Other 200842052: Mutual insurer exceeded the gross-receipts ceiling for exemption

Plain-English summary

A mutual property and casualty insurer had been exempt under § 501(c)(15). After correcting how the company classified policy fees, service charges, reinsurance payments, commissions, and expenses, the IRS found that premiums were more than half of gross receipts but total gross receipts exceeded $600,000. The company therefore also exceeded the $150,000 ceiling in the alternative test for mutual insurers. Its exemption was revoked, and it had to file Form 1120-PC for nonexempt years. Because it had never made a § 831(b) election, that alternative tax could not apply retroactively, though the company could elect it for a future taxable year requiring Form 1120-PC.

Ruling snapshot

• Question: Did the mutual insurer remain exempt under § 501(c)(15), and could it use the alternative § 831(b) tax?
• Outcome: Revocation. Gross receipts exceeded both applicable ceilings, and no retroactive § 831(b) election was available.
• Key authorities: IRC §§ 501(c)(15), 816(a), 831, 832(b)(5), 834(b), 834(c), 1201; Treas. Reg. § 301.9100-8; Notice 2006-42; Pension Funding Equity Act of 2004 § 206

Full text (IRS public release)

DEPARTMENT OF THE TREASURY
INTERNAL REVENUE SERVICE
Attn: Mandatory Review, MC 4920 DAL

1100 Commerce St.
TAX EXEMPT AND Dallas, TX 75242
GOVERNMENT ENTITIES
DIVISION

Date: July 17, 2008
Release Number: 200842052
Release Date: 10/17/08

UIL Code: 501.15-00 XX = Date Address = address

Legend

ORG = Organization name Employer Identification Number:
ORG Person to Contact/ID Number:
ADDRESS Contact Numbers:

CERTIFIED MAIL — RETURN RECEIPT REQUESTED
Dear :

In a determination letter dated February 19XX, you were held to be exempt from
Federal income tax under section 501(c)(15) of the Internal Revenue Code (the
Code).

Based on recent information received, we have determined you have not
operated in accordance with the provisions of section 501(c)(15) of the Code.
Accordingly, your exemption from Federal income tax is revoked effective
January 1, 20XX. This is a final adverse determination letter with regard to your
status under section 501(c)(15) of the Code.

We previously provided you a report of examination explaining why we believe
revocation of your exempt status is necessary. At that time, we informed you of
your right to contact the Taxpayer Advocate, as well as your appeal rights. On
May 15, 20XX, you signed Form 6018-A, Consent to Proposed Action, agreeing
to the revocation of your exempt status under section 501(c)(15) of the Code.

You have filed taxable returns on Form[s] 1120-PC, for the year[s] ended December 31,
20XX & 20XX with us. For future periods, you are required to file Form 1120-PC with
the appropriate service center indicated in the instructions for the return.

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, and ask for Taxpayer
Advocate Assistance. If you prefer, you may contact your local Taxpayer
Advocate at:

If you have any questions, please contact the person whose name and telephone
number are shown at the beginning of this letter.

Sincerely,

Marsha A. Ramirez
Director, EO Examinations

Form 886A Department of the Treasury - Internal Revenue Service Schedule No. or
Explanation of Items Exhibit
Name of Taxpayer Year/Period Ended
ORG 12/31/20XX
= Organization name XX = Date XYZ = State motto = motto County
= county CO-1 = 1st company
ISSUES

1. Does ORG qualify for tax exempt status under Internal Revenue Code (IRC)

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

2. If ORG does not qualify for tax exempt status for years beginning January 1,
20XX, what are the tax consequences?

3. If the tax exempt status is revoked, how will it affect future years?
FACTS

ORG (ORG) was formed on April 12, 19XX, in County, XYZ. ORG is operated as a
mutual motto company by its policyholders.

In August 19XX, ORG received a letter from the Internal Revenue Service stating that
they qualified for tax exempt status under Internal Revenue Code Section (IRC)
501(c)(15).

Originally ORG was formed to provide motto in two counties, County and County. ORG
has since expanded to include all of the following counties; County, County, County,
County, County, County, County, County and County.

ORG provides property and casualty motto. ORG specializes in providing motto
coverage to policyholders who seek basic coverage for $0 or less per property. The
types of motto policies that are offered include:

Direct Policies:
• Dwelling- motto on dwelling, contents and liability

• Farm Coverage- farm dwellings, barns, farm buildings, portable buildings and
structures, and improvements

• Farmowner Policy- covers residence, private structures, personal property,
additional living expenses, and liability. Additional coverage for equipment.

• Homeowners Policy- covers residence, private structures, personal property,
additional living expenses, and liability. Additional coverage for equipment.

• Comprehensive Personal Liability- bodily injury and property damage, medical
payments

• Comprehensive Personal Liability- bodily injury and property damage,
medical payments

• Premises Liability- bodily injury and property damage, medical payments

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
Explanation of Items Exhibit
Name of Taxpayer Year/Period Ended
ORG 12/31/20XX

• Mobile Home- covers residence, private structures, personal property, additional
living expenses, and liability. Additional coverage for equipment

These policies cover damage from hail, lightning, and fire on dwellings, barns, and
personal property as well as personal liability. At the end of 20XX there were
policies outstanding.

Premiums and policy fees are assessed against the members. A portion of the
premiums are reinsured with CO-1 (CO-1). ORG has entered into a Agreement with
CO-1. The agreement states that 100% of the business as hereafter defined under all
policies, binders, contracts of motto and reinsurance, whether oral or written (hereafter
called “policies”) whether in-force, new or renewed, by the company during the term of
this agreement, and covering business classified as Section II homeowners,
farmowners, and/or mobile -homeowners. The Net Retained Liability and Limit is $
combined single limit; $ medical payments. ORG receives a 15% commission.

Any claims that are filed are filed with ORG. ORG is responsible for paying the claims.
Under the reinsurance agreement, ORG will be reimbursed CO-1 for the amounts CO-1
is liable for.

Form 990 was filed for the 20XX tax year. The following is a breakdown of the Gross
Receipts received by ORG for the year ending December 31, 20XX, and the
percentage of Gross Premiums to Gross Receipts for the same year per Notice 2006-
42.

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

Page: -2-

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

Name of Taxpayer Year/Period Ended
ORG 12/31/20XX

ORG 20XX

Premiums-

Premiums-

Premiums —

Premiums

Premiums-

Premiums-

Premiums-

Premiums-

Premiums-

Premiums-

Total Premiums

Interest Income

Dividend Income

Interest Income- Trust

Interest Income- R

Gain On Sale of Securities

Policy Fees

Service Charges

Other Income

Total Gross Receipts

Percentage- Gross Premium/Reinsurance Income to Gross Receipts

ORG reports all premium income, whether earned or unearned first in the premium
accounts, the makes adjustments using the unearned accounts shown above.

On the Form 990 for year ending December 31, 20XX, ORG included other income-
policy fees, service charge Income and the reinsurance payments all under premiums.
Policy fees and service charge income are not considered premiums. Reinsurance
premiums payments made to CO-1 should have been reported separately as an
expense on Form 990.

Under investment income on the same Form 990, ORG included depreciation expense
and bank fees. Depreciation expense and bank fees should have been reported
separately as expenses on Form 990.

The total amount of commissions received from the reinsurer was reported as other
income on Form 990 where it should have been deducted from the total amount of
reinsurance premium payments and not income on Form 990. The commissions were
already reported as premium income when they were first received by ORG.

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
Explanation of Items Exhibit

Name of Taxpayer Year/Period Ended

ORG 12/31/20XX

The determination of gross receipts in the chart above takes these items into
consideration.

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.

No tax return has been filed for the 20XX tax year as of this writing.

LAW AND ANALYSIS

1. Does ORG qualify for tax exempt status under Internal Revenue Code (IRC)
Section 501(c)(15) for the years beginning January 1, 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.

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
Explanation of Items Exhibit
Name of Taxpayer Year/Period Ended
ORG 12/31/20XX

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 § 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 Internal Revenue Code (IRC) Section
501(c)(15)(A), and the operation of ORG during 20XX, it was determined from the chart
above that ORG did not qualify for tax exempt status for the years beginning January 1,
20XX. ORG was able to meet the 50% requirement of Gross Premiums to Gross
Receipts for 20XX ( however, their gross receipts exceeded the $600,000
limitation for 20XX ($ ). Since their gross receipts exceeded the $600,000
limitation, they automatically exceeded the $150,000 limitation allowed for mutual
insurance companies.

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:

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

Page: -5-

Form 886A Department of the Treasury - Internal Revenue Service Schedule No. or
Explanation of Items Exhibit
Name of Taxpayer Year/Period Ended
ORG 12/31/20XX

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,
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. Therefore, Section
206(e)(2) does not apply to this organization.

Therefore, for the years beginning January 1, 20XX, ORG did not qualify for tax exempt
status under IRC 501(c)(15).

2. If ORG does not qualify for tax exempt status for years beginning January
1, 20XX, what are the tax consequences?

Since ORG did not qualify for tax exempt status under IRC Section 501(c)(15) for the
years beginning January 1, 20XX, ORG’s tax exempt status should be revoked for
years beginning January 1, 20XX. ORG’s filings of the Form 990 were incorrect. ORG
should have filed Form 1120-PC for years beginning January 1, 20XX.

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

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

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

Name of Taxpayer Year/Period Ended

ORG 12/31/20XX

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-
(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 831(b), for years under examination and for any future year, until they decide to
file the election. The election has never been filed, either with the Form 990 or
separately. Any election filed now or in the future would only be effective for the year
the election was filed and all subsequent years. The election can not be made
retroactive.

3. If the tax exempt status is revoked, how will it affect future years?
The tax exempt status should be revoked for the years beginning January 1, 20XX.

Form 1120-PC is required for each year and all future years where ORG does not
qualify for exemption. If ORG meets the requirements under IRC 501(c)(15) in future

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

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

Name of Taxpayer Year/Period Ended

ORG 12/31/20XX

years, it may be allowed to file the Form 990 for each year they qualify, as a self-
declared entity. Otherwise, Form 1120-PC would be required. Any year in the future
that the Form 1120-PC is required, ORG is allowed to make an election under IRC
831(b). Once the election is made, it is effective for the year the election was made
and for all future years that the Form 1120-PC is required. The election can not be
made retroactive.

TAXPAYER’S POSITION

Unknown at the time of this writing
SUMMARY

It is the Governments 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 not meeting the qualifications for exemption under IRC 501(c)(15). Form
1120-PC would be required to be filed for any year where ORG does not qualify for
exemption under IRC 501(c)(15).

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

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

TAX EXEMPT AND
GOVERNMENT ENTITIES

DIVISION
April 18, : 2008
ORG Taxpayer Identification Number:
ADDRESS Form:
Tax Year(s) Ended:
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