Insurance sold to members' widows generated unrelated business income

Plain-English summary

A tax-exempt fraternal beneficiary society regularly sold new life insurance policies to the non-member widows of deceased insured members. A widow could buy different coverage from the deceased member's policy, had to satisfy ordinary underwriting requirements, and could name a beneficiary who was not the member's dependent. The IRS advised that these sales resembled ordinary commercial insurance rather than benefits arising from the mutual relationship among the society's members. Because the sales did not contribute importantly to the society's exempt purpose under section 501(c)(8), they were not substantially related under section 513. Income from the regularly conducted sales therefore entered the society's unrelated business taxable income under sections 511 and 512.

Ruling snapshot

• Question: Were the society's life insurance sales to non-member widows substantially related to its exempt fraternal purpose?
• Outcome: Advice given. The sales were an unrelated trade or business.
• Key authorities: IRC §§ 501(c)(8), 511, 512, and 513; Treas. Reg. §§ 1.501(c)(8)-1 and 1.513-1

Full text (IRS public release)

Release Number: 201425015 INTERNAL REVENUE SERVICE

Release Date: 6/20/2014
Date: July 14, 2011 TE/GE TECHNICAL ADVICE MEMORANDUM

UIL Code: 501.08-00

Area Director, Office of Appeals, Field Operations East, Area 4
Philadelphia, PA

Taxpayer's Name:
Taxpayer's Address:
Taxpayer's ID Number:
Years Involved:

Conference Held:

LEGEND:
M =
ISSUE:

Is M’s sale of life insurance policies to the non-member widows of deceased insured members
within a year following the member's death — policies under which the widow can name as a
beneficiary someone other than a dependent of the member — substantially related (within the
meaning of section 513 of the Internal Revenue Code (the “Code”)) to the exercise or
performance by M of any purpose or function described in section 501(c)(8)?

FACTS:

M is the parent entity of a fraternal beneficiary society that operates under the lodge system.
Membership in M is limited to men of a particular faith. Under a group ruling issued by the
Internal Revenue Service, M and its subordinate chapters are recognized as exempt from federal
income tax under section 501(a) of the Code by reason of being an organization described in
section 501(c)(8). Among the purposes (enumerated in M’s corporate charter) for which M was
formed are the purposes “of rendering pecuniary aid to its members, their families, and
beneficiaries of members and their families [and] of rendering mutual aid and assistance to its
sick, disabled, and needy members and their families.”

M operates as an insurance company and contracts with full-time insurance sales persons to sell
life insurance, annuities, and related products to its members. M sells individual life insurance
contracts to members that may include separate coverage for the member's spouse or
dependents. Such contracts also provide the insured’s spouse the right, after the insured’s
death, to request insurance coverage on her life and on the lives of the insured's minor children.
The right must be exercised within one year following M’s receipt of proof of the insured’s death.

Specifically, insurance contracts issued to members include the following provision or
endorsement:

Spouses Right to Apply for Insurance
In addition to the other rights and benefits provided under this contract, after the

Insured’s death the Insured’s spouse shall have the right to request insurance coverage:
(1) on her life; and (2) on the lives of the Insured’s minor children. This right must be

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exercised within one year following the Order's receipt of proof of the Insured’s death.
The insurance coverage requested will be issued, provided that satisfactory evidence of
insurability is submitted to the Order. The date the insurance coverage takes effect will
depend upon: (1) the rules of the Order; and (2) the date the Order accepts the evidence
of insurability.

For purposes of this provision, the following definitions apply: “insurance
coverage” includes all plans of life insurance, annuities, and long term care insurance
offered by the Order at the age and premium class of the proposed insured or annuitant
at the time of the exercise of this right. “Insured’s minor children” includes all children,
stepchildren, and legally adopted children of the Insured who have not yet reached their
18th birthday as of the date insurance coverage is requested; and “Insured’s spouse”
means the person to whom the Insured is married as of the date of the Insured’s death.

The widow’s right to purchase insurance within one year of her husband’s death is available only
to a spouse whose husband was insured by M at the time of his death. If the member was not
insured by M at the time of his death, the widow may not purchase insurance from M.

The widow may apply for coverage in a different amount, or of a different type, than that
previously held by the member. A widow must meet normal underwriting requirements and
criteria for the policy and amount she requests, and the insurance products that the widow is
entitled to purchase are virtually indistinguishable, both in features and in price, from the
insurance sold by taxable insurance providers.

M represents that the widow is under no obligation to name a dependent of the deceased
member as a beneficiary of any insurance coverage she purchases and is entitled to change the
beneficiary at any time, subject to any state law restrictions.

LAW:

Section 501(c)(8) of the Code exempts from federal income taxation fraternal beneficiary
societies, orders or associations—(A) operating under the lodge system or for the exclusive
benefit of the members of a fraternity itself operating under the lodge system, and (B) providing
for the payment of life, sick, accident, or other benefits to the members of such society, order, or
association, or their dependents.

Section 1.501(c)(8)-1 of the Income Tax Regulations (the “regulations”) provides that a fraternal
beneficiary society is exempt from tax only if operated under the “lodge system” or for the
exclusive benefit of the members so operating. “Operating under the lodge system” means
carrying on its activities under a form of organization that comprises local branches, chartered by
a parent organization and largely self-governing, called lodges, chapters, or the like. In order to
be exempt it is also necessary that the society have an established system for the payment to its
members or their dependents of life, sick, accident or other benefits.

Rev. Rul. 73-165, 1973-1 C.B. 224, holds that a fraternal beneficiary society which carries on
fraternal activities, operates under a lodge system, and provides for member benefit payments
may qualify for exemption under section 501(c)(8) of the Code. The ruling indicates that there is
no requirement for exemption that either the fraternal features or the benefit features predominate
as long as both features are present.

Section 511 of the Code imposes a tax on the unrelated business taxable income of
organizations otherwise exempt from federal income tax under section 501(c).

Section 512(a)(1) of the Code defines the term “unrelated business taxable income” as the gross
income derived by any organization from any unrelated trade or business regularly carried on by

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it, less the deductions allowed under Chapter 1 which are directly connected with the carrying on
of such trade or business, both computed with the modifications provided in section 512(b).

In the case of an organization subject to the tax imposed by section 511, section 513(a) of the
Code defines the term “unrelated trade or business” as any trade or business the conduct of
which is not substantially related (aside from the need of such organization for income or funds or
the use it makes of the profits derived) to the exercise or performance by such organization of the
purpose or function constituting the basis for its exemption under section 501.

Section 1.513-1(a) of the regulations says that gross income of an exempt organization subject to
the tax imposed by section 511 is includible in the computation of unrelated business taxable
income if: (1) it is income from a trade or business; (2) such trade or business is regularly carried
on by the organization; and (3) the conduct of such trade or business is not substantially related
(other than through the production of funds) to the organization’s performance of its exempt
functions.

Section 1.513-1(d)(1) of the regulations says that gross income derives from “unrelated trade or
business,” within the meaning of section 513(a), if the conduct of the trade or business which
produces the income is not substantially related (other than through the production of funds) to
the purposes for which exemption is granted. The presence of this requirement necessitates an
examination of the relationship between the business activities which generate the particular
income in question — the activities, that is, of producing or distributing the goods or performing the
services involved — and the accomplishment of the organization’s exempt purposes.

Section 1.513-1(d)(2) of the regulations says that trade or business is “related” to exempt
purposes, in the relevant sense, only where the conduct of the business activities has causal
relationship to the achievement of exempt purposes (other than through the production of
income); and it is “substantially related,” for purposes of section 513, only if the causal
relationship is a substantial one. Thus, for the conduct of trade or business from which a
particular amount of gross income is derived to be substantially related to purposes for which
exemption is granted, the production or distribution of the goods or the performance of the
services from which the gross income is derived must contribute importantly to the
accomplishment of those purposes. Where the production or distribution of the goods or the
performance of the services does not contribute importantly to the accomplishment of the exempt
purposes of the organization, the income from the sale of the goods or the performance of the
services does not derive from the conduct of related trade or business. Whether activities
productive of gross income contribute importantly to the accomplishment of any purpose for
which an organization is granted exemption depends in each case upon the facts and
circumstances involved.

ANALYSIS:

A fraternal beneficiary society described in section 501(c)(8) of the Code is one “operating under
the lodge system” and “providing for the payment of life, sick, accident or other benefits to the
members of such society, order, or association or their dependents.” Since the Code does not
define a “fraternal beneficiary society,” we presume that Congress used the term in the ordinary
sense, and according to its legal significance, at the time that fraternal beneficiary societies were
first exempted from federal income taxation under section 38 of the Tariff Act of August 5, 1909,
36 Stat. 113 (1909). See United States v. Cambridge Loan & Bldg. Co., 278 U.S. 55, 58 (1923)
(“When Congress exempted [building and loan] associations from the income tax of course it was
speaking of existing societies that commonly were known as such, not of ideals that would have
been hard to find”); Commercial Travelers’ Life & Accident Ass’n v. Rodway, 235 F. 370, 374
(N.D. Ohio 1913) (“The court shall assume that Congress used the term [fraternal beneficiary
association] according to its legal significance at the time the act [of 1909] was passed.”) (citation
omitted). The term “fraternal beneficiary society” (or association or order) was extensively
defined, judicially and by state statute, in the early twentieth century. Although most of the

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authorities containing these definitions do not directly address section 501(c)(8) (or its
predecessors), they have legal significance when interpreting the term “fraternal beneficiary
society” and the phrase “providing for the payment of life, sick, accident and other benefits to the
members of such society, order, or association or their dependents” contained in section
501(c)(8).

The most thorough judicial “definition” of the term “fraternal beneficiary association” can be found
in Nat'l Union v. Marlow, 74 F. 775, 778-79 (8th Cir. 1896), where the court said:

We must accordingly assume that the words “fraternal-beneficial” were used in their
ordinary sense, -- to designate an association or society that is engaged in some work
that is of a fraternal or beneficial character. According to this view, a fraternal-beneficial
society ... would be one whose members have adopted the same, or a very similar,
calling, avocation, or profession, or who are working in unison to accomplish some
worthy object, and who for that reason have banded themselves together as an
association or society to aid and assist one another, and to promote the common
cause.... As a general rule such associations have been formed for the purpose of
promoting the social, moral, and intellectual welfare of the members of such associations,
and their families, as well as for advancing their interests in other ways and in other
respects.... Many of these associations make a practice of assisting their sick and
disabled members, and of extending substantial aid to the families of deceased
members.

In Commercial Travelers’ Life & Accident Ass’n, 235 F. at 374, a federal court applied this
definition of “fraternal beneficiary society” contained in Nat'l Union v. Marlow to conclude that a
mutual protective association was not exempt from federal income taxation under the
predecessor of section 501(c)(8).

As originally conceived, then, fraternal beneficiary societies existed principally to foster the
communion and cooperation of their members for their mutual aid and benefit. In furtherance of
that confraternity, the members took it upon themselves to contribute jointly and uniformly in the
aid of their sick members and the families of deceased members. An early treatise on fraternal
insurance summarized the ideal of fraternalism as follows:

Therefore, let it be understood that the American fraternal system had its beginnings as a
result of the fraternal desire of men to cooperate for their mutual welfare and happiness,
and that the benefit plan they introduced followed an innate prompting to protect their
dependents.

See Walter Basye, History and Operation of Fraternal Insurance 39 (1919).

The first fraternal benefit funds were simple, equal assessments against all the members of the
society:

[T]he benefit fund under the plan of the first society consisted of a single assessment and
the money remained in the hands of the subordinate lodge recorders until demanded by
the grand lodge for the purpose of paying a death claim. Each death exhausted the fund,
but it was renewed by another assessment. Each member, upon an assessment call
being made, without distinction on account of age or length of membership, paid an equal
amount — one dollar.

Id. at 56.

"This memorandum does not specifically address the definition or limits of the term “dependent”
for purposes of section 501(c)(8), as setting the limits of that term is not necessary to address the
issue raised.

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It was the distinctiveness of the early fraternal benefit funds that provided a justification for the
treatment accorded fraternal beneficiary societies under federal and state law. In addition to
exemption from federal income taxation, fraternal beneficiary societies have commonly been
exempted from the operation of the general insurance laws of the states and from state taxes
except property taxes, as is the case under the laws of the state from which M received its
charter. And courts have found that the feature that most distinguishes fraternal benefit plans
from commercial insurance is that the fraternal plans are an expression of the fraternal ties
between the members and not a commercial undertaking between insurer and insured. Thus, in
Peterson v. Manhattan Life Ins. Co., 91 N.E. 466, 469 (Ill. 1910), the court said the following
regarding how fraternal beneficiary societies were distinguishable from commercial insurance
companies at the time the former were first exempted from federal income taxation:

in the ordinary sense a fraternal order is not an insurance company.... [T]he two classes
of corporations are organized under different acts and for different purposes. A life
insurance policy may be obtained either by the insured or any one having an interest in
his life, may be payable to his estate, to a creditor, or to a beneficiary named.... The
certificate of a beneficiary society may be obtained only by the member. It cannot be
payable to his estate, but only to his widow or children or some one belonging to the
classes mentioned in the statute....

Again, in Van de Water v. Order of United Commercial Travelers of America, 77 F.2d 331, 332
(2d Cir. 1935), the Court said:

Like mutual insurance companies, beneficial associations, doing business without capital
on the assessment plan, differ from companies dealing in insurance only. The point of
distinction lies in their organization. They are formed, usually, not as insurance
companies but as social and benevolent associations; the insurance being but an
incident, and not their main purpose. The insurance feature is conducted not for the
purpose of gain, but for the object of benevolence... The benefits are usually confined to
limited classes of persons, one not a member of the society being unable, as a rule, to
obtain a certificate of insurance, and the member's right to nominate the person to whom
death benefits shall be paid, is usually limited either by statute, article, or by by-law...
Usually, the society and its members, by their elected representatives, are both the
insurer and the insured, and the members have the right, through their representatives, to
make or change their contract of membership or insurance. The insurance feature of
such a fraternal society is exactly what its members, through their representative form of
government, provide.

The idea that fraternal insurance derives its uniqueness from the fraternal bonds of the members
was expounded by the Supreme Court of Missouri, in Biggs v. Modern Woodmen of America, 82
S.W.2d 898, 904 (Mo. 1935):

Fraternal benefit associations are essentially different in many respects from insurance
companies.... They confine their operations to their own members. They do not solicit
business from the general public.... They usually limit the class of persons who may be
designated as beneficiaries to certain relatives of members. They do not operate for
profit, but accumulate a fund from contributions of members to be used in the aid or relief
of members or their beneficiaries.... The members are, in effect, both insurers and
insured. The rights of the members or their beneficiaries to participate in the fund are not
fixed by the terms of the certificate, as in the case of an ordinary life insurance policy, but
depend also upon the constitution and by-laws of the association. Since they are self
governing bodies, regulations are made by the members themselves through their duly
elected representatives and, therefore, there is good reason to regard them in a
somewhat different light from conditions written in a policy of insurance by an ordinary
insurance company dealing with the general public for profit... Recognizing such

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differences, our Legislature has enacted a statute that such societies “shall be exempt
from all provisions of the insurance laws of this state, not only in governmental relations
with the state, but for every other purpose, and no law hereafter enacted shall apply to
them, unless they be expressly designated therein....”

The courts recognized that because state law at the time fraternal beneficiary societies were first
exempted from federal income taxation did not impose on these societies “the heavy duties and
restrictions” that were imposed on old-line companies, it was lawful and proper for the state “to
[admit] these societies into the arena of life insurance” only to the extent of “mak[ing] provisions
for the payment of benefits in case of death of its members” from funds “derived from
assessments or dues collected from its members.” See State ex rel. Supreme Lodge K. P. v.
Vandiver, 111 S.W. 911, 912-13 (Mo. 1908).

Accordingly, a primary distinction between the “payment of life, sick, accident, or other benefits to
the members of [a fraternal beneficiary society] or their dependents” and insurance sold by
taxable insurance firms lies in the nature of the membership rights in a fraternal beneficiary
society. The sale of insurance to a member is part of the “mutuality of interest” that exists
between the members of such societies. On the other hand, the sale of insurance to a non-
member is nothing more that a mere contractual relationship between a policyholder and an
insurance company. In Order of United Commercial Travelers of America v. Wolfe, 331 U.S. 586,
605-06 (1947), the Supreme Court said:

The relationship ... between a member and his fraternal benefit society differs from the
ordinary contractual relationship between a policyholder and a separately owned
corporate or “stock” insurance company. It differs also from that between an insured
member of the usual business form of a mutual insurance company and that company.
The fact of membership in the ... fraternal benefit society is the controlling and central
feature of the relationship.

As an organization described in section 501(c) of the Code, M is subject to the tax imposed under
section 511 on its unrelated business taxable income. Section 512(a)(1) tells us that “unrelated
business taxable income” is income from an unrelated trade or business regularly carried on.
Furthermore, section 1.513-1(a) of the regulations tells us that gross income is includible in the
computation of unrelated business taxable income if: (1) it is income from a trade or business; (2)
such business is regularly carried on; and (3) the conduct of such trade or business is not
substantially related to the organization’s exempt purposes.

M derives income from frequent and regular sales of insurance contracts to the widows of
deceased members. The sale of insurance is a trade or business and, in the case of M, such
sales are regularly carried on. Thus, unless such sales are substantially related to M's
performance of its exempt fraternal functions, the revenue derived from those sales is includible
in M’s unrelated business taxable income. To determine whether such sales constitute an
unrelated trade or business, section 1.513-1(d)(1) of the regulations tells us to examine the
relationship between those sales and the accomplishment of M's fraternal purposes. If it is found
that such sales do not contribute importantly to M’s exempt fraternal purposes, section 1.513-
1(d)(2) tells us that those sales are not substantially related to exempt purposes and are,
therefore, “unrelated trade or business” within the meaning of section 513 of the Code.

Any sale of insurance that is inconsistent with the historical meaning of the term “fraternal
beneficiary society” and the section 501(c)(8) phrase “providing for the payment of life, sick,
accident and other benefits to the members of such society, order, or association or their
dependents” is not substantially related to M’s exempt purposes described in section 501(c)(8)
(emphasis added). See Ocean Pines Ass'n, Inc. v. Comm’r, 135 T.C. 276, 283 (2010), aff’d 672
F.3d 284 (4th Cir. 2012) (“Logically, if. . . activities do not contribute to . . . [an organization's tax-
exempt purpose] in the context of determining whether an organization qualifies for exemption,

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then surely these same activities cannot be said to be related to the organization's exempt
purpose in the context of the UBTI provisions.”) (quoting Profl. Ins. Agents of Mich. v. Comm’r, 78
T.C. 246, 267 (1982), aff’d 726 F.2d 1097 (6th Cir. 1984)).

M is organized for the exempt fraternal purpose of rendering pecuniary and mutual aid and
assistance to its members and their dependents.2 Membership in M is limited to men. The
insurance contracts that M enters into with its members gives the member-insured’s spouse,
upon the death of the member-insured, the right to request insurance coverage on her own life or
the lives of the member-insured’s minor children, which insurance can provide benefits to
individuals who are not dependents of the member. The member-insured’s spouse is ineligible
for membership in M, and thus lacks any fraternal relationship or mutuality of interest with the
members of M. The insurance coverage that is offered to the widow after the member’s death is
no mere continuation of the member's policy. The widow may apply for coverage in a different
amount, or of a different type, than that previously held by the member. The widow is not
guaranteed coverage, but must satisfy M’s usual underwriting criteria before a policy will be
issued to her. Further, the insurance products that the widow is entitled to purchase are virtually
indistinguishable, both in features and in price, from the insurance sold by taxable insurance
providers. Consequently, the sale of insurance to the widow is no different than an ordinary
contractual relationship between a policyholder and an insurance company.

Importantly, among the requirements for exemption under section 501(c)(8) is the requirement
that a fraternal beneficiary society provide for the payment of “life, sick, accident, or other
benefits” (emphasis added) to the members of the society or their dependents. Thus, the sale of
an insurance policy by a fraternal beneficiary society cannot be said to contribute importantly to
such society's exempt fraternal purpose to the extent that anyone other than a member of the
society or a dependent of the member is named as a beneficiary of the policy.

If M allows the widow of a deceased member to purchase life insurance on her own life, the
proceeds of the policy would be payable, on the widow's own death, to beneficiaries selected by
the widow. Though the widow might name a dependent of the deceased member as the
beneficiary of the policy, she is under no obligation to do so, and she is entitled to change the
beneficiary at any time. Thus, the widow could name as a beneficiary, someone who was not a
member or dependent of a member of the fraternal benefit society. For example, if the widow
were to remarry after the member's death, she could name her new spouse or any children of the
new spouse, as beneficiaries of her insurance policy, none of whom could be considered
“dependents” of the member at the time of his death.

Consequently, M's sales of insurance contracts to the widows of deceased members have none
of the characteristics that courts have said make fraternal insurance distinguishable from
commercial insurance so as to justify exemption from taxation. Such contracts are not benefits
payable to the widow on the death of the member. Compare State ex rel. Supreme Lodge K. P.
v. Vandiver, above. Instead, such insurance contracts are obtainable by persons other than
members, are paid for by persons other than members, and are payable to persons who were
never nominated by the member and who may not even have been dependents of the member.
Compare Peterson v. Manhattan Life Ins. Co. and Van de Water v. Order of United Commercial
Travelers of America, above. Furthermore, by selling insurance contracts to the widows of
deceased members, M does not confine its insurance operations to its own members. Rather, it
enters into purely commercial arrangements with insureds whose rights are fixed by the terms of
the insurance policy and not dependent, by membership, on the constitution and by-laws of the
society. Compare Biggs v. Modern Woodmen of America, above. And because the insurance
contracts offered to widows are substantially similar in features and price to insurance contracts
offered by large mutual life insurance companies, such sales are not conducted “for the object of

Although M's corporate charter uses the term “families,” section 501(c)(8) describes providing
for the payment of benefits to “dependents.” Consistent with the Code section constituting the
basis for M's exemption, we use the term “dependents” in describing M's exempt purpose.

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benevolence,” but appear to be conducted “for the purpose of gain” (see Van de Water v. Order
of United Commercial Travelers of America).

Since there is nothing in M’s sale of insurance contracts to the widow of a deceased member to
distinguish the relationship that exists between the widow and M from an ordinary contractual
relationship between a policyholder and a corporate insurance company (compare Order of
United Commercial Travelers of America v. Wolfe, above), and since the widow would be able to
name as a beneficiary of her policy someone other than a dependent of the member, such sales
do not contribute importantly to M’s exempt fraternal purpose of rendering pecuniary aid to its
members and their dependents and thus are not substantially related (other than through the
production of funds) to M’s exempt fraternal purposes. Therefore, M’s sales of commercial-type
insurance to non-members constitutes an unrelated trade or business.

CONCLUSION:

M's sale of life insurance policies to the non-member widows of deceased insured members
within a year following the member's death — policies under which the widow can name as a
beneficiary someone other than a dependent of the member — is not substantially related (within
the meaning of section 513 of the Internal Revenue Code (the “Code”)) to the exercise or
performance by M of any purpose or function described in section 501(c)(8).

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