Tax Court Imposes 40% Accuracy-Related Penalties for Captive Insurance Scheme Lacking Economic Substance

The $1M+ Tax Hit: Court Slams Captive Insurance Scheme as Tax Avoidance

The stakes couldn’t have been higher in Jones v. Commissioner, where the U.S. Tax Court delivered a decisive blow to a captive insurance arrangement that cost taxpayers over $1 million in unpaid taxes and penalties. In a sweeping ruling filed September 29, 2026, the court held that the disputed captive insurance transactions lacked economic substance under § 7701(o), triggering 20% or 40% accuracy-related penalties under § 6662(a) and (b)(6). The court explicitly distinguished between penalties for disclosed versus nondisclosed transactions, relying on its recent precedent in Patel v. Commissioner, 165 T.C. 171 (2025), to impose the 40% enhanced penalty on taxpayers who failed to adequately disclose their arrangements.

The stakes were not merely financial—the court’s ruling underscored its willingness to wield the codified economic substance doctrine as a cudgel against abusive tax shelters. By upholding penalties for transactions that failed both the objective and subjective tests of § 7701(o), the Tax Court signaled that it will not defer to taxpayers’ creative structuring when the arrangement’s sole purpose is tax avoidance. The decision also highlighted the court’s power to parse complex financial transactions, dissecting the circular flow of funds and unreasonable premiums that defined the captive insurance scheme. For practitioners and taxpayers alike, the ruling serves as a stark reminder: when the Tax Court deems a transaction devoid of economic reality, the penalties will follow.

The Captive Insurance Charade: How a $1M Deduction Unraveled

The Tax Court’s scrutiny of the Clear Sky Insurance Co. (CSI) captive insurance arrangement began with a single, glaring question: How could a $1 million annual premium deduction possibly reflect real economic substance when the entire structure was designed to generate tax benefits with no meaningful risk transfer? The facts, as later documented in Jones I, T.C. Memo. 2025-25, reveal a carefully orchestrated scheme where premiums flowed in a circular pattern among related entities, claims were nonexistent, and the premiums themselves were priced at levels that defied actuarial logic. The arrangement’s collapse was not a matter of legal interpretation but of financial absurdity—one that the court would later dismantle under the economic substance doctrine codified in Section 7701(o), which requires transactions to have both an objective economic effect and a substantial non-tax purpose.

The story began in 2024, when Sani-Tech West (STW), a California-based manufacturer of industrial cleaning equipment, sought to reduce its tax liability by forming its own insurance company. STW’s owner, David Shor, incorporated CSI in Delaware—a state with favorable captive insurance laws—and appointed Sherry Maxson, STW’s CFO, as its president. Maxson, in turn, relied heavily on Debra Gaglioti, the chief operating officer of Planning Associates (a firm specializing in captive insurance structures), to design the program. The plan was simple: STW would pay premiums to CSI, which would then reinsure the risks with OMNI Insurance Co. (OMNI), a third-party reinsurer. The twist? OMNI would immediately return the premiums—minus a small fee—to CSI, creating a circular flow of funds that left STW with no real insurance protection and CSI with no actual exposure to loss.

The premiums themselves were the most glaring red flag. According to the court’s findings, STW paid CSI between $48 and 63 times the cost of comparable commercial insurance from providers like Hartford. For example, STW’s alleged cyber liability coverage under CSI cost $300,000 annually, while the same coverage from Hartford would have been priced at $4,800 to $6,300. The disparity was even more extreme for other coverages, with CSI’s premiums for supply chain disruption insurance exceeding Hartford’s by a factor of 50x. The justification for these exorbitant rates? STW claimed it had "shopped around" in the traditional market and negotiated down unnecessary coverages, but the court found this argument unpersuasive. As the opinion later noted, the final mix of coverages was dictated not by STW’s needs but by Gaglioti, who tailored the program to hit a "preordained target" of maximizing deductions while minimizing actual risk transfer.

The arrangement’s lack of economic reality extended beyond the premiums. Despite CSI offering 16 different policy coverages, STW submitted zero claims during the one-year period the arrangement was in place. The court would later highlight this as a fatal flaw: if the insurance was real, why were there no losses to cover? The absence of claims was particularly damning given that CSI’s policies were structured as excess coverage, which should have been less expensive than primary insurance. Instead, the premiums were so inflated that even a single claim would have been unlikely to justify the cost.

The circular flow of funds further exposed the scheme’s artificiality. Premiums paid by STW to CSI were immediately funneled to OMNI, which then returned the bulk of the funds—minus a small reinsurance fee—back to CSI. The only leakage in this system was a $10,000 fee paid to OMNI, leaving STW with no meaningful protection and CSI with no actual underwriting risk. The court would later quote the petitioners’ own admission that "Congress did not intend nor would they condone a taxpayer forming and putting funds into a captive where the funds were immediately withdrawn." Yet that is precisely what occurred: STW’s $1 million in premiums were siphoned through CSI and OMNI in a matter of weeks, with no discernible economic benefit other than the tax deduction.

The arrangement’s termination after just one year—despite Shor’s alleged need for cash the following year—only underscored its lack of substance. By December 2024, STW had paid CSI $1.2 million in premiums (for policies covering 2024 and part of 2025), yet the company had not filed a single claim. The lack of claims, combined with the circular funding mechanism, made it clear that the captive was not a genuine insurance company but a tax-avoidance vehicle. The IRS, in its briefing, would later argue that the entire structure was a sham transaction designed solely to generate deductions under Section 162, which allows deductions for ordinary and necessary business expenses. The court, however, would go further, finding that the arrangement failed even the more lenient Section 7701(o) economic substance test, which requires transactions to have both an objective economic effect and a substantial non-tax purpose.

The roles of the key players—Maxson, Gaglioti, and Shor—further revealed the scheme’s artificiality. Maxson, as CSI’s president, had no prior experience in insurance underwriting, yet she was tasked with setting premiums based on Gaglioti’s calculations. Gaglioti, in turn, had a financial incentive to structure the program to maximize deductions, as her firm likely earned fees based on the premium volume. Shor, meanwhile, stood to benefit directly from the tax savings, which he needed to offset losses from other ventures. The court’s later analysis would emphasize that the premiums were not the result of arm’s-length negotiations but of a prearranged structure designed to exploit tax loopholes. As the opinion noted, "we have serious reservations about the reasonableness of premiums developed to hit a preordained target." The lack of independent oversight, the absence of real risk transfer, and the circular flow of funds all pointed to a transaction that existed solely on paper.

The Battle Lines: Petitioners vs. IRS on Economic Substance

The IRS and the petitioners in Jones I, T.C. Memo. 2025-25 (Docket No. 17169-19) clashed over whether the captive insurance arrangement between Shor and Clear Sky Insurance Co. (CSI) had genuine economic substance or was a tax-motivated sham. The dispute centered on whether the transaction satisfied the statutory tests under Section 7701(o), which requires transactions to pass both an objective test (meaningful change in economic position) and a subjective test (substantial non-tax purpose). The IRS argued the arrangement was a circular flow of funds with no real economic impact, while the petitioners claimed it was a legitimate risk-management tool.

The petitioners contended that Shor’s company, STW, had shopped for coverages in the traditional insurance market and negotiated premiums downward by eliminating unnecessary coverages. They relied on Marn Rivelle’s expertise in setting premiums, asserting that Rivelle’s calculations justified the costs. The petitioners also argued that the arrangement served a genuine business purpose, such as insuring "unknown risks" that commercial insurers would not cover. Additionally, they defended the legitimacy of the captive insurance structure, claiming it complied with insurance formalities and transferred real risk.

The IRS, however, dismissed these claims as pretextual. It highlighted the circular flow of funds—where premiums paid by STW to CSI were immediately funneled to OMNI Insurance Co. and then back to CSI—as evidence of a sham transaction with no economic substance. The IRS also challenged the reasonableness of the premiums, noting they were 48 to 63 times more expensive than comparable commercial insurance from Hartford. Despite the high cost, STW submitted no claims during the coverage period, undermining the petitioners’ argument that the premiums were justified by risk transfer.

The IRS further argued that the petitioners’ reliance on Rivelle’s expertise was unconvincing, as the final mix of coverages was dictated by Debra Gaglioti, not Shor or STW. The court later noted that the premiums were "developed to hit a preordained target," suggesting the arrangement was designed solely to maximize tax deductions. The IRS also pointed to Shor’s imminent cash needs the following year as evidence that the transaction’s primary purpose was tax avoidance, not risk management. Finally, the IRS emphasized that the arrangement failed to meet basic insurance formalities, such as demonstrating a realistic possibility of claims or independent oversight.

The Court's Verdict: Why the Captive Insurance Scheme Failed Both Tests

The Tax Court delivered a decisive blow to the petitioners’ captive insurance arrangement, ruling that it failed both the objective and subjective prongs of the economic substance doctrine under § 7701(o). The court’s analysis, grounded in the conjunctive test established in Patel v. Commissioner, 165 T.C. 171 (2025), exposed the arrangement as a sham designed solely to manufacture tax deductions. Judge Lauber, writing for the court in Jones I v. Commissioner, T.C. Memo. 2025-25, at *5, emphasized that the transaction lacked any meaningful economic reality beyond its tax consequences.

The Objective Test: No Meaningful Change in Economic Position

Under § 7701(o)(1)(A), a transaction must result in a “meaningful change in the taxpayer’s economic position other than that arising from the tax benefit achieved by the transaction.” The court applied this standard with surgical precision, dismantling the petitioners’ arguments piece by piece. First, it rejected the notion that the circular flow of funds among related entities—STW, CSI, and OMNI—constituted a substantive economic transaction. The court held that “[a] circular flow of funds among related entities does not indicate a substantive economic transaction for tax purposes,” quoting Merryman v. Commissioner, 873 F.2d 879, 882 (5th Cir. 1989), aff’g T.C. Memo. 1988-72. The arrangement, as the IRS demonstrated, was a closed loop: premiums paid by STW to CSI were immediately funneled to OMNI, then returned to CSI with only “insignificant amounts” leaking out at each stage. The court found that this structure “does not vary, control, or change the flow of economic benefits,” as required by Patel, 165 T.C. at 194.

The petitioners’ attempt to distinguish their case from Patel by claiming they “shopped around” for traditional insurance and negotiated premiums fell flat. The court noted that while STW did purchase some coverage from Hartford, the captive premiums were “between 48 and 63 times as expensive” as comparable commercial policies. This staggering disparity, the court reasoned, could only be justified if the captive generated significantly more claims—a condition that was never met. Despite holding 16 different policy coverages, STW submitted no claims to CSI during the coverage period. The court dismissed the petitioners’ argument that they eliminated unnecessary coverages as “unconvincing,” pointing out that the final mix of coverages was dictated by Debra Gaglioti, a Planning Associates executive, rather than Shor or Maxson. The court concluded that the premiums were “developed to hit a preordained target,” a phrase it borrowed from Caylor Land & Dev., Inc. v. Commissioner, T.C. Memo. 2021-30, at *45–46, to underscore the arrangement’s tax-driven design.

The failure of basic insurance formalities further undermined the petitioners’ position. The court highlighted that some policy lines referenced “nonexistent documents” and commercial policy riders, rendering them unenforceable. Even for the coverages that met documentary requirements, the court questioned whether they could have satisfied any claims, given that OMNI’s reinsurance pool was not insurance at all. The court’s skepticism was palpable: “Aside from a deduction, what STW purchased, if anything, from CSI remains unclear. That is precisely the abuse the objective test seeks to uncover.”

The Subjective Test: No Substantial Nontax Business Purpose

Even if the petitioners had cleared the objective hurdle, the court would have still struck down the arrangement under the subjective test of § 7701(o)(1)(B), which requires a “substantial nontax business purpose” for the transaction. The court’s analysis here was equally damning. It first dismissed the petitioners’ claim that Shor and Maxson discontinued CSI after one year due to genuine concerns about STW’s “unknown” risks. The court found this argument “paradoxical,” noting that the risks CSI purported to insure—such as natural disasters and intellectual property infringement—remained relevant even after STW secured customer agreements. “Surely,” the court wrote, “continued coverage for losses caused by natural disasters remains valuable even after securing the understanding and cooperation of STW’s largest customers,” Jones I, T.C. Memo. 2025-25, at *26–27.

The court also rejected the petitioners’ assertion that Shor and Maxson personally selected the necessary coverages. Internal emails revealed that the critical business decision on coverage mix was made by Gaglioti, not the petitioners. The court found this delegation “telling,” as it suggested that the petitioners’ involvement was limited to signing off on a preordained structure. The court’s skepticism extended to the petitioners’ winding down of CSI, which they claimed was motivated by a desire to slash expenses for a potential sale. The court, however, saw through this rationale, noting that Shor believed STW was worth more than the offers received partly because of the captive insurance expense. The court concluded that the most plausible explanation for terminating CSI was not a reassessment of insurance needs but “Shor’s and Maxson’s desire to maximize its sale price.” The court’s final assessment was unequivocal: “It is similarly clear to us that maximizing shareholder return through tax savings was petitioners’ driving motivation for incorporating CSI.”

Penalties Escalate: 40% for Nondisclosure, 20% for Negligence

The Tax Court’s penalty analysis in Jones v. Commissioner, T.C. Memo. 2026-99, exposes the harsh consequences of failing to disclose abusive tax shelters—and the IRS’s willingness to escalate penalties when taxpayers gamble on "too good to be true" transactions. The court imposed a 40% penalty on most petitioners for nondisclosed captive insurance arrangements and a 20% penalty on the Shors for negligence tied to a constructive dividend. The ruling underscores the Tax Court’s willingness to wield its penalty authority aggressively, particularly when taxpayers hide transactions from scrutiny.

The 20% Penalty for Transactions Lacking Economic Substance (§ 6662(b)(6))

The court first addressed the 20% accuracy-related penalty under § 6662(b)(6), which applies to underpayments attributable to transactions that lack economic substance. The court explained that § 6662(b)(6) is triggered when a transaction fails the codified economic substance doctrine in § 7701(o)—a standard the court has repeatedly applied to captive insurance arrangements. As the court noted, the penalty is mandatory once the transaction is deemed to lack economic substance, with no escape through reasonable cause or good faith.

The IRS conceded that Clear Sky Insurance Co. (CSI)—the captive insurer at the center of the dispute—was not subject to the § 6662(i) 40% enhancement because CSI filed a Form 8886 (Reportable Transaction Disclosure Statement). However, the IRS argued that the remaining petitioners, who failed to disclose the arrangement, were liable for the 20% penalty under § 6662(b)(6). The court agreed, finding that the captive insurance transactions lacked economic substance under § 7701(o) and thus triggered the penalty.

The 40% Enhancement for Nondisclosed Transactions (§ 6662(i))

The court then turned to the 40% penalty enhancement under § 6662(i), which applies when an underpayment is attributable to a "nondisclosed noneconomic substance transaction." The court defined this term as a transaction where "the relevant facts affecting the tax treatment are not adequately disclosed in the return nor in a statement attached to the return." The court cited Patel v. Commissioner, 165 T.C. 171 (2025), for the proposition that mere deduction of "insurance expenses" without details does not constitute adequate disclosure.

The court found that most petitioners failed to disclose the captive insurance arrangement at all. The IRS argued that the petitioners had not filed Form 8886 or provided any meaningful details about the transaction in their returns. The court agreed, noting that the petitioners had simply deducted "insurance expenses" without explaining the nature of the arrangement, the premium calculations, or the risks purportedly insured. The court held that this failure to disclose triggered the 40% penalty enhancement under § 6662(i).

Why Most Petitioners Failed to Adequately Disclose

The court’s analysis revealed that the petitioners’ disclosure failures were not merely technical but fundamental. The IRS pointed out that the petitioners had not:

• Filed Form 8886 (the standard disclosure form for reportable transactions),
• Included any details about the captive insurance arrangement in their tax returns, or
• Provided any actuarial studies, risk assessments, or third-party evaluations to justify the premiums.

Instead, the petitioners had simply claimed deductions for "insurance expenses" without explaining the transaction’s structure, the premium amounts, or the purported risks. The court found this lack of disclosure to be fatal to their penalty defenses, stating:

"Mere declaration of a deduction does not entitle a taxpayer to a reduced penalty... What is critical is whether the taxpayer adequately disclosed enough relevant data concerning the treatment of the item to alert the Commissioner to a potential controversy."

The court cited Accardo v. Commissioner, 942 F.2d 444 (7th Cir. 1991), and Elliott v. Commissioner, T.C. Memo. 1997-294, for the proposition that adequate disclosure requires more than a vague reference to a deduction—it demands specific details about the transaction’s structure and tax treatment.

The IRS’s Concession for CSI

The IRS made a strategic concession in the case of CSI, agreeing that the 40% penalty enhancement did not apply. The court noted that CSI had filed a Form 8886 disclosing the transaction, which the IRS accepted as sufficient. This concession highlights the importance of filing Form 8886 for transactions that could be challenged under the economic substance doctrine. However, the court’s broader holding—that the transaction lacked economic substance—meant that CSI was still subject to the 20% penalty under § 6662(b)(6).

The Shors’ 20% Penalty for Negligence (§ 6662(b)(1) and (2))

The court separately addressed the Shors, who were not subject to the § 6662(b)(6) penalty because the IRS did not argue that their constructive dividend lacked economic substance. Instead, the IRS pursued penalties under § 6662(b)(1) (negligence) and § 6662(b)(2) (substantial understatement). The court found that the Shors were liable for a 20% accuracy-related penalty on these grounds.

The court explained that § 6662(b)(1) applies to underpayments attributable to negligence or disregard of rules or regulations, while § 6662(b)(2) applies to substantial understatements of income tax. The court found that the Shors’ failure to report the constructive dividend as income constituted negligence, noting that the transaction was "too good to be true" and should have raised red flags. The court held:

"The Shors’ failure to report the constructive dividend as income constitutes negligence under § 6662(b)(1). The transaction was structured in a way that should have alerted a reasonable taxpayer to the possibility of tax consequences."

The court also found that the Shors had substantially understated their income tax by failing to report the constructive dividend, triggering the § 6662(b)(2) penalty as an alternative ground.

The Court’s Uncompromising Stance on Penalties

The court’s penalty analysis reflects its willingness to exercise its authority over the IRS by strictly enforcing disclosure requirements and imposing penalties where taxpayers fail to meet their obligations. The court’s holding that mere deduction of expenses without disclosure is insufficient to avoid penalties sends a clear message: Taxpayers cannot hide behind vague deductions when the IRS comes knocking. The court’s willingness to impose the 40% penalty on most petitioners—despite the IRS’s concession for CSI—demonstrates its commitment to deterring abusive tax shelters through aggressive penalty enforcement.

For future taxpayers, the lesson is stark: Disclosure is not optional. Transactions that lack economic substance or involve aggressive tax planning must be fully disclosed to avoid catastrophic penalties. The Tax Court’s ruling in Jones v. Commissioner is a warning shot to taxpayers who gamble on "too good to be true" transactions without proper documentation or disclosure.

The Fallout: What This Means for Captive Insurance and Tax Shelters

The Tax Court’s ruling in Jones v. Commissioner (T.C. Memo. 2025-25) does not merely resolve a single dispute—it reshapes the legal landscape for captive insurance arrangements and other tax shelters by asserting sweeping authority over the IRS’s enforcement discretion. The court’s decision to apply Section 7701(o), the codified economic substance doctrine, to captive insurance transactions signals a new era of judicial skepticism toward arrangements that prioritize tax avoidance over genuine business purpose. By rejecting the Shors’ arguments that their captive insurance company (CSI) served a legitimate risk-management function, the court sent a clear message: transactions lacking economic substance will be dismantled, and taxpayers who rely on circular funding structures or non-arm’s-length negotiations will face severe consequences.

The court’s exercise of authority extends beyond the immediate case. In its opinion, the court explicitly rejected the Shors’ claim that their concerns about STW’s “unknown” risks motivated the captive insurance arrangement, stating: “We are not convinced to change either of our conclusions on the core issues of whether CSI engaged in a legitimate insurance arrangement (it did not) or whether the premiums were negotiated in an arm’s-length transaction (they were not).” This rejection of taxpayer narratives that prioritize tax planning over economic reality underscores the court’s willingness to pierce the veil of form over substance, a power traditionally reserved for the IRS but now wielded by the Tax Court itself. The ruling demonstrates that the court will not defer to taxpayer assertions of business purpose when the transaction’s structure and operation reveal a clear tax-avoidance motive.

For future taxpayers, the court’s emphasis on adequate disclosure cannot be overstated. The decision reinforces that Section 6662(i), which imposes a 40% accuracy-related penalty for nondisclosed noneconomic substance transactions, is not a theoretical threat but a practical reality. The IRS has long used this penalty as a deterrent, but the Tax Court’s ruling in Jones makes it abundantly clear that silence is not an option. Taxpayers who fail to file Form 8886 (Reportable Transaction Disclosure Statement) for captive insurance arrangements—or any transaction that could be challenged under Section 7701(o)—will face automatic penalties that dwarf the original tax benefit. The court’s uncompromising stance on disclosure aligns with the IRS’s aggressive enforcement posture, as evidenced by its 2021 Large Business & International (LB&I) Directive, which prioritized audits of micro-captive insurance arrangements due to their high potential for abuse.

The risks of circular funds and lack of arm’s-length negotiations in captive insurance arrangements have also been laid bare. The court’s finding that the premiums paid to CSI were not negotiated at arm’s length—combined with the minimal claims paid out over the arrangement’s duration—demonstrates that the Tax Court will scrutinize the financial mechanics of these transactions with the same rigor as the IRS. Taxpayers who structure captives as mere conduits for tax deferral, with premiums flowing back to the parent company in the form of loans or distributions, will find little sympathy in court. The decision in Jones serves as a warning that cash flows must reflect genuine risk transfer, not tax-driven shuffling of funds.

The court’s skepticism of taxpayer claims about business purpose—particularly when transactions are terminated for tax reasons—further tightens the noose around abusive tax shelters. The Shors argued that their concerns about STW’s risks justified the captive insurance arrangement, but the court dismissed this as a post-hoc justification. This reasoning echoes prior rulings, such as Avrahami v. Commissioner, where the Tax Court rejected similar claims, and signals that taxpayers cannot retroactively invent a business purpose to justify transactions that were clearly designed for tax avoidance. The court’s refusal to entertain such arguments underscores its commitment to substance over form, a principle that will likely extend to other tax shelters, including syndicated conservation easements and partnership tax strategies.

The potential for similar penalties in other tax shelter cases is now undeniable. The Tax Court’s ruling in Jones creates a blueprint for the IRS to challenge a wide range of transactions under Section 7701(o), from micro-captive insurance arrangements to conservation easements and more. Taxpayers who have relied on aggressive tax planning should expect increased scrutiny, not just from the IRS but from the courts themselves. The court’s willingness to disregard taxpayer narratives and impose penalties based on economic substance—rather than formal compliance—means that the days of “too good to be true” tax strategies are numbered.

For the IRS, the Jones decision is a strategic victory. The court’s endorsement of the IRS’s position on economic substance and penalties validates the agency’s aggressive enforcement tactics, particularly in the captive insurance arena. The IRS’s 2021 LB&I Directive targeting micro-captive arrangements has already led to a surge in audits, and the Tax Court’s ruling will only embolden the agency to double down on these cases. Taxpayers who have not yet unwound their captive insurance arrangements—or who have not properly documented their business purpose—should act swiftly to avoid catastrophic penalties.

The fallout from Jones v. Commissioner is clear: the Tax Court is no longer a passive arbiter of tax disputes but an active enforcer of economic substance. Taxpayers who gamble on aggressive tax planning without genuine business purpose or adequate disclosure will face not only the disallowance of deductions but also crushing penalties that far exceed the original tax benefit. The IRS, armed with the court’s imprimatur, will likely expand its focus to other captive insurance arrangements and tax shelters in the coming years. The message is unambiguous: substance must precede form, and disclosure is non-negotiable.