Determination 200851035: A small farm mutual lost its exemption when Congress changed the test from premiums to gross receipts

Plain-English summary

The IRS revoked a mutual property and casualty insurer's exemption under section 501(c)(15) after the law changed its eligibility test. The insurer's premiums made up more than half of gross receipts, but its gross receipts exceeded the $600,000 ceiling in both examined years. The letter also states that the insurer had not made the section 831(b) election for those years and could not make it retroactively. The insurer consented to the proposed revocation and filed Forms 1120-PC for the examined years. The public text substitutes "motto" for "insurance" in parts of the examination report.

Ruling snapshot

• Question: Does a small mutual property and casualty insurer keep its exemption under section 501(c)(15) after the 2004 amendment replaced the $350,000 net written premiums test with a $600,000 gross receipts test, and if not, can it still elect the small-company alternative tax in section 831(b) for those years?
• Outcome: Exemption revoked effective 1 January, by consent on Form 6018-A. The company met the requirement that more than half of gross receipts be premiums, at 96.21 and 96.31 percent, but its gross receipts as defined by Notice 2006-42 exceeded $600,000 in both examined years, and therefore also exceeded the $150,000 mutual company ceiling. The receivership transition rule did not apply. Forms 1120-PC are required for the examined years and for every future year in which the company does not qualify. The section 831(b) election was never filed, cannot be made retroactively, and would run only from the year it is filed forward.
• Key authorities: IRC sections 501(c)(15) and 501(c)(15)(A), 816(a), 831(a) and 831(b), 834(b), 832(b)(5)(A)(i), 118 and 11; section 206 of the Pension Funding Equity Act of 2004, P.L. 108-218, including the effective date and receivership transition rule in section 206(e); Notice 2006-42, 2006-19 I.R.B.; Treas. Reg. 301.9100-8(a)(1), (a)(2) and (a)(3).

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: September 25, 2008

Number: 200851035

Release Date: 12/19/2008 EO

LEGEND UIL:501.15-00

ORG = Organization name XX = Date Address = address

ORG Employer Identification Number:
ADDRESS Person to Contact/ID Number:

Contact Numbers:
CERTIFIED MAIL — RETURN RECEIPT REQUESTED
Dear

In a determination letter dated January 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 August 25, 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

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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,

Vicki L. Hansen
Acting Director, EO Examinations

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

TAX EXEMPT AND

GOVERNMENT ENTITIES May 16, 2008
DIVISION ,
LEGEND
ORG = Organization name XX = Date Address = address

Taxpayer Identification Number:
ORG Form:
ADDRESS 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 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 886-A Department of the Treasury - Internal Revenue Service Schedule No. or Explanation of Items Exhibit Name of Taxpayer Year/Period Ended ORG 12/31/20XX 12/31/20XX LEGEND ORG = Organization name XX = Date XYZ = State motto = motto

CO-1, CO-2, CO-3, CO-4, CO-5 = 1st, 2nd, 3rd, 4th & 5th 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) was formed in 19XX in the State of XYZ. ORG is operated as a mutual motto company by its policyholders.

According to information secured, 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), with a ruling date of January 19XX.

Originally ORG was formed as a county motto company. Later they changed to a state

• motto company, allowing them to issue policies throughout the State of XYZ.

ORG provided property and casualty motto on a direct basis. Information secured during the examination included examples of the policies issued and an application form. The types of policies and coverage of each include:

• Farm Coverage policy covers dwelling, farm barns, farm buildings, improvements
  and betterments, personal property, live stock and machinery.

• Farm Personal Liability Coverage covers personal liability.

• Dwelling Coverage (Basic & Broad Form) covers residence, personal property,
  additional living costs.

• Dwelling Coverage- Renters covers personal property of renters.

• Personal Liability Coverage covers personal liability.

The application form showed the ability to insure house, personal property, additional costs, mobile homes, barns, garages, machine sheds, grain bins, hay, grain in bins and equipment such as tractors and bailers.

Form 886-A (Rev. 4-68) Department of the Treasury - Internal Revenue Service Page: -1-

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

ORG was also involved in reinsurance contracts. Details of these contracts follow:

1.

Protective Facultative Pro Rata Reinsurance Contract. CO-1 (37.50%), CO-2

(5%), CO-3 (32.50%), CO-4 Division on Behalf of CO-4 syndicate 2020 (25.00%). Reinsure the Company's Surplus Liability.

• Coverage- Pro Rata Share- Property business

• Maximum cession- $

• Minimum retention- $

• Brokerage paid by Reinsurer- 5%

2. Interests and Liabilities Agreement as respects the Property Facultative pro Rata

reinsurance Contract. CO-1 (37.50%), CO-2 (5%), CO-3 (32.50%), CO-4

Division on Behalf of CO-4 syndicate 2020 (25.00%).

Obligatory Reinsurance Treaty; Extended Coverage Quota Share Reinsurance Treaty; Special Casualty Excess of Loss Reinsurance.

• Obligatory Reinsurance Treaty
• Coverage Property- 3 lines with a maximum cession of $

• Minimum Retention $

• Coverage Casualty- 100% Quota Share covering bodily injury, property
  damage liability, and medical payments on homeowners, farmowners, and farmers comprehensive liability

• Maximum cession $

• Ceding Commission: 20%

• Occurrence Limit- Reinsurer’s liability in respect to any one Loss
  Occurrence shall not exceed an amount equal to 250% of the annual ceded premium earned.

• Brokerage paid by Reinsurers: 2.75%

• Extended Coverage Quota Share Reinsurance Treaty

• Coverage- 95% Quota Share Reinsurance on Extended Coverages only
• Maximum Cession: $
• Ceding Commission: 10% (flat)

• Brokerage paid by Reinsurers: 2.25%

• Special Casualty Excess of Loss Reinsurance

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

• Coverage- 100% of $ in excess of $ combined net loss, per occurrence
  covering Bodily Injury and Property Damage Liability including Medical Payments

• Rate: Ceded premiums calculated per underwriting manual provided by
  CO-5

• Brokerage paid by Reinsurers: 15.0%

Premiums and policy fees are assessed against the members. A portion of the premiums are reinsured with through the reinsurance agreement above. Any claims that are filed are filed with ORG. ORG is responsible for paying the claims. Under the reinsurance agreements, ORG will be reimbursed for the amounts the reinsurers are liable for.

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

ORG 20XX 20XX

Total Premiums/Assessments

Interest Income

Dividend Income

Total Gross Receipts

Percentage- Gross
Premium/Reinsurance Income
to Gross Receipts

On the Form 990 for years ending December 31, 20XX & 20XX, ORG included under other income reimbursements from reinsurers for claims. This amount is not considered part of gross receipts but rather a deduction on losses incurred and therefore, not included in the chart above.

The total amount of commissions received from the reinsurer was netted against the amount of reinsurance payments properly and not reported as part of gross receipts on Forms 990 or 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.

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

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

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 motto 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 motto 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 motto companies (motto companies other than life motto 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 motto 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, 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):

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

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

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 motto 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 motto 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 & 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 (96.21%) & 20XX (96.31%), however, their gross receipts exceeded the $600,000 limitation for 20XX ($ ) & 20XX ($ ). Since their gross receipts exceeded the $600,000 limitation, they automatically exceeded the
$150,000 limitation allowed for mutual motto 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:

EFFECTIVE DATE-

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

(1) IN GENERAL- Except as provided in paragraph (2), the amendments made by this section shall apply to taxable years beginning after December 31, 20XX.

(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, 20XX, 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, 20XX, and (B) on April 1, 20XX, 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, 20XX.

ORG was not involved in a court ordered liquidation during 20XX or 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).”

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

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 (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

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

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

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

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