IRS denies exemption to a captive insurance company serving community clinics

Plain-English summary

The IRS denied exemption under IRC § 501(c)(3) to a proposed nonprofit captive insurance company serving community healthcare clinics. The organization’s articles authorized it to provide insurance and operate as a captive insurer, and its planned activities involved premiums, reinsurance, and investment income. The IRS concluded that these powers and activities were commercial in nature, that the organization did not satisfy the organizational and operational tests, and that its insurance activity was not shown to be provided substantially below cost as required by IRC § 501(m)(3)(A). The ruling explains why serving charitable organizations does not by itself make commercial-type insurance an exempt activity.

Ruling snapshot

• Question: Did the proposed captive insurance company qualify for exemption under IRC § 501(c)(3)?
• Outcome: denied
• Key authorities: IRC §§ 170, 501(a), 501(c)(3), 501(m), 6110, and 7428; Treas. Reg. §§ 1.501(a)-1(c), 1.501(c)(3)-1(a)(1), 1.501(c)(3)-1(b), 1.501(c)(3)-1(c), and 1.501(c)(3)-1(d)

Full text (IRS public release)

DEPARTMENT OF THE TREASURY
INTERNAL REVENUE SERVICE
WASHINGTON, D.C. 20224

TAX EXEMPT AND
GOVERNMENT ENTITIES

DIVISION

Number: 201218017 Contact Person:
Release Date: 5/4/2012
Identification Number:

Date: February 8, 2012
Contact Number:

Employer Identification Number:
Form Required To Be Filed:

Tax Years:
UIL: 501.03-00

Dear

This is our final determination that you do not qualify for exemption from Federal income tax as an organization described in Internal Revenue Code section 501(c)(3). Recently, we sent you a letter in response to your application that proposed an adverse determination. The letter explained the facts, law and rationale, and gave you 30 days to file a protest. Since we did not receive a protest within the requisite 30 days, the proposed adverse determination is now final.

Because you do not qualify for exemption as an organization described in Code section 501(c)(3), donors may not deduct contributions to you under Code section 170. You must file Federal income tax returns on the form and for the years listed above within 30 days of this letter, unless you request an extension of time to file. File the returns in accordance with their instructions, and do not send them to this office. Failure to file the returns timely may result in a penalty.

We will make this letter and our proposed adverse determination letter available for public inspection under Code section 6110, after deleting certain identifying information. Please read the enclosed Notice 437, Notice of Intention to Disclose, and review the two attached letters that show our proposed deletions. If you disagree with our proposed deletions, follow the instructions in Notice 437. If you agree with our deletions, you do not need to take any further action.

If you have any questions about this letter, please contact the person whose name and telephone number are shown in the heading of this letter. If you have any questions about your Federal income tax status and responsibilities, please contact IRS Customer Service at

1-800-829-1040 or the IRS Customer Service number for businesses, 1-800-829-4933. The IRS Customer Service number for people with hearing impairments is 1-800-829-4059.

Sincerely,

Lois G. Lerner
Director, Exempt Organizations

Initiator Reviewer

SE:T:EO:RA:T:1 SE:T:EO:RA:T:1

DEPARTMENT OF THE TREASURY
INTERNAL REVENUE SERVICE
WASHINGTON, D.C. 20224

TAX EXEMPT AND
GOVERNMENT ENTITIES

DIVISION

Contact Person:
Identification Number:

Date: October 27, 2011
Contact Number:

FAX Number:

Employer Identification Number:
UIL: 501.03-00

Legend:

A
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B
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C
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D
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E
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Date 1
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Date 2
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Dear

We have considered your application for recognition of exemption from Federal income tax under Internal Revenue Code section 501(a). Based on the information provided, we have concluded that you do not qualify for exemption under Code section 501(c)(3). The basis for our conclusion is set forth below.

Facts:

You were originally incorporated on Date 1 as a for-profit corporation. On August 20, 20, you filed a certificate of conversion under which you converted to a nonprofit corporation under the laws of the State of A. Your Amended and Restated Articles of Incorporation state that your primary purpose is to be a non-profit captive insurance company under state statute. Further, they state that you are organized and shall be operated exclusively for charitable purposes, by supporting, benefiting or carrying out some or all of the purposes of not-for-profit community healthcare clinics in the State of B. Your Articles authorize you to provide or enter into arrangements for the provision of insurance of various liability risks of the clinics, and to act as a nonprofit captive insurance company in such classes of insurance under applicable law as are approved by the Insurance Commissioner of the State of A.

Part IV of the Form 1023 Application for Recognition of Exemption Under Section 501(c)(3) of the Internal Revenue Code asks for a narrative description of your activities. Your

response to Part IV directs us to see the “Business Plan” that accompanies your application. The Business Plan, entitled “Plan of Operations” (the “Plan’”) and dated “June 2004” (which date precedes your conversion to a nonprofit corporation), states that you are “being form[ed] in the State of A as a Class 3 Association captive insurance company.” According to the Plan, your primary objective is “to provide a quality, affordable, and stable option to the Workers’ Compensation crisis that exists in the State of B to Community Clinics,” which clinics are non- profit community clinics composed of both rural and urban locations providing medical, dental, and mental health services to lower income individuals in the State of B.

The Plan states that you will be an Association captive sponsored by C, which was formed by community clinics working in coordination with a management company located in State of A. C has applied to the Internal Revenue Service for recognition of exemption as an organization described in section 501(c)(3) of the Code. C in coordination with the management company formed subsidiary D solely as a holding company for your stock. D is your sole member. D has also applied to the Service for recognition of exemption as an organization described in section 501(c)(3). You share a common board of directors with C and D. One of your executive directors is the managing director of the management company that assisted in your formation and provides you with bookkeeping services.

The community clinics that are member-owners of C can obtain workers’ compensation and employer liability coverage through E, a for-profit company that provides insurance and reinsurance to captive insurance companies. E, in turn, has entered into a reinsurance arrangement with you. You will assume premiums and risk on the policies of those member- owners from E up to a specified limit. Your revenues consist of premiums and investment income.

You state that you are not applying for exemption as a cooperative hospital service organization under section 501(e) of the Code, and that you do not claim to qualify as one. You also state that your activities now are the same as they were before you converted from a profit corporation to a non-profit corporation, and that you have always been in the business of providing reinsurance coverage up to a specified limit for member-owners of C.

Law:

Section 501(a) of the Internal Revenue Code (the “Code”) provides for the exemption from federal income taxation of organizations described in section 501(c).

Section 501(c)(3) of the Code describes organizations which are organized and operated exclusively for charitable purposes, no part of the net earnings of which inures to the benefit of any private shareholder or individual.

Section 501(m)(1) of the Code provides that an organization described in section 501(c)(3) or (4) shall be exempt from tax under section 501(a) only if no substantial part of its activities consists of providing commercial-type insurance.

Section 501(m)(3)(A) of the Code provides that, for purposes of section 501(m), the term “commercial-type insurance” shall not include insurance provided as substantially below cost to

a class of charitable recipients.

Section 1.501(a)-1(c) of the Income Tax Regulations (the “regulations”) defines the term “private shareholder or individual” in section 501 as persons having a personal and private interest in the activities of the organization.

Section 1.501(c)(3)-1(a)(1) of the regulations provides that an organization must be both organized and operated exclusively for one or more of the purposes specified in section 501(c)(3) of the Code in order to be exempt as an organization described in such section.

Section 1.501(c)(3)-1(b)(1)(i) of the regulations provides that an organization is organized exclusively for one or more exempt purposes only if its articles of incorporation: a) Limit the purposes of such organization to one or more exempt purposes; and, b) Do not expressly empower the organization to engage, otherwise than as an insubstantial part of its activities, in activities which in themselves are not in furtherance of one or more exempt purposes.

Section 1.501(c)(3)-1(b)(1)(iii) of the regulations provides that an organization is not organized and operated exclusively for one or more exempt purposes if its articles expressly empower it to carry on, otherwise than as an insubstantial part of its activities, activities which are not in furtherance of one or more exempt purposes, even though such organization is, by the terms of such articles, created for a purpose that is no broader than the purposes specified in section 501(c)(3). Thus, an organization that is empowered by its articles “to engage in a manufacturing business,” or “to engage in the operation of a social club” does not meet the organizational test regardless of the fact that its articles may state that such organization is created “for charitable purposes within the meaning of section 501(c)(3) of the Code.”

Section 1.501(c)(3)-1(c)(1) of the regulations provides that an organization will be regarded as "operated exclusively" for one or more exempt purposes only if it is engaged primarily in activities which accomplish one or more of such exempt purposes specified in section 501(c)(3). An organization will not be so regarded if more than an insubstantial part of its activities is not in furtherance of an exempt purpose.

Section 1.501(c)(3)-1(d)(1)(ii) of the regulations provides that an organization is not organized or operated exclusively for one or more of the purposes specified in subdivision (i) of this subparagraph unless it serves a public rather than a private interest. Thus, to meet the requirement of this subdivision, it is necessary for an organization to establish that it is not organized or operated for the benefit of private interests such as designated individuals, the creator or his family, shareholders of the organization, or persons controlled, directly or indirectly, by such private interests.

Rev. Rul. 71-529, 1971-2 C.B. 234, concerns an organization formed to aid organizations exempt from tax under section 501(c)(3) of the Code by assisting them to manage more effectively their endowment or investment funds. The organization receives capital from the participating exempt organizations, which capital is then placed in one or more common funds in the custody of various banks. Membership in the organization is restricted to colleges

and universities exempt under section 501(c)(3). Its board of directors is composed of representatives of the member organizations. Most of the operating expenses of the organization, including the costs of the services of the investment counselors and the custodian banks, are paid for by grants from independent charitable organizations. The member organizations pay only a nominal fee for the services performed. These fees represent less than fifteen percent of the total costs of operation. The ruling states that, by providing the services described above to its members, the organization is performing an essential function for charitable organizations. By performing this function for the organizations for a charge that is substantially below cost, the organization is performing a charitable activity within the meaning of section 501(c)(3) of the Code.

In Better Business Bureau of Washington D.C., Inc. v. United States, 326 U.S. 279, 283 (1945), the Supreme Court said that the presence of a single non-exempt purpose, if substantial

in nature, will destroy the exemption regardless of the number or importance of truly exempt purposes.

In Nonprofits’ Insurance Alliance of Cal. v. United States, 32 Fed. Cl. 277 (1994), the Court of Federal Claims considered whether a group self-insurance risk pool with membership consisting of 487 unrelated nonprofit corporations qualified as a tax-exempt organization. The organization was formed to provide reasonably priced liability coverage to its members at stable prices not available from commercial insurers. Noting that the sale of insurance is an inherently commercial activity ordinarily carried on by commercial for-profit companies, the Court found the plaintiff's activities to be commercial in nature because plaintiff was engaged in the actual underwriting of insurance policies and contracts with other firms to secure reinsurance for claims in excess of a certain amount. The court found that plaintiff's activities possessed many of the attributes of a mutual insurance company, such as accumulated profits that inure to the benefit of members. Further, noting that competition with commercial firms is strong evidence of the predominance of a nonexempt commercial purpose, the court said that, by providing insurance coverage and charging premiums, the plaintiff placed itself in competition with other commercial insurance firms. Finally, the court said that providing insurance to 487 unrelated exempt organizations is not an activity that would normally be performed by the member organizations. Accordingly, the court held that the plaintiff had failed the operational test under section 501(c)(3) because of the existence of a substantial nonexempt, commercial purpose. The court then said that, even assuming that plaintiff qualified as an organization described in section 501(c)(3) of the Code, plaintiff, serving as a group self-insurance risk pool, must demonstrate that section 501(m)(1) of the Code does not preclude its exempt status.

in Florida Hospital Trust Fund v. Comm’r, 103 T.C. 140, 158 (1994), aff'd, 71 F.3d 808 (11th Cir. 1996), the Tax Court disagreed with the petitioner’s argument that the insurance in question was not “commercial-type” insurance. The Court, citing its opinion in Paratransit Ins. Corp. v. Comm’r, 102 T.C. 745, 754 (1994), said that “we understand that Congress intended for section 501(m) to apply to those organizations providing any ‘type of insurance that can be purchased in the commercial market’ .... There is no dispute that hospital professional liability and workers’ compensation insurance are normally offered by commercial insurance. Accordingly, we conclude that petitioners are providing commercial-type insurance within the meaning of section 501(m).”

Rationale:

To qualify as an organization described in section 501(c)(3) of the Code that is exempt from Federal income taxation under section 501(a), an organization must demonstrate that: (1) it is organized and operated exclusively for certain specified exempt purposes, and (2) no part of its net earnings inures to the benefit of a private shareholder or individual. Further, as provided in section 501(m), an organization described in section 501(c)(3) shall be exempt from tax only if no substantial part of its activities consists of providing commercial-type insurance.

Section 1.501(c)(3)-1(a)(1) of the regulations explains that you cannot be exempt under section 501(c)(3) of the Code if you do not meet the organizational test under section 1.501(c)(3)-1(b) or the operational test under section 1.501(c)(3)-1(c).

Organizational Test

Section 1.501(c)(3)-1(b) of the regulations explains that you would not meet the organizational test if your articles empower you to engage (as a substantial part of your activities) in activities which in themselves are not in furtherance of one or more of the exempt purposes set forth in section 501(c)(3).

You are organized for the primary purpose of being a non-profit captive insurance company. Your Amended and Restated Articles of Incorporation authorize you to:

“4. Provide or enter into arrangements for the provision of insurance of various liability risks of the Clinics.

“2. Act as a nonprofit captive insurance company in such classes of insurance under applicable law and as are approved by the Insurance Commissioner of the State of M.

“3. Todo and transact any and every other kind of business which is permitted under the general nonprofit corporation and applicable captive insurance laws of the State of M ... and to transact any other lawful business for which nonprofit corporations may be incorporated under the [M Nonprofit Corporations Act]....”

As explained below under the heading “Operational Test,” the provision of insurance, and operation as an insurance company, without more, are commercial activities that are not in furtherance of any exempt purpose described in section 501(c)(3). Since you are organized for the primary purpose of being a captive insurance company, and, to that end, your articles of incorporation empower you to engage in insurance business, we find that you do not meet the organizational test under section 1.501(c)(3)-1(b) of the regulations. The fact that your articles further provide that you are “organized and shall be operated exclusively for charitable purposes” does not change the fact that your articles empower you to conduct a business that is not in furtherance of any exempt purpose.

Operational Test

Section 1.501(c)(3)-1(c)(1) of the regulations explains that you would be regarded as “operated exclusively” for one more exempt purposes only if you engage primarily in activities which accomplish one or more of the exempt purposes specified in section 501(c)(3) of the

Code. The presence of a single nonexempt purpose, if substantial in nature, will destroy the exemption regardless of the number or importance of the truly exempt purposes. See Better Business Bureau of Washington, D.C., Inc v. United States, above.

We find that you do not meet the operational test under section 1.501(c)(3)-1(c)(1) of the regulations for many of the same reasons that the plaintiff organization in Nonprofits’ Insurance Alliance of Cal. v. United States, above, did not meet that test. Like the plaintiff organization in that case, you were formed to provide or enter into arrangements for the provision of insurance, and act as a captive insurance company, for a membership consisting of numerous unrelated entities, the community clinics. Like those of the plaintiff organization, your activities possess many of the attributes of a mutual insurance company. You provide your members workers’ compensation and employer liability coverage, either directly or by reinsuring a portion of the risk under policies issued by a for-profit insurance company. In providing insurance coverage for your members, you are engaged primarily in an inherently commercial activity ordinarily carried on by commercial for-profit insurance companies. In conducting the same activities you conducted as a for-profit organization, and by deriving your revenues primarily from insurance premiums, you are undoubtedly in competition with commercial insurers.

In addition, you would not meet the operational test under section 1.501(c)(3)-1(c)(2) of the regulations if you allowed your net earnings to inure to the benefit of persons having a personal and private interest in your activities. One of your executive directors is also the manager director of a management company that provides bookkeeping services to you and the related subsidiaries. You have not provided sufficient details of this arrangement to enable us to assess whether it offends section 1.501(c)(3)-1(C)(2), or otherwise indicates that you are organized or operated for the benefit of “private shareholders or individuals” within the meaning of section 1.501(c)(3)-1(d)(1)(ii).

Section 501(m)

Aside from the issue of whether you are described in section 501(c)(3) of the Code, you would be precluded from exemption from federal taxation under section 501(a) by operation of section 501(m). Section 501(m) says that an organization described in section 501(c)(3) is not entitled to exempt status under section 501(a) if a substantial part of its activities consists of providing commercial-type insurance.

In Florida Hospital Trust Fund v. Comm’r, above, the Tax Court distinguished between purchasing insurance for a hospital group versus providing insurance for a hospital group, with the latter being a non-exempt commercial type activity. The Court said that “in employing the term ‘commercial-type’ insurance, we understand that Congress intended for section 501(m) to apply to those corporations providing any ‘type of insurance that can be purchased in the commercial market’.” Saying that “there is no dispute that hospital professional liability and workers’ compensation insurance are normally offered by commercial insurers,” the Court concluded that petitioners were providing commercial-type insurance within the meaning of section 501(m).

Similarly, we find that the coverage you provide your members — workers’ compensation and employer liability coverage — are types of insurance that can be purchased on the

commercial market. Nevertheless, you contend that your activities do not constitute “commercial-type insurance” by reason of section 501(m)(3)(A), which section carves out an exception to the term “commercial-type insurance” for insurance that is provided at substantially below cost to a class of charitable recipients. In support of your position, you state that you were “originally established to provider coverage at a reasonable cost” and that, “depending on market conditions, the reasonable price ... may be substantially lower than the commercial pricing of similar coverage in the open market.” But the test under section 501(m)(3)(A) is not whether your prices are substantially lower than commercial pricing, but whether they are substantially below your costs.

In Rev. Rul. 71-529, above, we said that an organization providing investment management services to related organization was performing a charitable activity within the meaning of section 501(c)(3) where the member organizations paid only a nominal fee for the services performed for then, which fee represented less than fifteen percent of the total cost of operations. You have presented no evidence that you are providing insurance to your members at anything approximating 15 percent of cost. On the contrary, you merely state that, at times, your coverage might be provided at substantially below market value; you make no mention that you will provide coverage at rates that are below your cost. Since you apparently do not provide insurance and substantially below cost, and insofar as your current activities are no different than the activities you undertook as a for-profit entity, we find that your primary purpose, and a substantial amount of your activities, consists of the provision of commercial-type insurance. Consequently, you are precluded by section 501(m)(1) from exemption from tax under section 501(a).

Conclusion:
You do not qualify for exemption under section 501(c)(3) of the Code.

You have the right to file a protest if you believe this determination is incorrect. To protest, you must submit a statement of your views and fully explain your reasoning. You must submit the statement, signed by one of your officers, within 30 days from the date of this letter. We will consider your statement and decide if the information affects our determination.

Your protest statement should be accompanied by the following declaration:

Under penalties of perjury, I declare that I have examined this protest statement, including accompanying documents, and, to the best of my knowledge and belief, the statement contains all the relevant facts, and such facts are true, correct, and complete.

You also have a right to request a conference to discuss your protest. This request should be made when you file your protest statement. An attorney, certified public accountant, or an individual enrolled to practice before the Internal Revenue Service may represent you. If you want representation during the conference procedures, you must file a proper power of attorney, Form 2848, Power of Attorney and Declaration of Representative, if you have not already done so. For more information about representation, see Publication 947, Practice before the IRS and Power of Attorney. All forms and publications mentioned in this letter can be found at www.irs.gov, Forms and Publications.

If you do not file a protest within 30 days, you will not be able to file a suit for declaratory judgment in court because the Internal Revenue Service (IRS) will consider the failure to protest as a failure to exhaust available administrative remedies. Code section 7428(b)(2) provides, in part, that a declaratory judgment or decree shall not be issued in any proceeding unless the Tax Court, the United States Court of Federal Claims, or the District Court of the United States for the District of Columbia determines that the organization involved has exhausted all of the administrative remedies available to it within the IRS.

If you do not intend to protest this determination, you do not need to take any further action. If we do not hear from you within 30 days, we will issue a final adverse determination letter. That letter will provide information about filing tax returns and other matters.

Please send your protest statement, Form 2848 and any supporting documents to this address:

Internal Revenue Service

TE/GE SE: T: EO: RA: T:

Exempt Organizations Technical Group 1
1111 Constitution Avenue, NW
Washington DC 20224

You may also fax your statement using the fax number shown in the heading of this letter. If you fax your statement, please call the person identified in the heading of this letter to confirm that he or she received your fax.

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

Sincerely,

Lois G. Lerner
Director, Exempt Organizations

Initiator Reviewer

SE:T:EO:RA:T:1 SE:T:EO:RA:T:1