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 =
B =
C =
D =
E =
Date 1 =
Date 2 =

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