Other 200842058: Mutual insurer lost its tax exemption

Plain-English summary

A mutual property insurer had been recognized as exempt under § 501(c)(15). The IRS examination found that the insurer’s gross receipts were within the $600,000 ceiling but premiums were not more than half of gross receipts, and that it also failed the separate $150,000 gross-receipts and 35-percent premium tests for mutual insurers. The organization was not in a court-supervised liquidation eligible for the statutory transition rule. The IRS therefore revoked the exemption effective from the beginning of the examined period and required Form 1120-PC for each nonexempt year. Because the insurer had never made the § 831(b) election, it could not apply that alternative tax retroactively, though it could elect for a future taxable year in which it filed Form 1120-PC.

Ruling snapshot

• Question: Did the mutual insurer continue to qualify for exemption under § 501(c)(15), and what filing and election rules applied after revocation?
• Outcome: Revocation. The insurer failed both gross-receipts and premium-percentage tests and had to file taxable insurance-company returns for nonexempt years.
• 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: June 5, 2008

Release Number: 200842058
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 November 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
June 12, 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, U.S. Property and Casualty
Insurance Company Income Tax Return, 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
LEGEND
ORG = Organization name XX = Date XYZ = State CO-1, CO-2, CO-3,
CO-4, CO-5, CO-6, CO-7 & CO-8 = 1ST, 2ND, 3RD, 4TH, 5TH, 6TH, 7TH, & 8TH COMPANIES
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) is a mutual insurance company formed in the State of XYZ in 19XX. The
only type of insurance it sells is property insurance. Coverage includes fire, lightning
and extended coverage. Policies are usually written for 3 year periods.

Application Form 1024 and determination letter was not available at the time of the
audit. According to information secured from the Service’s database, organization is
tax exempt under Internal Revenue Code section 501(c)(15) and has a Form 990 filing
requirement.

The Articles of Incorporation that was filed in 19XX with the State of XYZ state the

purpose of the organization to be to engage in all kinds of insurance business as a

county mutual insurance company as may now or hereafter be authorized under the

laws of the State of XYZ, and without limiting said objectives, to engage in all the

insurance business set forth under the provisions of the general statute of XYZ Chapter
, Article , Section , Subsection

It also states that every person, association, firm, or corporation insured by this
corporation shall be a member thereof and entitled to one vote.

ORG provided a Declaration page on one of the insured. The page showed insurance
on a one story, framed, approved roof, storage building. Insurance covered fire and
lightning, and extended coverage. The policy was written for a 3 year period, 20XX-

. The amount that was covered was $ with a premium of $.

ORG was involved in reinsurance agreements. One agreement was a CO-7. The
reinsurers were CO-1; CO-2 CO-3; CO-4; The CO-5; and The CO-6. ORG was to cede

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

the organization’s surplus liability on risks covered hereunder, subject to limits set forth
herein. Cessions shall be limited to an amount equal to three times the organization's
net retention, subject to a minimum retention of $ and to a maximum cession hereunder
of $ on any one risk covered hereunder. However, if the cession is greater than $, the
maximum cessions as respects any one animal shall not exceed $. Premiums- exact
proportion of Gross Net Written Premium Income. Commissions were 20%.

ORG was also involved in an Interest and Liabilities Agreement. The agreement listed
the same reinsurers as above. A breakdown of the percentages of each reinsurer was
as follows:

• CO-1 37.50%

• CO-2 CO-3 15.00%
• CO-7 4.00%

• The CO-5 32.50%
• The CO-6 11.00%

Premium and Loss Payments to made to CO-8. Brokerage earned by CO-8 shall be
deducted from ceded premiums at a rate of %.

• Coverage: Pro Rata Share — Property Business
• Maximum Cession: $
• Minimum Retention: $
• Lines:

There were policies in force at the end of 20XX. The amount of policies in force at
the end of 20XX was $.

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
Premium Refunds added
back in |

Reinsurance Premiums
added back in

Total Premiums
Investment Income
Capital Gains/(Losses)
Other Revenue

Total Gross Receipts
Percentage- Gross
Premium/Reinsurance
Income to Gross Receipts

In reporting its premium income on Form 990, the organization deducted premiums
refunded and premiums reinsured from total premiums. In computing total premiums
and gross receipts per Notice 2006-42, these two amounts should not have been
deducted. The chart above shows them being added back in to arrive at total
premiums and gross receipts.

ORG received rental income that was deducted against the rental expense in the trial
balance so the income never showed as part of gross receipts on the Form 990. The
income is included in the computation of gross receipts in the chart above.

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 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

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

(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 § 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

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

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 Gross Receipts Limitation of $600,000 ($ )
but was unable to meet the more than 50% requirement of Gross Premiums to Gross
Receipts ( %).

Since ORG is a mutual insurance company, it had the chance to meet the second set of
requirements specific to mutual companies. Based on the chart above, ORG was
unable to meet the second set of requirements because ORG’s Gross Receipts
exceeded the $150,000 limitation ($ ) and the Gross Premiums to Gross
Receipts percentage did not meet the more than 35% requirement ( %).

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

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

(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 Forms 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
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.

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

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 (i) 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
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

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
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 June 5, 2008
LEGEND
ORG = Organization name XX = Date XYZ = State
ORG Taxpayer Identification Number:
ADDRESS Form:

Tax Year(s) Ended:
December 31, 20XX
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 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