Determination 1338046: IRS revokes a small insurer's exemption after its premiums failed the 50 percent test

Plain-English summary

The IRS revoked an organization's exemption under IRC § 501(c)(15) for years beginning January 1, 20xx. The organization was formed to reinsure mechanical breakdown and guaranteed automotive protection agreements and had filed Form 990. The IRS counted receipts of companies in the organization's controlled group and concluded that total receipts stayed below the applicable limit, but premiums did not make up more than 50 percent of gross receipts. The IRS also noted that no IRC § 831(b) election had been filed, so the organization could not use that alternative tax treatment for the year under examination. It required Form 1120-PC for years in which the organization did not qualify and said a future § 831(b) election would apply only from the year it was made onward.

Ruling snapshot

• Question: Did the organization qualify for exemption under IRC § 501(c)(15), and what were the tax consequences of revocation?
• Outcome: Revocation of the organization's exemption under IRC § 501(c)(15).
• Key authorities: IRC §§ 501(c)(15), 831, 834, 1563; P.L. 108-218; Notice 2006-42; Treas. Reg. § 301.9100-8.

Full text (IRS public release)

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

1100 Commerce St.
TAX EXEMPT AND
GOVERNMENT ENTITIES
DIVISION
Dallas, TX 75242
Date: March 9, 2013

Number: 201338046
Release Date: 9/20/2013

Employer Identification Number:

LEGEND:
ORG = Name of Organization Person to Contact/ID Number:
ADDRESS = Name of Address
Date = xx Contact Numbers:
Voice
Fax
UIL: 501.15-00

CERTIFIED MAIL — RETURN RECEIPT REQUESTED

Dear

In a determination letter dated April 14, 20xx, 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
February 13, 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 1120-PC, U.S. Property and Casualty Insurance
Company Income Tax Return, for the year[s] ended December 31, 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, 1-877-777-4778, and ask for
Taxpayer Advocate Assistance. If you prefer, you may contact your local
Taxpayer Advocate at:

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

Sincerely,

Sunita Lough
Director, EO Examinations

DEPARTMENT OF THE TREASURY
INTERNAL REVENUE SERVICE
1100 Commerce Street
Dallas, TX 75242
TAX EXEMPT AND
GOVERNMENT ENTITIES
DIVISION
February 4, 2009
Taxpayer Identification Number: .
Legend: Form:
ORG= Name of ORG
ADDRESS= Address of ORG Tax Year(s) Ended:
Person to Contact/ID Number:
ORG Contact Numbers:
ADDRESS Telephone:
Fax:
Dear

We have enclosed a copy of our report of examination explaining why we believe an
adjustment of your organization's exempt status is necessary.

We have also enclosed Publication 892, Exempt Organization Appeal Procedures for
Unagreed Issues, and Publication 3498, The Examination Process. These
publications include information on your rights as a taxpayer, including administrative
appeal procedures within the Internal Revenue Service.

If you request a conference with Appeals, we will forward your written statement of
protest to the Appeals Office, and they will contact you. For your convenience, an
envelope is enclosed. If you and Appeals do not agree on some or all of the issues
after your Appeals conference, the Appeals Office will advise you of its final decision

If you elect not to request Appeals consideration but instead accept our findings, please
sign and return the enclosed Form 6018-A, Consent to Proposed Adverse Action. We
will then send you a final letter modifying or revoking your exempt status under I.R.C. §
501(c)(15). If we do not hear from you within 30 days from the date of this letter, we will
process your case on the basis of the recommendations shown in the report of
examination and send a final letter advising of our determination.

In either situation outlined in the paragraph above (execution of Form 6018-A or failure
to respond within 30 days), you are required to file federal income tax returns for the tax
period(s) shown above, for all years still open under the statute of limitations, and for all
later years. File the federal tax return for the tax period(s) shown above with this agent

within 60 days from the date of this letter, unless a request for an extension of time is
granted. File returns for later tax years with the appropriate service center indicated in
the instructions for those returns.

You have the right to contact the office of the Taxpayer Advocate. Taxpayer Advocate
assistance is not a substitute for established IRS procedures, such as the formal
appeals process. The Taxpayer Advocate cannot reverse a legally correct tax
determination, or extend the time fixed by law that you have to file a petition in a United
States court. The Taxpayer Advocate can, however, see that a tax matter that may not
have been resolved through normal channels gets prompt and proper handling. You
may call toll-free 1-877-777-4778 and ask for Taxpayer Advocate Assistance.

If you have any questions, please call the contact person at the telephone number
shown in the heading of this letter. If you write, please provide a telephone number and
the most convenient time to call if we need to contact you.

Thank you for your cooperation.

Sincerely,

Renee B Wells by MER

Renee B. Wells
Acting 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

Legend:
ORG= Name of Org

NUM = ID Number of ORG
COUNTRY = Country of ORG
Year = xx

Related = Org related to ours

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 was formed in the Country on May 23, 20xx. Its purpose as stated in its
Memorandum and Articles of Association are unrestricted. ORGI was formed on a
stock basis. 0 shares were authorized at a par value of $ per share. President is
the sole shareholder of the organization.

ORG filed a 953(d) election with the Service on September 6, 20xx. President was
listed as the sole shareholder.

Application Form 1024 was filed on July 9, 20xx. ORG stated that it was incorporated
on June 7, 20xx and was domiciled in the Country. Its purpose as stated in the
application form was to reinsure vehicle service contracts and guaranteed automotive
protection contracts from company, a company domiciled.

Application form stated that ORG produced by two unaffiliated dealership groups. The
two groups and owners of each are as follows:

[illegible] (Corp)
Includes: Motors

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

• More Motors
  Included with the application form was the 953(d) election. The election stated that
  President was the sole shareholder. Also stated was that President was not a
  shareholder in either of the two organizations mentioned above.

Based on the information provided in the application form, a determination letter was
issued by the Service, dated April 14, 20xx, granting tax exempt status to ORG under
Internal Revenue Code (IRC) 501(c)(15).

ORG was formed to reinsure mechanical breakdown (warranty) business and total loss
protection (GAP) from Corp. Corp. offers the insurance to customers of four
dealerships. These dealerships are:

Motors One
Motors Two
Motors Three
Motors Four.

These dealerships would sell mechanical warranty agreements and loss prevention
agreements to their customers, provided by Corp. Corp. would then reinsure these
agreements with ORG. Corp. was responsible for reviewing and paying of claims.
ORG reimbursed Corp. for any liability associated with these claims.

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.

ORG 20xx

Premiums Written

Total Premiums

Interest Income

Total Gross Receipts $

Total Gross Receipts

Percentage- Gross
Premium/Reinsurance
Income to Gross Receipts %

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

A breakdown of other organizations that President is sole or partial shareholder, along
with the percentages of ownership and those organization’s gross receipts is below:

PERCENT GROSS
NAME OF ORG. OWNERSHIP RECEIPTS

President Corp.

% $

Presidents Corporation is an S corporation that files Form 1120-S on a calendar year

basis.

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.

ORG has not been involved in any court ordered liquidations.

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

LAW AND ANALYSIS

1. Does ORG. qualify for tax exempt status under Internal Revenue Code (IRC)
   Section 501(c)(15) for the years beginning January 1, 20xx?

Internal Revenue Code section 501(c)(15)(A) exempts from Federal income tax
insurance companies (as defined in section 816(a)) other than life (including
interinsurers and reciprocal underwriters) if-

(i.) (I) the gross receipts for the taxable year do not exceed $600,000, and
(II) more than 50 percent of such gross receipts consist of premiums, or

(ii.) in the case of a mutual insurance company-
(I) the gross receipts of which for the taxable year do not exceed $150,000
and,
(II) more than 35 percent of such gross receipts consist of premiums.

Clause (ii) shall not apply to a company if any employee of the company, or a member
of the employee’s family (as defined in section 2032(A)(e)(2), is an employee of another
company exempt from taxation by reason of this paragraph (or would be so exempt but
for this sentence).

Sec. 206, Clarification of Exemption from Tax for Small Property and Casualty
Insurance Companies, of the Pension Funding Equity Act of 2004, P.L. 108-218,
amended section 501(c)(15)(A) to change the definition of small property and casualty
insurance companies (insurance companies other than life insurance companies)
exempt from income taxes to: (1) a company whose gross receipts for the taxable year
do not exceed $600,000, and over half such gross receipts consist of premiums
(currently, whose net written premiums (or, if greater, direct written premiums) for the
taxable year do not exceed $350,000); or (2) a mutual insurance company (a) whose
gross receipts for the taxable year do not exceed $150,000 and more than 35 percent
of which consist of premiums and (b) none of whose employees (or member of the
employee's family) is an employee of another company exempt from tax under section
501(c)(15). These changes were applicable after December 31, 2003.

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;

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

B. Items described in § 834(b) (gross investment income of a non-life insurance
company); and

C. Other items that are properly included in the taxpayer's gross income under
subchapter B of chapter 1, subtitle A, of the Code.

Thus, gross receipts include both tax-free interest and the gain (but not the entire
amount realized) from the sale or exchange of capital assets, because those items are
described in § 834(b). Gross receipts do not, however, include amounts other than
premium income or gross investment income unless those amounts are otherwise
included in gross income. Accordingly, the term gross receipts does not include
contributions to capital excluded from gross income under § 118, or salvage or
reinsurance recovered accounted for as offsets to losses incurred under

§ 832(b)(5)(A)(i).

Section 834(b)(1)(D) of the Internal Revenue Code includes under gross receipts the
gains from the sale or exchanges of capital assets to the extent provided in subchapter
P (section 1201 and following, relating to capital gains and losses).

Section 834(c)(6) of the Internal Revenue Code allows a deduction for Capital Losses
to the extent provided in subchapter P (section 1201 and following) plus losses from
capital assets sold or exchanged in order to obtain funds to meet abnormal insurance
losses and to provide for the payment of dividends and similar distributions to
policyholders.

Notice 2006-42 also states that amounts received by all members of the insurance
company’s controlled group (as defined in section 501(c)(15)(C)) are taken into account
for purposes of these tests.

IRC 501(c)(15)(B) states, “For purposes of subparagraph (A), in determining whether
any company or association is described in subparagraph (A), such company or
association shall be treated as receiving during the taxable year amounts described in
subparagraph (A) which are received during such year by all other companies or
associations which are part of the same controlled group as the insurance company or
association for which the determination is made.”

IRC 501(c)(15)(C) states, “For purposes of subparagraph (B), the term “controlled
group” has the meaning given such term by section 831(b)(2)(B)(ii), except that in
applying section 831(b)(2)(B)(ii) for purposes of this subparagraph, subparagraph (B) &
(C) of section 1563(b)(2) shall be disregarded.”

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

IRC 831(b)(2)(B)(ii) states, “Controlled Group. For purposes of clause (i), the term
“controlled group” means any controlled group of corporations, (as defined in section
1563(a)); except that-
(I) “more than 50 percent” shall be substituted for “at least 80 percent” each place
it appears in section 1563(a), and
(II) Subsections (a)(4) and (b)(2)(D) of section 1563 shall not apply”

IRC 1563(a)(2) states, “Brother-sister controlled group. Two or more corporations if 5
or fewer persons who are individuals, estates, or trusts own (within the meaning of
subsection (d)(2)) stock possessing more than 50 percent of the total combined voting
power of all classes of stock entitled to vote or more than 50 percent of the total value
of shares of all classes of stock of each corporation, taking into account the stock
ownership of each such person only to the extent such stock ownership is identical with
respect to each such corporation.”

IRC 1563(d)(2) states, “Brother-sister controlled group. For purposes of determining
whether a corporation is a member of a brother-sister controlled group of corporations,
(within the meaning of subsection (a)(1)), stock owned by a corporation means-

(A) stock owned directly by such corporation, and
(B) stock owned with the application of paragraphs (1), (2), and (3) of subsection (e).”

Therefore, gross receipts from all other companies or associations that are part of the
controlled group with DATONI, must be included in the gross receipts computation to
determine whether DATONI qualifies for tax exempt status under IRC 501(c)(15). This
includes S Corporations that file Form 1120-S but not organizations that file Form 1065.

Based on the gross receipts of ORG and the gross receipts of Presidents Corporation,
total gross receipts per Notice 2006-42, did not exceed the $600,000 limitation for year
ending December 31, 20xx as explained in IRC 501(c)(15). However, the percentage
of premiums to gross receipts did not exceed the 50% requirement for year ending
December 31, 20xx. The percentage was determined as follows:

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
ORG 20xx
Premiums Written $
Total Premiums $
Interest Income $
Gross Receipts -
Presidents Corporation
$
Total Gross Receipts $
Percentage- Gross
Premium/Reinsurance
Income to Gross Receipts %

Therefore, for the years beginning January 1, 20xx, ORG no longer qualified for tax
exemption under IRC 501(c)(15).

Section 206(e) of the Pension Funding Act of 2004, P.L. 108-218 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

(B) on April 1, 2004, is in a receivership, liquidation, or similar
proceeding under the supervision of a State court,

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

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.

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

2. If ORG Ltd. 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 filing of the Form 990 was incorrect. For the
year beginning January 1, 20xx, should have filed Form 1120-PC.

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.
The election under clause (ii) shall apply to the taxable year for which made and
for all subsequent taxable years for which the requirements of clause (1) are

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

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

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 year 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.

Form 886-A (rev.4-68) Department of the Treasury - Internal Revenue Service
Page: -9-

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

TAXPAYER’S POSITION

Unknown at the time of this writing

SUMMARY

It is the Governments position, based on the above facts, law and analysis, that the tax
exemption status of ORG for the years beginning January 1, 20xx, should be revoked
based on not meeting the qualifications for exemption under IRC 501(c)(15). Form
1120-PC would be required to be filed for any year where ORG does not qualify for
exemption under IRC 501(c)(15).

Form 886-A (rev.4-68) Department of the Treasury - Internal Revenue Service
Page: -10-