention because of its discussion of § 7701(o)’s requirement that the common law ESD be “relevant.” § 7701(o)(1) & (o)(5)(C). I have written on this issue before. See Liberty Global's Tax Scam Fails in Tenth Circuit (Federal Tax Procedure Blog 4/30/26), here; The Economic Substance Doctrine ("ESD")--the Common Law and § 7701(o) (Federal Tax Procedure Blog 3/31/26; 4/8/26), here; and Tax Court in Unanimous Reviewed Opinion Interprets and Applies the Accuracy-Related Economic Substance Penalty (Federal Tax Procedure Blog 11/12/25), here. I thought this might be a good point to offer further thoughts on § 7701(o) and the requirement that the common law ESD be “relevant.” (Actually, anticipating a theme below, my thoughts today may be a clarification of my earlier thoughts.)

Section § 7701(o), titled “Clarification,” states the general prongs of the common law ESD requirement—meaningful economic position effect and substantial nontax purpose. § 7701(o)(1). Then, in the balance of § 7701(o), some specific rules for applying the ESD are provided, such as that the nontax profit potential “be substantial in relation to the expected value of the net tax benefits that would be allowed if the transaction were respected.” § 7701(o)(2)(A). Those in the tax world for some time know precisely why that “clarification” was there—to foreclose taxpayer arguments that remote, unlikely profit potentials could still meet that prong of the common law ESD.

Kadau II addresses the term “relevant” in § 7701(o). Kadau II accepted the holding in Patel v. Commissioner, 165 T.C. ___, No. 10 (11/12/25) (reviewed unanimous) that § 7701(o) requires that the common law ESD must be “relevant” before § 7701(o) can apply. The Court in Kadau II did not need to address that predicate requirement because petitioners in briefing said (p. 4, emphasis supplied):

As the Court held in Patel III, a threshold determination must be made as to whether the economic substance doctrine is relevant. Because Petitioners formed a small captive insurance company, Petitioners acknowledge that section 7701(o) is applicable. The dispositive question is whether Petitioners’ transactions satisfy its requirements. Accordingly, we refrain from addressing any threshold determination issues and proceed directly to examination of the transaction by applying the foregoing elements outlined in section 7701(o)(1).

There has been a lot of commotion about that issue (discussed in my earlier blogs linked above), apparently because some imagine that the taxpayer can escape the clutch of § 7701(o) and the increased accuracy related penalty if the IRS cannot show that the common law ESD (without the clarification in § 7701(o)) is “relevant,” a requirement that § 7701(o)(5)(C) requires be made “be made in the same manner as if this subsection had never been enacted.”

As I read and try to make sense of § 7701(o)’s relevancy requirement, it serves to foreclose a taxpayer argument that the specifics of § 7701(o) (such as how the profit potential is determined) could be avoided by arguing that the common law ESD does not apply. In other words, the taxpayer may argue that, under the general profit potential test of the common law ESD, long-shot profit potentials foreclosed by § 7701(o)(1) could still apply to avoid the common law ESD. Hence, had § 7701(o) required that the common law ESD actually apply as a predicate to § 7701(o), the taxpayer could argue that long-shot, remote profit potentials could prevent the common law ESD from applying, thereby avoiding § 7701(o)’s foreclosure of such positions. In effect, requiring the actual application of the common law ESD might defeat the purpose of § 7701(o). By using the term “relevant,” Congress foreclosed the possibility that taxpayers would assert such spurious profit potentials as defeating the § 7701(o) application altogether. I have no idea whether that explanation was the legislative intent, but that is the only explanation that makes sense.

Thus, § 7701(o) may mean that, except for that predicate test of relevancy, the common law ESD is incorporated in § 7701(o), so that ESD is now codified (rather than just clarified). Another option is that the common law ESD continues independent of § 7701(o) and is just "clarified" so that, where the special rules of § 7701(o) apply, the common law ESD must include those special rules. If this latter interpretation is correct, that means that (i) the common law ESD can still change with circumstances as is often the case with common law rules or doctrines and (ii) the evolving common law ESD will permit § 7701(o) and the penalty provisions to apply to the evolving ESD.