The entrance to the U.S. Tax Court in Washington. Credit: Rex Wholster/Adobe Stock
A U.S. Tax Court judge has ruled that a taxpayer who set up a microcaptive property and casualty insurance arrangement that used an annuity and a life insurance policy as the only investments must add a 40% penalty, not just a 20% penalty, when he pays the Internal Revenue Service back for tax breaks he originally claimed for the years 2012 through 2015.
Curtis Kadau, the president and owner of Surface Engineering & Alloy Co., a manufacturer, said he set up the microcaptive insurance arrangement to provide insurance for his company.
The arrangement "created a cyclical flow of funding," leaving the impression that the microcaptive's investments "were nothing more than a structural shell for Mr. Kadau's estate planning rather than an effective means of investing premiums to hedge against risk," Judge Christian Weiler wrote in a memorandum opinion that announced the ruling.
"We conclude that the microcaptive arrangement lacked a substantial purpose apart from federal income tax effect," the judge said.
Representatives for the taxpayer and the IRS were not immediately available for comment.
What it means: The new ruling could affect the advisors of clients who have used life insurance policies or annuity contracts as funding vehicles for microcaptive insurance arrangements.
Those clients may want to review their microcaptive insurance arrangements with tax attorneys.
The numbers: The IRS does not report revenue from applying the 40% penalty separately, but the U.S. Treasury Department estimated in 2009, when a 30% penalty provision was being discussed, that the 30% penalty provision could raise about $901 million per year by 2019.
The IRS assessed $1.5 billion in accuracy penalties in connection with 595,398 underpayments of all kinds in 2024, according to the latest detailed IRS penalty data available.
The 40% penalty: The new Kadau ruling reflects the impact of the Health Care and Education Reconciliation Act of 2010.
Section 6662(a) of the Internal Revenue Code imposes a 20% penalty when a taxpayer must pay the IRS back for a "tax benefit" that was inaccurate because the taxpayer relied on a transaction "lacking economic substance."
An accuracy penalty provision in HCERA added section 6662(i) to the Internal Revenue Code.
Section 6662(i) imposes a 40% penalty on tax break paybacks that involve some types of arrangements classified as "nondisclosed noneconomic substance transactions."
The 40% penalty may apply when part of a transaction lacks economic substance, and "'the relevant facts affecting the tax treatment are not adequately disclosed in the return nor in a statement attached to the return,'" Weiler wrote in the Kadau ruling, quoting a November 2025 ruling on the case Patel and Patel v. IRS.
The Surface Engineering returns did not disclose the connection the company had with its insurer, did not include a disclosure statement form, and did not include a schedule or other form identifying the connection with the microcaptive arrangement, Weiler wrote.
"Considering the circumstances before us, we determine that petitioners failed to adequately disclose relevant facts or provide sufficient information on their individual returns, and likewise on Surface Engineering's corporate returns, to enable respondent to identify the fact that premiums paid and deducted were part of a microcaptive arrangement," the judge concluded.
The Kadau microcaptive: A microcaptive is a very small insurance company that has just one owner or a small, closely related group of owners.
Kadau started his company in 1996. He and his late wife, Lori Kadau, worked with a financial advisor who recommended the use of a microcaptive arrangement in 2012.
An advisory firm then helped him form a captive insurer, Risk & Asset, in Nevis, a jurisdiction in the Caribbean.
The microcaptive was funded with a $6 million life insurance policy and an annuity, according to a ruling on the case issued in July 2025.
The IRS has been fighting the arrangement in court for years. Weiler ruled in favor of the IRS in the July 2025 ruling in part because of allegations that the premium payments made to the microcaptive were at least 2.5 times higher than the premiums for comparable commercial insurance.
The judge wrote that he believed that the arrangement was designed to maximize the Kadaus' ability to deduct the premiums from their taxes rather than to provide affordable, well-tailored insurance.
The judge postponed a ruling on an IRS request for him to impose the 40% HCERA penalty on some of the cash Kadau would have to pay back.
He said that the 40% section 6662(i) penalty was relatively new and that he needed more time to study the implications.
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