Updated November 13 to add discussion of threshold relevancy determination

The Internal Revenue Service (IRS) and the Department of the Treasury have issued Rev. Proc. 2025-31 to provide a safe harbor for trusts seeking to engage in the staking of digital assets while maintaining their favorable classification as investment trusts under § 301.7701-4(c) and as grantor trusts for Federal income tax purposes. This procedure addresses the critical question of whether staking activities constitute a "business" enterprise or grant the trust a prohibited "power to vary the investment," either of which could lead to reclassification as an association taxable as a corporation.

Purpose of Relief

The relief granted is a definitive safe harbor: provided all specified requirements are met, the authorization and resulting staking of digital assets will not prevent the trust from qualifying as an investment trust under § 301.7701-4(c) and as a grantor trust. Furthermore, the Revenue Procedure provides a limited window, beginning on November 10, 2025, for existing trusts to amend their governing instruments to authorize staking in accordance with the safe harbor requirements without jeopardizing their status.

Factual Background: Digital Assets and Proof-of-Stake

Digital assets, defined as digital representations of value recorded on a cryptographically secured distributed ledger or similar technology (under section 6045(g)(3)(D) of the Code), are generally treated as property for Federal income tax purposes. This procedure focuses exclusively on digital assets whose transactions are carried out on a permissionless network utilizing a proof-of-stake consensus mechanism.

The proof-of-stake mechanism requires validator node operators to commit or "stake" digital assets to become eligible to validate new blocks of data and update the network’s blockchain. While staked, these digital assets are "locked up" and nontransferable for a period specified by the protocol. The need for this activity stems from the requirement to maintain the security and integrity of the blockchain, specifically by preventing a single party or group from controlling a majority of the total staked assets, which could allow manipulation (e.g., "double spending"). Staking is thus incentivized through "rewards," which are newly minted digital assets and/or fees paid by parties seeking to add transactions to the blockchain. Conversely, a validator failing to act in accordance with the consensus mechanism may face a penalty known as "slashing," resulting in the forfeiture of some staked units.

Trusts typically participate in staking through custodial staking, where a third-party custodian takes custody of the assets and facilitates staking with one or more staking providers.

IRS Legal Analysis and Rationale for Relief

The relief is needed because the classification of a state-law trust for Federal income tax purposes is governed by Regulation § 301.7701-4. An entity recognized for Federal tax purposes that is not properly classified as a trust is considered a "business entity".

Trust vs. Business Entity

An arrangement is treated as a trust if its purpose is to vest in trustees the responsibility to protect or conserve property for beneficiaries who are not associates in a joint enterprise for the conduct of business for profit. Conversely, arrangements created as a device to carry on a profit-making business are classified as business or commercial trusts, which are not taxed as trusts but rather as associations (e.g., corporations or partnerships).

The Prohibited Power to Vary Investments

Crucially, an investment trust holding assets with a single class of ownership interests must satisfy the requirement under § 301.7701-4(c) that there is no power under the trust agreement to vary the investments of the certificate holders.

A power to vary investments exists where the trust instrument grants a managerial power enabling the trust to take advantage of variations in the market to improve the investments of certificate holders. This principle was established in Comm’r v. North American Bond Trust, 122 F.2d 545 (2d Cir. 1941), cert. denied, 314 U.S. 701 (1942).

The IRS reviewed prior rulings to distinguish between activities of protection/conservation and activities that constitute a prohibited managerial power:

No Power to Vary: If the trustee is limited to short-term, fixed-return investments (e.g., short-term U.S. obligations or CDs) that eliminate the opportunity to profit from market fluctuations, the power to invest is not considered a power to vary the trust’s investment (Rev. Rul. 75-192, 1975-1 C.B. 384). Likewise, the power to consent to changes in credit support for debt obligations to maintain the value of trust property by preserving the credit rating of bonds is not a power to vary (Rev. Rul. 90-63, 1990-2 C.B. 270).
Business or Managerial Activity: Trusts whose trustees possess broad powers, such as purchasing and selling real estate, erecting structures, making improvements, and borrowing money, are classified as associations taxable as corporations (Rev. Rul. 78-371, 1978-2 C.B. 344).

Grantor Trust Status

A person treated as the owner of an undivided fractional interest in a trust under Subpart E of Part I, Subchapter J of Chapter 1 of the Code (sections 671 and following), is considered to own the trust assets attributable to that interest for Federal income tax purposes (Rev. Rul. 88-103, 1988-2 C.B. 304; Rev. Rul. 85-13, 1985-1 C.B. 184). Section 671 provides for the inclusion of the trust’s income, deductions, and credits in the computation of the owner’s taxable income. Section 677(a) treats the grantor as the owner if the income may be distributed or accumulated for the grantor without the consent of an adverse party.

Application of Law and the Safe Harbor Requirements

The safe harbor allows trusts to stake digital assets only if the activity aligns with the purpose of protecting and conserving property and explicitly prohibits the trust from exercising a power to vary investments.

Essential Requirements for Investment Trust Status

To qualify under the safe harbor, the trust must satisfy the following technical requirements outlined in Section 6.02:

Asset Limitation: The trust may own only cash and units of a single type of digital asset, provided transactions are carried out on a proof-of-stake permissionless network.
Purpose of Staking: The staking activity must primarily serve to protect and conserve trust property by mitigating the risk that an external party could control a majority of staked assets and reduce the value of the trust’s holdings.
Prohibition on Managerial Power: The trust agreement must explicitly prohibit the trust from seeking to take advantage of variations in the market to improve investments, including variations based on the value of the digital assets or the amount of staking rewards.
Limited Activities: Permitted activities are highly restricted, primarily revolving around the issuance and redemption of trust interests (accepting deposits, distributing assets/cash), paying expenses (including selling assets for cash to cover expenses), holding assets, and directing staking.
Custody and Control: A custodian must hold the digital assets at addresses under its control. Only the custodian may access the private keys to effect a sale, transfer, or exercise ownership rights. Crucially, the trust must retain ownership of the digital assets for Federal income tax purposes even while they are staked.
Arm’s Length Staking Arrangement: The trust/sponsor must be unrelated to the staking provider, and the trust must direct staking through custodians. The allocation of staking rewards must be an arm’s length allocation independent of the provider’s or custodian’s expenses. The trust, custodian, and sponsor are prohibited from directing or controlling the staking provider’s activities, except to direct staking/unstaking.
Indemnification: The trust’s digital assets must be indemnified from slashing penalties resulting from the activities of staking providers, underscoring the conservation purpose.
Rewards Distribution: The only new assets received from staking must be additional units of the single type of digital asset held by the trust. Staking rewards, net of expenses, must be distributed in-kind or sold for cash and the proceeds distributed to interest holders on a periodic basis, no less frequently than quarterly.

Compliance with Securities Regulation and Liquidity

A significant component of the safe harbor involves external regulatory compliance, ensuring the trust’s operations do not resemble an active business venture divorced from investor protection:

Exchange Trading: Interests in the trust must be traded on a national securities exchange, and the trust’s activities must comply with SEC regulations and rules. Required public disclosure regarding staking must have been reviewed and approved by the SEC.
Liquidity Risk Management: The trust must maintain written liquidity risk policies and procedures that comply with the rules of the national securities exchange. These policies are designed to ensure the trust can meet redemption requests, especially considering that staked assets are "locked up".
Liquidity Reserve: To comply with exchange rules that assets be readily available, the trust may stake less than all its digital assets to create and maintain a liquidity reserve. This reserve must be based solely on factors related to meeting redemption requests within the required period.
Contingent Liquidity Arrangement: The trust may enter into a contingent liquidity arrangement (e.g., a lending facility or an arrangement to sell/purchase assets) to mitigate adverse liquidity events that might otherwise prevent the distribution of assets or cash for redemptions.

The requirement that the trust adhere to strict liquidity policies mandated by the national securities exchange ensures that management decisions regarding staking and unstaking are driven by fiduciary duties related to conservation and meeting investor redemptions, rather than market timing to maximize profit, thereby supporting the classification as an investment trust.

Effective Date

Rev. Proc. 2025-31 is effective for tax years ending on or after November 10, 2025.

Note: No inferences should be drawn from this Revenue Procedure regarding other Federal income tax consequences, including whether income attributable to staking would be treated as income effectively connected with a U.S. trade or business or as unrelated business taxable income.

Prepared with assistance from NotebookLM.

Examining Penalties in Microcaptive Transactions: Patel v. Commissioner

Sunil S. Patel and Laurie McAnally Patel, et al. v. Commissioner of Internal Revenue, 165 T.C. No. 10, November 12, 2025

The United States Tax Court, in Sunil S. Patel and Laurie McAnally Patel, et al. v. Commissioner of Internal Revenue, 165 T.C. No. 10 (2025), addressed the imposition of accuracy-related penalties following its determination in Patel v. Commissioner, T.C. Memo. 2024-34 (Patel II), that amounts paid to purported captive insurance companies Magellan and Plymouth, and to the reinsurer Capstone Reinsurance Co., Ltd. (Capstone), were not insurance premiums for federal income tax purposes. This Opinion specifically resolves the remaining issue: whether Petitioners (Ps) are liable for various accuracy-related penalties under I.R.C. § 6662(a), including penalties predicated on the codified economic substance doctrine under I.R.C. § 7701(o). The relevant tax years at issue are 2013, 2014, 2015, and 2016.

Factual Background and Transaction Structure

Dr. Patel, who possesses extensive education, including a Ph.D. in immunology and an M.D., and describes himself as a "savvy financial person," decided to form a captive insurance company based on self-study and his goals of aggressive growth and wealth accumulation. Dr. Patel subsequently formed Magellan Insurance Co. (Magellan) and, later, Plymouth Insurance Co. (Plymouth), a second microcaptive, even after receiving warnings about heightened IRS scrutiny of captives and realizing that his accountant had been contacted by the IRS regarding Magellan.

The structure of the arrangement included several key characteristics that undermined their validity as insurance for tax purposes:

Premium Pricing for Deduction: Premium pricing was developed to facilitate favorable income tax treatment, not for business purposes. Dr. Patel provided target premiums that aimed for the maximum deductible amount allowed under I.R.C. § 831(b) (which was $1.2 million, later increased to $2.2 million). The actuary, Allen Rosenbach, was flexible and changed premium amounts when requested.
Lack of Business Rationale: No feasibility study was conducted to determine the necessity, costs, or merits of a captive arrangement for Dr. Patel’s businesses, nor did anyone explore the cost and availability of comparable policies in the commercial market.
Circular Flow of Funds: Magellan and Plymouth participated in a purported risk pool through Capstone, which utilized a Reinsurance Agreement and a Quota Share Retrocession Agreement creating a circular flow of funds. Money paid by Dr. Patel’s operating entities (OST, ICR, and SCR) to the captives flowed to Capstone and then a significant percentage flowed back to the captives.
Commercial Coverage Maintained: Dr. Patel continued to purchase commercial insurance coverage for his entities, covering many of the same risks as the captive policies, despite professing an inherent distrust of commercial insurance. His businesses paid over $4.5 million in premiums to the microcaptives, while commercial premiums ranged only between approximately $68,000 and $106,000 per year.

Taxpayer’s Request for Relief and Penalties at Issue

The Commissioner disallowed the deductions for insurance expenses and determined the Patels were liable for accuracy-related penalties. The accuracy-related penalties remaining at issue, after court rulings and respondent concessions regarding supervisory approval under I.R.C. § 6751(b), included:

Year	Penalties at Issue
2013	I.R.C. § 6662(b)(1) (Negligence)
2014	I.R.C. § 6662(b)(1), (b)(2), (b)(6), and (i)
2015	I.R.C. § 6662(b)(1), (b)(2), (b)(6), and (i)
2016	I.R.C. § 6662(b)(1), (b)(2), and (b)(6)

Because the Commissioner asserted the economic substance doctrine as a new ground for disallowance and asserted the I.R.C. § 6662(i) increased penalties for the first time in an Answer, the Commissioner bore the full burden of proof on those specific issues.

Court’s Analysis: Codified Economic Substance Doctrine

I.R.C. § 6662(a) imposes a 20% penalty on the portion of an underpayment attributable to the disallowance of claimed tax benefits due to a transaction lacking economic substance within the meaning of I.R.C. § 7701(o).

Relevancy Determination under I.R.C. § 7701(o)

The court first addressed a statutory interpretation issue, concluding that I.R.C. § 7701(o) requires a relevancy determination before the two-part economic substance test is applied. I.R.C. § 7701(o)(5)(C) dictates that the determination of whether the economic substance doctrine is relevant must be made in the same manner as if the statute had never been enacted.

Note that this holding is at odds with the holding of the US District Court for the District of Colorado in Liberty Global, Inc. v. United States, Case No. 1:20-cv-03501, decided on October 31, 2023 and now on appeal before the Tenth Circuit. The District Court had held that there was no relevancy determination. We’ll discuss why the Tax Court unanimously disagreed with that holding at the end of this article.

Reviewing common law, the court noted that the economic substance doctrine is clearly relevant in cases involving insurance transactions and, specifically, captive insurance. Citing the precedent in Malone & Hyde, Inc., & Subs. v. Commissioner, 62 F.3d 835 (6th Cir. 1995), the court confirmed that the doctrine applies to captive arrangements.

The Patels argued the doctrine should not apply because the microcaptive structure was "Congressionally induced" or incentivized by I.R.C. § 831(b). The court rejected this, noting that the inducement cited was the tax treatment of small insurers, but the issue at hand was the deductibility of premiums under I.R.C. § 162 for purported insurance that was found not to be insurance in Patel II. The court concluded the doctrine was relevant to these cases.

The Two-Part Conjunctive Test

Once relevancy is established, a transaction is treated as having economic substance only if it satisfies both the objective and subjective tests set forth in I.R.C. § 7701(o)(1):

Objective Test (Change in Economic Position): The transaction must change in a meaningful way (apart from Federal income tax effects) the taxpayer’s economic position.
Subjective Test (Substantial Purpose): The taxpayer must have a substantial purpose (apart from Federal income tax effects) for entering into the transaction.

Application of the Law to the Facts

Objective Test Failure

The court determined that the microcaptive arrangement failed the objective test, as the transactions did not meaningfully change the Patels’ economic position. Relying on Southgate Master Fund, L.L.C. ex rel. Montgomery Cap. Advisors, LLC v. United States, 659 F.3d 466, 481 (5th Cir. 2011), the court held the transactions failed because they did not "vary[,] control[,] or change the flow of economic benefits". The evidence of the circular flow of funds via Capstone, the excessive premiums paid to the captives ($4.5 million versus roughly $100,000 for commercial coverage), and the continued maintenance of commercial insurance coverage confirmed that no meaningful change in economic position occurred aside from federal tax effects.

Subjective Test Failure

The Patels also failed to demonstrate a substantial non-tax business purpose. The evidence overwhelmingly showed that Dr. Patel orchestrated the captives to maximize income tax deductions. Premiums were set not by actuarial principles, but by the target maximum deductible amount specified by Dr. Patel himself. Emails confirmed that the purpose of forming the captives was related to Dr. Patel being an "MD paying almost 2.5M in income taxes" and seeking to reduce those taxes.

The court concluded that the Patels entered into the microcaptive transactions to reduce their federal income tax bill, not for any legitimate business purpose. Since the transactions failed both the objective and subjective tests, the court held that the claimed tax benefits were disallowed "by reason of" a transaction lacking economic substance within the meaning of I.R.C. § 7701(o).

Increased Penalty for Nondisclosure

The court addressed the imposition of the I.R.C. § 6662(i) increased penalty, which raises the rate from 20% to 40% for any underpayment attributable to a nondisclosed noneconomic substance transaction. Under I.R.C. § 6662(i)(2), a transaction is considered "nondisclosed" if the relevant facts affecting the tax treatment are not adequately disclosed in the return or an attached statement.

Adequate disclosure is a factual question requiring the taxpayer to provide sufficient information to alert the Commissioner to a potential controversy. The court found that the Patels did not adequately disclose the relevant facts on their 2014 and 2015 returns. Specifically, they failed to disclose: (1) the flow of funds to himself and his family through intermediary entities; (2) the identities and relationships of all involved entities and promoters (e.g., CIC Services, Mr. Sean King, and Mr. Coomes); (3) the method of premium calculation; or (4) the Capstone pooling arrangement.

Consequently, the court sustained the Commissioner’s increased rate penalty under I.R.C. § 6662(i) for the 2014 and 2015 taxable years.

Alternative Penalty Determinations

As alternative grounds, and as the primary ground for 2013 where I.R.C. § 6662(b)(6) did not apply due to prior procedural rulings, the court also sustained penalties for negligence and substantial understatement.

Negligence or Disregard of Rules or Regulations

Negligence, under I.R.C. § 6662(b)(1), includes any failure to make a reasonable attempt to comply with the Code. The court determined that Dr. Patel, despite his high education and financial sophistication, was negligent by failing to question or investigate whether it was proper to drastically reduce his tax liabilities through what should have seemed like a "too good to be true" transaction. His decision to form a second captive after being warned of IRS scrutiny further supported the finding of negligence.

Substantial Understatements

An understatement is substantial if it exceeds the greater of $5,000 or 10% of the tax required to be shown on the return (I.R.C. § 6662(d)(1)(A)). The understatements for 2014, 2015, and 2016 substantially exceeded the 10% threshold in each year. The court thus sustained the I.R.C. § 6662(b)(2) penalties.

Defenses to Accuracy-Related Penalties

Substantial Authority

The court found that the Patels did not have substantial authority for their deductions, as this is an objective standard based on the law and facts. While the Patels cited precedent regarding captive insurance, the court reiterated that no prior captive case supported deductions for payments that were not, in fact, insurance. The cited authority merely suggested a captive arrangement can exist if the requirements of insurance are met, which the Patels’ arrangement was not designed to meet.

Reasonable Cause and Good Faith

The defense of reasonable cause and good faith under I.R.C. § 6664(c)(1) does not apply to penalties attributable to the codified economic substance doctrine (I.R.C. § 6662(b)(6) and (i)). For the remaining penalties, the Patels had the burden of proof to show they exercised ordinary business care and prudence.

Reliance on an adviser is a component of this defense, but the reliance must be on a competent, independent professional who is provided necessary and accurate information. The court found that Dr. Patel could not reasonably rely on Mr. Coomes or Mr. Sean King/CIC Services because they were "promoters" of the transactions—meaning they structured, designed, and profited from the microcaptive arrangements.

Furthermore, considering Dr. Patel’s own high level of education and his self-professed financial savvy, he should have recognized the tax-avoidance nature of the transaction as too good to be true. The Patels therefore failed to meet their burden of proving reasonable cause and good faith.

Conclusion

The Tax Court sustained the Commissioner’s determinations regarding the codified economic substance doctrine penalties under I.R.C. § 6662(a) and (b)(6) for tax years 2014 through 2016, as well as the increased rate penalty under I.R.C. § 6662(i) for 2014 and 2015. The court also sustained the remaining accuracy-related penalties (negligence and substantial understatement) for 2013 and as alternative grounds for the subsequent years.

The judgment reaffirms that the codified economic substance doctrine requires the application of the two-part test (objective economic change and subjective substantial purpose) where the doctrine is relevant, and that abusive microcaptive transactions—characterized by circular funds, tax-driven premium pricing, and a lack of true risk distribution—will fail this test.

Analogy to solidify understanding: The Patels’ microcaptive scheme, when viewed through the lens of economic substance, resembled a financial closed loop pretending to be an open market. It was like trying to satisfy a homeowner’s insurance requirement by paying premiums into a piggy bank controlled by the homeowner, where the deposits were capped only by the maximum tax-deductible limit. While the piggy bank (the captive) had a name, and the "premium" was deposited, the funds ultimately circulated back to the owner’s benefit (via wealth accumulation or estate planning) without genuinely transferring risk outside the economic family unit. The Tax Court recognized that, absent true business justification or objective economic change, the primary function of this loop was simply to manufacture a deductible expense.

The Threshold Relevancy Determination Requirement

As noted previously, the Tax Court’s reported decision is directly at odds with the holding in the 2023 case of Liberty Global, Inc. The reasons the Tax Court gave for agreeing with the taxpayer in this case that there had to be a threshold determination, as well as why ultimately that did not help the taxpayer, is discussed below.

Necessity of a Relevancy Determination under Section 7701(o)

The court held that the codified economic substance doctrine requires a relevancy determination within the meaning of Internal Revenue Code (I.R.C.) § 7701(o).

Statutory Text Analysis: The court concluded that the necessity for a relevancy determination was clear on the face of the statute.
- Section 7701(o)(1) conditions the application of the doctrine on specific circumstances, stating it applies only "[i]n the case of any transaction to which the economic substance doctrine is relevant".
- Section 7701(o)(5) expressly directs the court to make this determination and explains how to make it: "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".
Relevancy vs. Two-Part Test: The court clarified that the relevancy determination is not coextensive with the two-part test (objective change in economic position and subjective substantial purpose) outlined in Section 7701(o)(1)(A) and (B). Conflating the relevancy requirement with the two-part test would deprive the statute’s reference to relevance of independent meaning, which courts generally seek to avoid.
Legislative History: Legislative history confirms this interpretation, stating that the codified doctrine "does not change current law standards in determining when to utilize an economic substance analysis," ensuring it is not intended to apply to every transaction.

Why the Transaction Met the Relevancy Test

The court determined that the economic substance doctrine was relevant in the Patels’ cases.

Since Congress directed courts to determine relevancy as if the statute had never been enacted (i.e., by applying common law standards), the court looked to existing jurisprudence regarding similar arrangements.

Precedent in Insurance Transactions: The court noted that the economic substance doctrine had been applied in various contexts, including captive insurance transactions, over the previous 90 years.
Application of Malone & Hyde: The court relied heavily on the precedent set in Malone & Hyde, Inc., & Subs. v. Commissioner, describing it as the "closest case to those before us".
- In Malone & Hyde, the Sixth Circuit required the Tax Court to determine first "whether [the taxpayer] created [the Bermuda subsidiary] for a legitimate business purpose or whether the captive was in fact a sham corporation".
- The Malone & Hyde ruling held that a transaction is not "otherwise bona fide" if the deduction is achieved through the use of an undercapitalized foreign insurance captive that is "propped-up by guarantees of the parent corporation". Payments to such a sham captive would not constitute bona fide business expenses deductible under Section 162(a).
Drawing Parallels: The court stated that the parallels between Malone & Hyde and the Patels’ microcaptive transactions (Magellan and Plymouth) "are easy to draw," and the court perceived "no mitigating factors" that would argue for a different approach.
Rejection of "Congressionally Induced" Argument: The Patels argued that the economic substance doctrine should not apply because they engaged in a purported "Congressionally induced" transaction, citing the favorable tax treatment of small insurers under Section 831(b). The court rejected this argument, noting that the economic substance doctrine already applies to insurance arrangements. Crucially, the court had already concluded in a prior opinion (Patel II) that the deducted payments did not constitute insurance for federal tax purposes, and the Patels failed to show any congressional inducement to claim deductions for premiums paid for purported insurance that was not, in fact, insurance.

Therefore, based on established common law concerning captive insurance arrangements, the court concluded that the economic substance doctrine was relevant to the Patels’ transactions.

Prepared with assistance from NotebookLM.