Other 200842049: Inactive reinsurance program no longer qualified as an insurer

Plain-English summary

A state-created nonprofit reinsurance program had previously received exemption under § 501(c)(15), but no carriers participated during the examined years. It collected no premiums, issued or reinsured no policies, paid no claims, and maintained no reserves, while its only income came from investments. The IRS concluded that it was not operating as an insurance company because insurance was not its primary business and there was no risk shifting or risk distribution. Its activities had materially changed since exemption was granted, so the IRS denied protection from retroactive revocation under § 7805(b). Even if treated as an insurer, the organization had no premium income and therefore failed both premium-percentage tests in § 501(c)(15). It also could not use § 831(b) retroactively because it had never made the required election.

Ruling snapshot

• Question: Did an inactive reinsurance program remain exempt under § 501(c)(15), and could it avoid retroactive revocation or use § 831(b)?
• Outcome: Revocation. It was not operating as an insurer and independently failed the premium-percentage requirements.
• Key authorities: IRC §§ 501(c)(15), 816, 831, 7805(b); Treas. Reg. §§ 1.801-3(a)(1), 301.7805-1(b), 301.9100-8; Notice 2006-42

Full text (IRS public release)

DEPARTMENT OF THE TREASURY
INTERNAL REVENUE SERVICE
1100 Commerce Street
Dallas, TX 75242

TAX EXEMPT AND

GOVERNMENT ENTITIES February 19, 2008
DIVISION

UIL: 501.15-00

Release Number: 200842049

Release Date: 10/17/08 XX = Date Address = address

Legend

ORG = Organization name Taxpayer Identification Number:
Form:

ORG Tax Year(s) Ended:

ADDRESS Person to Contact/ID Number:
Contact Numbers:
Telephone:
Fax:

Dear

We have enclosed a copy of our report of examination explaining why we believe an
adjustment of your organization’s exempt status is necessary.

We have also enclosed Publication 892, Exempt Organization Appeal Procedures for
Unagreed Issues, and Publication 3498, The Examination Process. These publications
include information on your rights as a taxpayer, including administrative appeal
procedures within the Internal Revenue Service.

If you request a conference with Appeals, we will forward your written statement of
protest to the Appeals Office, and they will contact you. For your convenience, an
envelope is enclosed. If you and Appeals do not agree on some or all of the issues
after your Appeals conference, the Appeals Office will advise you of its final decision

If you elect not to request Appeals consideration but instead accept our findings, please
sign and return the enclosed Form 6018-A, Consent to Proposed Adverse Action. We
will then send you a final letter modifying or revoking your exempt status under I.R.C. §
501(c)(15). If we do not hear from you within 30 days from the date of this letter, we will
process your case on the basis of the recommendations shown in the report of
examination and send a final letter advising of our determination.

In either situation outlined in the paragraph above (execution of Form 6018-A or failure
to respond within 30 days), you are required to file federal income tax returns for the tax
period(s) shown above, for all years still open under the statute of limitations, and for all
later years. File the federal tax return for the tax period(s) shown above with this agent
within 60 days from the date of this letter, unless a request for an extension of time is
granted. File returns for later tax years with the appropriate service center indicated in

the instructions for those returns.

You have the right to contact the office of the Taxpayer Advocate. Taxpayer Advocate
assistance is not a substitute for established IRS procedures, such as the formal
appeals process. The Taxpayer Advocate cannot reverse a legally correct tax
determination, or extend the time fixed by law that you have to file a petition in a United
States court. The Taxpayer Advocate can, however, see that a tax matter that may not
have been resolved through normal channels gets prompt and proper handling. You
may call toll-free 1-877-777-4778 and ask for Taxpayer Advocate Assistance.

If you have any questions, please call the contact person at the telephone number
shown in the heading of this letter. If you write, please provide a telephone number and
the most convenient time to call if we need to contact you.

Thank you for your cooperation.

Sincerely,

Marsha A. Ramirez
Director, EO Examinations

Enclosures:
Publication 892
Publication 3498
Form 6018-A

Report of Examination
Envelope

Form 886A Department of the Treasury - Internal Revenue Service Schedule No. or Exhibit

Explanation of Items

Name of Taxpayer Year/Period Ended
ORG December 31, 20XX
December 31, 20XX
LEGEND
ORG = Organization name XX = Date XYZ = State motto = motto
ORG-Plan = Organization plan
ISSUES

1. Does ORG qualify as an insurance company under Internal Revenue Code Section

501(c)(15), for the years beginning January 1, 20XX?

2. If ORG does not qualify as an insurance company under Internal Revenue Code Section
501(c)(15), can ORG rely on the determination letter granted by the Service allowing it to
claim tax exempt status pursuant to Internal Revenue Code Section 501(c)(15)?

3. If ORG can not rely on the determination letter granted by the Service allowing it to claim
tax exempt status pursuant to Internal Revenue Code Section 501(c)(15), is it entitled to
relief under Internal Revenue Code Section 7805(b)?

4. If ORG can not rely on the determination letter granted by the Service allowing it to claim
tax exempt status pursuant to under Internal Revenue Code Section 501(c)(15), what is
the effective date of the revocation?

5. If ORG can not rely on the determination letter granted by the Service allowing it to
claim tax exempt status pursuant to Internal Revenue Code Section 501(c)(15), based on
the facts that it does not meet the requirements of an insurance company under Internal
Revenue Code Section 501(c)(15), what are the tax consequences?

6. If ORG does qualify as an insurance company under Internal Revenue Code Section
501(c)(15), does it meet the other requirements under Internal Revenue Code Section
501(c)(15) for tax exemption?

7. If ORG does not meet the other qualifications under Internal Revenue Code Section
501(c)(15), can ORG rely on the determination letter granted by the Service allowing it to
claim tax exempt status pursuant to Internal Revenue Code Section 501(c)(15)?

8. If ORG does not meet the other qualifications under Internal Revenue Code Section
501(c)(15), is it entitled to file an election under IRC 831(b) and be taxed only on its
investment income?

9. If ORG can not rely on the determination letter granted by the Service allowing it to claim
tax exempt status pursuant to Internal Revenue Code Section 501(c)(15), based on the
facts that it does not meet the requirements of Internal Revenue Code Section 501(c)(15),
what are the tax consequences for years beginning January 1, 20XX?

Form 886-A (Rev.4-68) Department of the Treasury - Internal Revenue Service

Page: -1-

Form 886A Department of the Treasury - Internal Revenue Service Schedule No. or Exhibit
Explanation of Items

Name of Taxpayer Year/Period Ended
ORG December 31, 20XX
December 31, 20XX
FACTS
ORG (ORG) was formed in the State of XYZ through Title _, Insurance Code, Insurance
Chapter  ; Motto. The purpose and intent of Chapter are to promote the
availability of motto coverage to employers regardless of their status or

experience, to prevent abusive rating practices, to require disclosure of rating practices to
purchasers, to establish rules regarding renewability of coverage, to establish limitations on the

use of exclusions, to provide for the development of “basic” and “standard”

plans to be offered to all employers, to provide for establishment of a
reinsurance program, and to improve the overall fairness and efficiency of the group motto
market.

Section _of Chapter _, creates a nonprofit entity to be known as the ORG. The Program
shall operate subject to the supervision and control of the board. The board shall consist of 9
members, all appointed by the State of XYZ.

A Plan of Operation for the organization was secured from the Taxpayer during the examination.
The Plan stated that the Program shall be known as the ORG, a nonprofit entity created pursuant
to et seq. (ORG-Plan). The Plan also provided the definition of membership to be all
reinsuring carriers, as defined in licensed to transact motto in XYZ that offers a

benefit plan. All Reinsuring Carriers shall maintain membership in the Program as a
condition of doing motto business or being able to offer subscriber contracts, in XYZ. It also
stated the purpose of the Program as it is stated in Chapter _, as explained above.

ORG did not provide a copy of their exemption letter during the examination. Based on the
Service’s records, tax exempt status under Internal Revenue Code (IRC) 501(c)(15) was granted

in March of 19XX.

The Form 990 filed by ORG for the year ended December 31, 20XX was selected for
examination, to determine whether the organization remains qualified under IRC 501(c)(15).
The Code section was modified starting in 20XX, adding new limitations and requirements for
qualification.

In response to the Information Document Request (IDR) issued with original letter, the
organization stated that there were no Carriers that were participating in the program at the
present time. The only income that was received was investment income.

In review of the documents received from ORG, it was verified that the only income received
was from investment income. Only investment income was reported on the Form 900.

Form 886-A (Rev.4-68) Department of the Treasury - Internal Revenue Service
Page: -2-


Form 886 A Department of the Treasury - Internal Revenue Service Schedule No. or Exhibit
Explanation of Items

Name of Taxpayer Year/Period Ended
ORG December 31, 20XX

December 31, 20XX

It was decided to expand the examination to include the Form 990 for the year ended December
31, 20XX. A copy of the Form 990 was secured and that also showed only investment income.
There was no premium income reported on the return either.

A breakdown of the two years can be seen in the chart below:

ORG 20XX 20XX

Premiums Earned

Other Investment Income

Total Gross Receipts

Percentage- Gross Premium/Reinsurance Income to Gross Receipts

During both years there were no claims filed or paid. There were no participants to file any
claims. Only expenses incurred during both years included bank fees and administrative fees.
No reserves were maintained since there were no potential claims to be filed or to be paid.

As stated above, ORG was formed in the state of XYZ so a 953(d) election to be considered a
domestic organization for tax purpose was not filed or applicable.

An election under IRC 831(b) has never been filed. As of the writing of this report, there has
never been a filing of the election, either with the filing of the Forms 990 or separately.

LAW AND ANALYSIS

1. Does ORG qualify as an insurance company under Internal Revenue Code Section
501(c)(15), for the years beginning January 1, 20XX?

As stated above, ORG has had no participants in the program during the years under
examination. No premiums have been collected, no claims have been filed or payments made,
no reserves maintained. The only activity being conducted by ORG is the maintaining of
investment accounts and receiving investment income from those accounts. .

Neither I.R.C. 501(c)(15) nor its corresponding regulations define an “insurance company.”
Subchapter L of the Code (I.R.C. sections 801-848), however, addresses the taxation of insurance
companies. The term “insurance company” has the same meaning under section 501(c)(15) as it
does in Subchapter L. See H. Conf. Rep. No. 99-841, 99th Cong., 2nd Sess. (Vol. I) 370-71,
reprinted in 1986-3 (Vol. 4) C.B. 370-71.

Form 886-A (Rev.4-68) Department of the Treasury - Internal Revenue Service
Page: -3-

Form 886A Department of the Treasury - Internal Revenue Service Schedule No. or Exhibit
Explanation of Items

Name of Taxpayer Year/Period Ended
ORG December 31, 20XX

December 31, 20XX

I.R.C. section 816 (formally I.R.C. section 801) defines a life insurance company. As part of this
definition, I.R.C. section 816 provides, “the term ‘insurance company’ means any company more
than half of the business of which during the taxable year is the issuing of insurance or annuity
contracts or the reinsuring of risks underwritten by insurance companies.”

Treas. Reg. section 1.801-3(a)(1) defines an insurance company as,

A company whose primary and predominant business activity during the taxable year is the
issuing of insurance or annuity contracts or the reinsuring of risks underwritten by insurance
companies. Thus, though its name, charter powers, and subjection to State insurance laws are
significant in determining the business which a company is authorized and intends to carry on, it
is the character of the business actually done in the taxable year which determines whether a
company is taxable as an insurance company under the Internal Revenue Code.

In this case, ORG’S primary and predominant business activity is not the issuing of insurance or
annuity contracts or the reinsuring of risks underwritten by insurance companies. ORG is not
involved in either of these two activities. Its sole purpose right now is to collect investment
income from the investment accounts.

Another aspect to consider in this case is that there is no insurance contract that provides both
risk shifting and risk distribution. In AMERCO & Subsidiaries, 96 T.C. 18 (1991), a case
affirmed by the 9th Circuit, the Tax Court adopted a three-part test The three parts consist of; (1)
Is the risk an insurance risk?; (2) Is there risk shifting and risk distribution?; and (3) Is there
insurance in its generally accepted sense?

Neither the Internal Revenue Code nor the Regulations specifically define the term “insurance
contract.” The courts have generally required that a transaction involve both risk shifting (from
the insured’s perspective) and risk distribution (from the insurer’s perspective) in order to be
characterized as insurance. Helvering v. LeGierse, 312 U.S. 531, 539 (1941); Gulf Oil Corp. v.
Commissioner, 914 F.2d 396, 411 (3rd Cir. 1990).

Risk shifting occurs when a person facing the possibility of a loss transfers some or all of the
financial consequences of the loss to the insurer. Rev. Rul. 88-72, 1988-2 C.B. 31, clarified by
Rev. Rul. 89-61, 1989-1 C.B. 75. The risk transferred pursuant to an insurance contract must be
a risk of economic loss. Allied Fidelity Corp. v. Commissioner, 66 T.C. 1068 (1976), aff'd., 572
F.2d 1190 (7th Cir. 1978), cert. denied, 439 U.S. 835 (1978).

It is exam’s position that risk distribution requires both a distribution of exposure units and a
distribution of a pool of premiums. In addressing distribution courts have focused on one or the
other, but no case has address both.

Form 886-A (Rev.4-68) Department of the Treasury - Internal Revenue Service
Page: -4-


Form 886A Department of the Treasury - Internal Revenue Service Schedule No. or Exhibit
Explanation of Items

Name of Taxpayer Year/Period Ended
ORG December 31, 20XX

December 31, 20XX

Risk distribution of exposure units refers to the operation of the statistical phenomenon known as
the “the law of large numbers.” When additional statistically independent risk exposure units are
insured, although the potential total losses increase, there is also an increase in the predictability
of average loss. This increase in the predictability of the average loss decreases the amount of
the capital that an insurance company needs per risk unit to remain at a given solvency level. See
Rev. Rul. 89-61, 1989-1 C.B. 75.

The Courts have not spent a great deal of time explaining what they mean by risk distribution.
No court has squarely held that there can be no risk distribution if there is only one, or a few,
insureds. A fair reading of the court opinions addressing the issue, however, supports the IRS’s
position. See Barnes Vv. United States, 801 F.2d 984, 985 (7th Cir. 1986) (“Risk distributing is the
spreading of the risk of loss among the participants in an insurance program.”). See also,
Commissioner v. Treganowan, 183 F.2d 288 , 291 (2nd Cir. 1950). Such spreading is effectuated
by pooling among unrelated insureds. “ [Rl]isk distribution means that the party assuming the
risk distributes his potential liability, in part, among others.” Beech Aircraft Corp. v. United
States, 797 F.2d 920, 922 (10th Cir. 1986). Risk distribution is accomplished where the risk is
distributed among insureds other than the entity that incurred the loss. See Ross v. Odem, 401
F.2d 464 (5th Cir. 1968).

The Sixth Circuit touched on the issue of risk distribution in Humana, Inc. v. Commissioner, 881
F.2d 247, 257 (6th Cir. 1989), noting that there was adequate risk distribution, “where the captive
insures several separate corporations within an affiliated group and losses can be spread among
the several distinct corporate entities.” The Ninth Circuit has also measured risk distribution by
explaining, “[iJnsuring many independent risks in return for numerous premiums serves to
distribute risk. By assuming numerous relatively small, independent risks that occur randomly
over time, the insurer smoothes out losses to match more closely its receipt of premiums.”
Clougherty Packing Co. v. Commissioner, 811 F.2d 1297, 1300 (9th Cir. 1987)

ORG does not issue or reinsure any policies. Its only activity is collecting investment income
from their investment accounts. There is no risk shifting and risk distribution with ORG because
ORG has no insurance policies.

Also, to show that ORG is not an insurance company is the lack of reserves to pay claims, and
the payment of claims themselves. ORG has no reserves to pay any claims. There are no
participants in the program so there is no need to have reserves.

Therefore, it is of the Service’s position that ORG does not qualify as an insurance company
under IRC 501(c)(15). To qualify for tax exempt status under IRC 501(c)(15), an organization
must be operating as an insurance company.

2. If ORG does not qualify as an insurance company under Internal Revenue Code
Section 501(c)(15), can ORG rely on the determination letter granted by the Service

Form 886-A (Rev.4-68) Department of the Treasury - Internal Revenue Service
Page: -5-


Form 886 A Department of the Treasury - Internal Revenue Service Schedule No. or Exhibit
Explanation of Items

Name of Taxpayer Year/Period Ended
ORG December 31, 20XX

December 31, 20XX

allowing it to claim tax exempt status pursuant to Internal Revenue Code Section
501(c)(15)?

To qualify for tax exempt status under IRC 501(c)(15), an organization must be operating as an
insurance company. Since ORG does not qualify as an insurance company it does not qualify for
tax exempt status under IRC 501(c)(15), therefore it can not rely on the determination letter
granted by the Service allowing it to claim tax exempt status pursuant to IRC 501(c)(15). The
organization’s tax exemption should be revoked for years beginning January 1, 20XX.

3. If ORG can not rely on the determination letter granted by the Service allowing it to
claim tax exempt status pursuant to Internal Revenue Code Section 501(c)(15), is it
entitled to relief under Internal Revenue Code Section 7805(b)?

An organization may ordinarily rely on a favorable determination letter received from the Internal
Revenue Service. Regulations 1.501(a)-1(a)(2); Rev. Proc. 2005-4, 14.02 (cross-referencing
13.01 et seq.) 2005-4 C.B. 128. An organization may not rely on a favorable determination
letter, however, if the organization omitted or misstated a material fact, in its application or in
supporting documents. In addition, an organization may not rely on a favorable determination if
there is a material change, inconsistent with exemption, in the organization’s character, purposes,
or methods of operation after the determination letter is issued. Regulations 601.201 (n)(3)(i);
Rev. Proc. 90-27, 13.02, 1990-1 C.B. 514. Any such changes must be reported to the Service so
that continuing recognition of exempt status can be evaluated.

The Commissioner may revoke a favorable determination letter for good cause. Regulations
1.501(a)-1(a)(2). A favorable determination letter may be revoked by written notice to the
organization to whom the determination originally was issued. Regulations 601.201(m) (cross-
referencing Reg. 601.201(1)); Rev. Proc. 90-27, 14, 1990-1 C.B. 514, 518.

If the Commissioner revokes the tax exempt status of an organization, the remaining question is
whether the revocation should be applied prospectively or retroactively. Generally, revocation of
a determination letter is prospective. Rev. Proc. 2007-4, 14.02 (cross-referencing 13.01 et seq.).
Revocation of a determination letter may, however, be retroactive if the organization omitted or
misstated a material fact or operated in a manner materially different from that originally
represented. Regulations 601.201 (n)(6)(i); Rev. Proc. 90-27, 14.01; Rev. Proc. 2007-4 14.02
(cross-referencing 13.01 et seq.).

In cases where the organization omitted or misstated a material fact, revocation may be
retroactive to all open years under the statute. Regulations 601.201(I)(1). In cases where
revocation is due to a material change, inconsistent with exempt status, in the character, the
purpose, or the method of operation, revocation will ordinarily take effect as of the date of the
material change. Regulations 601 .201(n)(6)(i); Rev. Proc. 90-27. In any event, revocation will

Form 886-A (Rev.4-68) Department of the Treasury - Internal Revenue Service
Page: -6-


Form 886 A Department of the Treasury - Internal Revenue Service Schedule No. or Exhibit
Explanation of Items

Year/Period Ended
December 31, 20XX
December 31, 20XX

Name of Taxpayer
ORG

ordinarily take effect no later than the time at which the organization received written notice that
its exemption ruling or determination letter might be revoked. Regulations 601.201(n)(6)(i).

Under certain circumstances, however, the Commissioner may, in his discretion grant relief from
retroactive revocation under I.R.C. 7805(b) of the Code. Section 7805(b)(8) of the Internal

Revenue Code provides:

APPLICATION TO RULINGS. The Secretary may prescribe the extent, if any, to which
any ruling (including any judicial decision or any administrative determination other than
by regulation) relating to the internal revenue laws, shall be applied without retroactive
effect. Section 301.7805-1(b) of the regulations delegates authority grated by I.R.C.
7805(b) to the Commissioner (or the Commissioner’s delegate).

To request I.R.C. 7805(b) relief, the organization must submit a statement in support of this
application of I.R.C. 7805(b), as described in Rev. Proc. 2005-4, 14.02. See also Rev. Proc.
2005-5, 19. The organization’s statement must expressly assert that the request is being made
pursuant to I.R.C. 7805(b). The organization’s statement must also indicate the relief requested
and give reasons and arguments in support of the relief requested. It must also be accompanied
by any documents bearing on the request. The organization’s explanation and arguments should
discuss the five factors bearing on retroactivity listed in Rev. Proc. 2005-4, 14.02(1) (cross-
referencing 13.05), as they relate to the situation at issue. These five items are, in effect, the
same as the factors provided in Regulations 601.201(1)(5) and 601.201(m), Statement of

Procedural Rules, which states:

Except in rare or unusual circumstances, the revocation or modification of a ruling will
not be applied retroactively with respect to the taxpayer to whom the ruling was originally
issued or to a taxpayer whose tax liability was directly involved in such a ruling if:

1. there has been no misstatement or omission of material facts,

2. the facts at the time of the transaction are not materially different from the facts on
which the [determination letter] was based;

3. there has been no change in applicable law,

4. the [determination letter] was originally issued for a proposed transaction; and

5, the taxpayer directly involved in the {determination letter] acted in good faith in
reliance upon the [determination letter] and revoking or modifying the
{determination letter] retroactively would be to the taxpayer’s determinant.

If relief is granted under I.R.C. 7805(b), the effective date of revocation of a determination letter
is no later than the date on which the organization first received written notice that its exemption
might be revoked. Regulations 601.201(n)(6)(i); Virginia Education Fund v. Commissioner, 85
T.C. 743, 7522-3 (1985), aff'd 799 F.2d 903 (4th Cir. 1986). This does not preclude the effective
date of revocation being earlier than the date on which the organization first received written

Form 886-A (Rev.4-68) Department of the Treasury - Internal Revenue Service
Page: -7-

eee

Form 886A Department of the Treasury - Internal Revenue Service Schedule No. or Exhibit
Explanation of Items

Name of Taxpayer Year/Period Ended
ORG December 31, 20XX

December 31, 20XX

notice that its exemption might be revoked. Virginia Education Fund v. Commissioner, 85 T.C.
at 753.

The Supreme Court has held that the Commissioner has broad discretion under I.R.C. 7805(b)
(and its predecessor) in deciding whether to revoke a ruling retroactively. Automobile Club of
Michigan v. Commissioner, 353 U.S. 180, 184 (1957). See also Dixon v. United States, 381
U.S. 68, 74-75 (1965). The Commissioner’s determination is reviewable by the courts only for
abuse of that discretion. Virginia Education Fund v. Commissioner, 85 T.C. 743, 752 (1985).

It is the Service’s position that the activities of the organization have changed dramatically
compared to the organizing documents above. If the organization would seek exemption now,
based on its current activities, there is a very high probability it would not receive a
determination letter from the Service granting tax exempt status under IRC 501(c)(15). The
insurance activities that were conducted when the organization applied for exemption are no
longer being conducted.

Therefore, it is appropriate for the Commissioner to NOT grant relief from retroactive revocation
of ORG’s determination letter.

4. If ORG can not rely on the determination letter granted by the Service allowing it to
claim tax exempt status pursuant to under Internal Revenue Code Section
501(c)(15), what is the effective date of the revocation?

ORG is not entitled to relief under I.R.C. 7805(b). The effective date of revocation should be for
years beginning January 1, 20XX. This is the first year under examination.

5. If ORG can not rely on the determination letter granted by the Service allowing it to
claim tax exempt status pursuant to Internal Revenue Code Section 501(c)(15),
based on the facts that it does not meet the requirements of an insurance company
under Internal Revenue Code Section 501(c)(15), what are the tax consequences?

Since ORG’s tax exempt status should be revoked for years beginning January 1, 20XX, ORG
would be responsible for filing Forms 1120 for years beginning January 1, 20XX.

6. If ORG does qualify as an insurance company under Internal Revenue Code Section
501(c)(15), does it meet the other requirements under Internal Revenue Code
Section 501(c)(15) for tax exemption?

If for some reason ORG is considered an insurance company under IRC 501(c)(15), then the
question is whether ORG meets the other requirements to qualify under IRC 501(c)(15).

Form 886-A (Rev.4-68) Department of the Treasury - Internal Revenue Service
Page: -8-

a

Form 886A Department of the Treasury - Internal Revenue Service Schedule No. or Exhibit
Explanation of Items

Name of Taxpayer Year/Period Ended
ORG December 31, 20XX

December 31, 20XX

Internal Revenue Code section 501(c)(15)(A) exempts from Federal income tax insurance
companies (as defined in section 816(a)) other than life (including interinsurers and reciprocal
underwriters) if-

(i.) (I) the gross receipts for the taxable year do not exceed $600,000, and
(II) more than 50 percent of such gross receipts consist of premiums, or

(ii.) in the case of a mutual insurance company-
(I) the gross receipts of which for the taxable year do not exceed $150,000 and,
(II) more than 35 percent of such gross receipts consist of premiums.

Clause (ii) shall not apply to a company if any employee of the company, or a member of the
employee’s family (as defined in section 2032(A)(e)(2), is an employee of another company
exempt from taxation by reason of this paragraph (or would be so exempt but for this sentence).

Sec. 206, Clarification of Exemption from Tax for Small Property and Casualty Insurance
Companies, of the Pension Funding Equity Act of 2004, P.L. 108-218, amended section
501(c)(15)(A) to change the definition of small property and casualty insurance companies
(insurance companies other than life insurance companies) exempt from income taxes to: (1)a
company whose gross receipts for the taxable year do not exceed $600,000, and over half such
gross receipts consist of premiums (currently, whose net written premiums (or, if greater, direct
written premiums) for the taxable year do not exceed $350,000); or (2) a mutual insurance
company (a) whose gross receipts for the taxable year do not exceed $150,000 and more than 35
percent of which consist of premiums and (b) none of whose employees (or member of the
employee’s family) is an employee of another company exempt from tax under section
501(c)(15). These changes were applicable after December 31, 2003.

Notice 2006-42, IRB, 2006-19 provides guidance as to the meaning of “gross receipts” for
purposes of section 501(c)(15)(A) of the Internal Revenue Code. This notice advises taxpayers
that the Service will include amounts received from the following sources during the taxable year
in “gross receipts” for purposes of § 501(c)(15)(A):
A. Premiums (including deposits and assessments), without reduction for return premiums or
premiums paid for reinsurance;

B. Items described in § 834(b) (gross investment income of a non-life insurance company);
and

C. Other items that are properly included in the taxpayer’s gross income under subchapter B
of chapter 1; subtitle A, of the Code.

Thus, gross receipts include both tax-free interest and the gain (but not the entire amount
realized) from the sale or exchange of capital assets, because those items are described in

Form 886-A (Rev.4-68) Department of the Treasury - Internal Revenue Service
Page: -9-


Form 886A Department of the Treasury - Internal Revenue Service Schedule No. or Exhibit
Explanation of Items

Name of Taxpayer Year/Period Ended
ORG December 31, 20XX

December 31, 20XX

§ 834(b). Gross receipts do not, however, include amounts other than premium income or gross
investment income unless those amounts are otherwise included in gross income. Accordingly,
the term gross receipts does not include contributions to capital excluded from gross income
under § 118, or salvage or reinsurance recovered accounted for as offsets to losses incurred under

§ 832(b)(5)(A)(i).

Section 834(b)(1)(D) of the Internal Revenue Code includes under gross receipts the gains from
the sale or exchanges of capital assets to the extent provided in subchapter P (section 1201 and
following, relating to capital gains and losses).

Section 834(c)(6) of the Internal Revenue Code allows a deduction for Capital Losses to the
extent provided in subchapter P (section 1201 and following) plus losses from capital assets sold
or exchanged in order to obtain funds to meet abnormal insurance losses and to provide for the
payment of dividends and similar distributions to policyholders.

Based on the changes in the limitations under IRC 501(c)(15)(A), and the operation of ORG
during 20XX & 20XX, it was determined by the chart above, that ORG did not qualify for tax
exempt status for years starting January 1, 20XX. ORG was able to meet the $600,000 gross
receipts limitation (20XX- $ ; 20XX- $ ) however, it was not able to meet the 50%
requirement of Gross Premiums to Gross Receipts (20XX- %; 20XX- %);

As a non-stock company, (mutual), ORG did meet the requirement of under $150,000 in gross
receipts (20XX- $ ; 20XX- $ ) but was unable not meet the 35% requirement of
premiums to gross receipts (20XX- %; 20XX- %).

To be qualified under IRC 501(c)(15), ORG had to meet all requirements, either under IRC
501(c)(15)(A)(i) or (a)(ii). ORG did not meet the requirements under either section of the code.

Section 206(e) of the Pension Funding Act of 2004, P.L. 118-218 provides the effective date of
the new requirements for exemption under IRC 501 (c)(15). It states:

EFFECTIVE DATE-

(1) IN GENERAL- Except as provided in paragraph (2), the amendments made by this section
shall apply to taxable years beginning after December 31, 2003.

(2) TRANSITION RULE FOR COMPANIES IN RECEIVERSHIP OR LIQUIDATION-
In the case of a company or association which--

(A) for the taxable year which includes April 1, 2004, meets the requirements of section
501(c)(15)(A) of the Internal Revenue Code of 1986, as in effect for the last taxable year
beginning before January 1, 2004, and

(B) on April 1, 2004, is in a receivership, liquidation, or similar proceeding under the supervision
of a State court,

Form 886-A (Rev.4-68) Department of the Treasury - Internal Revenue Service
Page: -10-


Form 886A Department of the Treasury - Internal Revenue Service Schedule No. or Exhibit
Explanation of Items
Name of Taxpayer Year/Period Ended

ORG December 31, 20XX
December 31, 20XX

the amendments made by this section shall apply to taxable years beginning after the earlier of
the date such proceeding ends or December 31, 2007.

ORG was not involved in a court ordered liquidation during 20XX and 20XX. Therefore,
Section 206(e) does not apply to this organization.

Based on the information above, even if ORG is considered an insurance company, they did not
meet the requirements under IRC 501(c)(15) and their tax exempt status should be revoked.

7. If ORG does not meet the other qualifications under Internal Revenue Code Section
501(c)(15), can ORG rely on the determination letter granted by the Service
allowing it to claim tax exempt status pursuant to Internal Revenue Code Section
501(c)(15)?

To qualify for tax exempt status under IRC 501(c)(15), an organization must be operating as an
insurance company as well as meet the other requirements under this code section. Since ORG
did not meet the other requirements, it does not qualify for tax exempt status under IRC
501(c)(15), therefore it can not rely on the determination letter granted by the Service allowing it
to claim tax exempt status pursuant to IRC 501(c)(15). The organization’s tax exemption should
be revoked for years beginning January 1, 20XX.

8. If ORG does not meet the other qualifications under Internal Revenue Code Section
501(c)(15), is it entitled to file an election under IRC 831(b) and be taxed only on its
investment income?

IRC 831 discusses tax on insurance companies other than life insurance companies.

IRC 831(a) states as a general rule, “Taxes computed as provided in section 11 shall be imposed
for each taxable year on the taxable income of every insurance company other than a life
insurance company.”

IRC 831(b) provides an alternative tax for certain small companies. It states in IRC 831(b)(1)
that, in general, “In lieu of the tax otherwise applicable under subsection (a), there is hereby
imposed for each taxable year on the income of every insurance company to which this
subsection applies a tax computed by multiplying the taxable investment income of such
company for such taxable year by the rates provided in section 11(b).”

IRC 831(b)(2) discusses the companies to which this subsection applies.

(A) In general. This subsection shall apply to every insurance company other than life
(including interinsurers and reciprocal underwriters) if-

Form 886-A (Rev.4-68) Department of the Treasury - Internal Revenue Service
Page: -11-


Form 886A Department of the Treasury - Internal Revenue Service Schedule No. or Exhibit
Explanation of Items

Name of Taxpayer Year/Period Ended
ORG December 31, 20XX

December 31, 20XX

(i) the net written premiums (or, if greater, direct written premiums) for the taxable year do not
exceed $1,200,000, and

(ii) such company elects the application of this subsection for such taxable year.

The election under clause (ii) shall apply to the taxable year for which made and for all
subsequent taxable years for which the requirements of clause (1) are met. Such election, once
made, may be revoked only with the consent of the Secretary.

Regulations (Regs.) 301.9100-8(a)(2) discusses the time for making elections. Under (i) it states
in general that except as otherwise provided in this section, the elections described in paragraph
(a)(1) of this section, must be made by the later of-

(A) The due date (taking into account any extensions of time to file obtained by the
taxpayer) of the tax return for the first taxable year for which the election is effective,
or

(B) January 22, 1990 (in which case the election generally must be made by amended
return)

Regs. 301.9100-8(a)(1) mentioned above includes IRC 831(b)(2)(A).

Regs. 301.9100-8(a)(3) describes the manner of making elections. It states, “ Except otherwise

provided in this section, the elections described in paragraph (a)(1) of this section must be made
by attaching a statement to the tax return for the first taxable year for which the election is to be
effective.”

Based on the Code and Regulation sections above, ORG is not entitled to the relief under IRC
831(b), for 20XX & 20XX, because it did not meet the requirements of Regs 301.9100-8(a)(2),
and therefore would be required to report all income and expenses on Form 1120-PC for each
year. As of this writing, the election has never filed, either with the filing of the Form 990 or
separately. When an election is filed, it would only allow the organization to receive relief under
IRC 831(b) in the year it is filed and all future years. The election would not be retroactive to
any prior years.

9. If ORG can not rely on the determination letter granted by the Service allowing it to
claim tax exempt status pursuant to Internal Revenue Code Section 501(c)(15),
based on the facts that it does not meet the requirements of Internal Revenue Code
Section 501(c)(15), what are the tax consequences for years beginning January 1,
20XX?

Since ORG’s tax exempt status should be revoked for years beginning January 1, 20XX, ORG
would be responsible for filing Forms 1120-PC for years beginning January 1, 20XX.

Form 886-A (Rev.4-68) Department of the Treasury - Internal Revenue Service
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Form 886A Department of the Treasury - Internal Revenue Service
Explanation of Items

Schedule No. or Exhibit

Name of Taxpayer Year/Period Ended
ORG December 31, 20XX
December 31, 20XX
TAXPAYER’S POSITION

Unknown at the time of this writing.

SUMMARY

It is the Service’s position, based on the above facts, law and analysis, that the tax exemption
status of ORG for the years beginning January 1, 20XX should be revoked based on ORG not
operating as an insurance company, thereby failing to meet the qualifications for exemption
under IRC 501(c)(15). Forms 1120 would be required to be filed for years beginning January 1,

20XX.

If it is determined that ORG was operating as an insurance company, the tax exempt status
should still be revoked because they have not met the other requirements of IRC 501(c)(15).
Then Forms 1120-PC would be required to be filed for years beginning January 1, 20XX.

Form 886-A (Rev.4-68) Department of the Treasury - Internal Revenue Service

Page: -13-