Small insurer loses exemption after premium income disappears

Plain-English summary

A controlled foreign stock insurance company had elected under section 953(d) to be treated as a domestic corporation and received exemption under section 501(c)(15). After a related business entered bankruptcy, the company stopped writing new coverage and used its remaining activity to pay claims and refund premiums on existing vehicle service contracts. Its gross receipts stayed below the $600,000 limit, but it received no positive premium income, so premiums were not more than 50 percent of gross receipts as required by the Pension Funding Equity Act of 2004. The IRS concluded that the company remained an insurance company under Subchapter L but no longer qualified for tax exemption. It revoked the exemption effective January 1 of the redacted year, and the company agreed.

Ruling snapshot

• Question: Did the stock insurer satisfy the section 501(c)(15) gross receipts and premium-income tests?
• Outcome: Revocation
• Key authorities: IRC §§ 501(c)(15) and 953(d); Pension Funding Equity Act of 2004; Notice 2006-42

Full text (IRS public release)

DEPARTMENT OF THE TREASURY
INTERNAL REVENUE SERVICE

TAX EXEMPT AND
GOVERNMENT
ENTITIES DIVISION

Date: 8/22/2014

Release Number: 201447041

Release Date: 11/21/2014
UIL Code: 501-15-00 Employer Identification Number:

Person to Contact / ID Number:

Contact Numbers:
Voice:
Fax:

CERTIFIED MAIL — RETURN RECEIPT REQUESTED
Dear

In a determination letter dated June 9, 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 May 28, 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 a taxable return on Form 1120-PC, U.S. Property and Casualty Insurance
Company Income Tax Return, for the year ended December 31, 20XX, with the

Service Center. For future periods, you are required to file income tax returns 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,

Marsha A. Ramirez
Director, EO Examinations

Encl: Form 6018-A

Internal Revenue Service Department of the Treasury

Taxpayer Identification Number:

Date: May 15, 2008

Form:
Tax Year(s) Ended:
Person to Contact/ID Number:

Contact Numbers:
Telephone:

Fax:

CERTIFIED MAIL - RETURN RECEIPT REQUESTED
Dear

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

If you do not agree with our position you may appeal your case. The enclosed Publication 3498, The
Examination Process, explains how to appeal an Internal Revenue Service (IRS) decision. Publication 3498
also includes information on your rights as a taxpayer and the IRS collection process.

If you request a conference, 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, or if you do not
request an Appeals conference, you may file suit in United States Tax Court, the United States Court of Federal
Claims, or United States District Court, after satisfying procedural and jurisdictional requirements as described
in Publication 3498.

Letter 3610 (Rev. 11-2003)
Catalog Number: 34801V

You may also request that we refer this matter for technical advice as explained in Publication 892, Exempt
Organization Appeal Procedures for Unagreed Issues. If a determination letter is issued to you based on
technical advice, no further administrative appeal is available to you within the IRS on the issue that was the
subject of the technical advice.

If you accept our findings, please sign and return the enclosed Form 6018, Consent to Proposed Adverse
Action. We will then send you a final letter revoking your exempt status. 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 this letter will become final. In that event, you will be required to file Federal income
tax returns for the tax period(s) shown above. File these returns with the Ogden Service Center 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 prefer, you may contact your local Taxpayer Advocate at:

Taxpayer Advocate Service

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

Thank you for your cooperation.

Sincerely,

Marsha A. Ramirez
Director, EO Examinations

Enclosures:
Publication 892
Publication 3498
Form 6018

Report of Examination
Envelope

Letter 3610 (Rev. 11-2003)
Catalog Number: 34801V

Schedule number or exhibit

Form 886-A
(Rev. January 1994) EXPLANATIONS OF ITEMS

Name of taxpayer Tax Identification Number Year/Period ended
12/31/20XX
ISSUE:
Whether , a controlled foreign corporation,

meets the new requirements for tax-exempt status, under IRC 501(c) (15), as
described in the Pension Funding Equity Act of 2004?

FACTS:

, (hereinafter “ ”) was
incorporated on January 12, 20XX, in , under the
Business Corporation Ordinance 19XX. The primary purposes for which the
corporation was formed are:

1. To engage in any lawful act or activity for which corporations
   may be organized under the Ordinance;

2. Without prejudice to the generality of clause (1) hereof to
   transact all or any kinds of re-insurance business in any part
   of the world save and except in the Federation of — and

3. To do all such things as may be deemed incidental or conducive
   to the attainment of the above objects or either of them
   including (where necessary) the application for all requisite
   licenses and governmental or other consents under any relevant
   ordinance or regulations thereunder in force from time to time.

The purposes of the Corporation are to be carried out and conducted

mainly outside in conformance with section 123(2) of the Ordinance.
The liability of members is limited. is authorized to issue
shares of $ per share. The corporation actually issued only shares.
The , who owns shares, is the sole shareholder of
the corporation. The Trust was created by for

traditional estate planning purposes in September 19XX.

The registered office of the corporation is located in . The Registered Agent of the corporation is

, the trustee of the shareholder of
filed an election under Internal Revenue Code section 953(d) to be treated
as a domestic corporation for United States tax purposes, on October 1,
20XX. The election commenced on January 12, 20XX.

Form 886-A (1-1994) Catalog Number 20810W Page 1 of 8 publish. no.irs.gov Department of the Treasury-Internal Revenue Service

Schedule number or exhibit

Form 886-A
(Rev. January 1994) EXPLANATIONS OF ITEMS

Name of taxpayer Tax Identification Number Year/Period ended
12/31/20XX
Internal Revenue Service records reveal that was granted

exemption as a small insurance company described in section 501(c) (15) of
the Internal Revenue Code on June 8, 20XX, commencing June 9, 20XX, for
all tax years beginning before January 1, 20XX, when net written premiums
(or, if greater, direct written premiums) do not exceed $ . For tax
years beginning on or after January 1, 20XX, the corporation is exempt if
(a) gross receipts for the taxable year do not exceed $600,000, and (b)
more than 50 percent of the gross receipts for the taxable year consists
of premiums.

is required to file annual information return, Form 990. The
Form 990 return filed for the year ended December 31, 20XX, was examined
by TE/GE, . During the initial inspection of the Form
990 for 20XX, it was noted that did accurately report being exempt
under IRC 501(c) (15) on line J in the heading of the return.

Since the passage of the Pension Funding Equity Act of 2004,

filed Form 990 returns for tax years ended December 31, 20XX, and
December 31, 20XX. filed Form 1120-PC for the 20XX tax year. On its
Form 990 returns filed for the year ended December 31, 20XX,
reported the following sources of income:

20XX
Gifts, Grants and Contributions -0-
Program Service Revenue -0-
Membership dues/assessments -0-
Interest on savings -0-
Dividends , -0-
Gain of Sale of Assets -0-
Other income -0-

Totals $

was originally operated to accept reinsured risk that originated as
appearance protection vehicle service contracts, with Group serving as
the direct writer, and , serving as the
administrator. This arrangement changed after

filed for bankruptcy in June 20XX.

Subsequent to the bankruptcy of
operated, primarily, to directly insure vehicle service contracts for new
and used cars sold by certain auto dealerships in the State of

Form 886-A (1-1994) Catalog Number 20810W Page 2 of 8 publish. no.irs.gov Department of the Treasury-Internal Revenue Service

Form 886-A EXPLANATIONS OF ITEMS

(Rev. January 1994)

Schedule number or exhibit

Name of taxpayer

Tax Identification Number

Year/Period ended
12/31/20XX

The vehicle service contracts are for appearance protection (sealant)

contracts written by

is

the long time business operator in the chemical industry that produces
chemicals used in the appearance protection sealant.

In 20XX, specifically,

any policies cancelled by consumers.

did not engage in new insurance

business. Nor was the company in “run-off” status during the year.
primary activity was to pay claims arising from existing appearance

protection certificates still outstanding and, to make reimbursements for

did not receive any premium

income in 20XX. The organization did pay a refund of premium in the

amount of $

20XX gross receipts consisted of interest from temporary
savings; dividends from publicly traded securities; and gain from the sale

of assets

gross receipts are less than the $600,000 limitation imposed

by the Pension Funding Equity Act of 2004.

However, based on the sources

of receipts reported on the 20XX Form 990 return, premium income was not
“more than” % of the corporation’s gross receipts.

There is no evidence of any other significant activities conducted by

during 20XX.

During the 20XX tax year,
The corporation filed Form 1120-PC, U.S. Property and Casualty Insurance
for the 20XX tax year, and paid tax on its

Company Income Tax Return,
taxable investment income.

did not

claim to be tax-exempt.

Although was not in voluntary “run-off” or “court ordered”
liquidation status in 20XX, the corporation is deemed to be an insurance
company under Subchapter L of the Internal Revenue Code, because it
continued to pay claims and/or refunds on existing policies. However,
does not qualify for tax-exempt status under IRC 501(c) (15), for the 20XX
tax year, because it failed to meet the new requirements for tax-exempt
status as described in the Pension Funding Equity Act of 2004.

Form 886-A (1-1994) Catalog Number 20810W

Page 3 of 8

publish. no.irs.gov

Department of the Treasury-Internal Revenue Service

Schedule number or exhibit

Form 886-A
(Rev. January 1994) EXPLANATIONS OF ITEMS

Name of taxpayer Tax identification Number Year/Period ended
12/31/20XX

PRIOR LAW

I.R.C. § 501 provides that certain entities are exempt from taxation.
Included in these entities are “[i]nsurance companies or associations
other than life (including interinsurers and reciprocal underwriters) if
the net written premiums (or, if greater, direct written premiums) for the
taxable year do not exceed $350,000.” I.R.C. § 501(c) (15) (A). If an
entity is a part of a consolidated group, all net written premiums (or
direct written premiums) of the members of the group are aggregated to
determine whether the insurance company meets the requirements of I.R.C.

§ 501(c) (15) (A).

The prior law was effective for tax years beginning after December
31, 1986, through December 31, 2003, the effective date of the Pension
Funding Equity Act of 2004.*

CURRENT LAW

For tax years beginning after December 21, 2003, an organization must
meet the following two-part test to qualify for exemption under IRC
501(c) (15) :”

1. Gross receipts for the year may not exceed $600,000 and
2. Premiums must be more than 50% of the organization’s total
   gross receipts.

Mutual insurance companies must meet either the above test, or the
following alternative test:

1. Gross receipts for the year may not exceed $150,000 and
2. Premiums must be more than 35% of the organization’s total
   gross receipts.

The alternative test for a mutual insurance company does not apply if
an employee of the company, or a member of the employee’s family [as
defined in IRC section 2032A(e) (2)] is an employee of another company
exempt from tax (or would be exempt) under IRC section 501(c) (15).

1 Prior to 1986, the direct or net written premium ceiling was limited to $150,000. The Tax Reform Act of 1986 increased the direct
or net written premium ceiling to $350,000 per year.
2 Notice 2006-42, I.R.B. 2006-19, April 24, 2006.

Form 886-A (1-1994) Catalog Number 20810W Page 4 of 8 publish. no.irs.gov Department of the Treasury-Internal Revenue Service

Schedule number or exhibit

Form 886-A EXPLANATIONS OF ITEMS

(Rev. January 1994)
Name of taxpayer Tax Identification Number Year/Period ended

12/31/20XX

If an organization is in a receivership, liquidation, or similar
proceeding under the supervision of a state court on April 1, 2004, the
new law applies to taxable years beginning after the date such proceeding
ends or December 31, 2007, whichever is earlier.

GOVERNMENT’S POSITION:

Internal Revenue Code section 501(c) (15) originally referred only to
certain mutual insurance companies or associations other than life or
marine. The Tax Reform Act of 1986 (“TRA-86”) eliminated the distinction
between small mutual insurance companies and other small insurance
companies and extended exemption under IRC 501(c) (15) to all eligible
small insurance companies, whether stock or mutual.

TRA 86 also changed the nature of the ceiling amount for tax
exemption from certain gross receipts to direct or net written premiums.
The ceiling amount was changed from $150,000 to $350,000. Therefore,
under TRA 84, to qualify for exemption as a small insurance company, the
direct or net written premiums received by an organization could not
exceed $350,000 for a taxable year.

The requirements established under TRA 86 posed serious problems for
the Service, because the requirements did not place any limitation of the
amount of investment income small insurance companies could earn. Many
taxpayers and tax professionals took advantage of the tax-exempt treatment
allowed to small insurance companies by contributing highly appreciated
income producing assets to the tax-exempt organizations. The assets
produced substantial investment income that was not taxed due to the tax-
exempt status of the small insurance companies.

Congress intended to curb this loophole in the law by including
language in Section 206 of the Pension Funding Act of 2004, which, once
again, changed the requirements for tax-exempt status for Small Property
and Casualty Insurance Companies.

On April 10, 2004, President Bush signed H.R. 3108, the Pension
Funding Equity Act of 2004, P.L. 108-218. One purpose of the legislation
was to tighten the rules for property and casualty insurance companies to
qualify as tax-exempt under section 501(c) (15) of the Code, or to elect to
be taxed only on their investment income. The bill contained the following
comments from the Conference Report:

Form 886-A (1-1994) Catalog Number 20810W Page 5 of 8 publish. no.irs.gov Department of the Treasury-Internal Revenue Service

Schedule number or exhibit
Form 886-A EXPLANATIONS OF ITEMS
(Rev. January 1994)
Name of taxpayer Tax Identification Number Year/Period ended

12/31/20XX

The limitation to mutual companies and the limitation
on employees are intended to address the conferees’
concern about the inappropriate use of tax-exempt
insurance companies to shelter investment income,
including in the case of companies with gross receipts
under $150,000. It is intended that the provision not
permit the use of small companies with common owners
or employees to shelter investment income for the
benefit of such owners or employees.

The new legislation amended IRC 501(c) (15) for tax years beginning
after December 31, 2003. The new law replaced the “written premiums test”
with a “gross receipts and percentage of premiums test.”

The new law placed an overall limitation on the amount of gross
receipts small insurance companies could earn for each taxable year.

Therefore, for years beginning after December 31, 2003, small
insurance companies can not have gross receipts in excess of $600,000 to
qualify for tax-exempt status under IRC 501(c) (15). In addition, of its
total gross receipts, more than 50% must be derived from premium income.

The facts present in this case clearly demonstrate that
does not meet the new requirements for tax-exempt status under IRC
501(c) (15), in 20XX, because its gross receipts do not consists of
adequate “premiums” to meet the “more than 50%” test imposed by the new

law. During the 20XX tax year, did not receive positive premium
income. On the 20XX Form 990 return, reported negative premiums of
($ ), which typically represent reimbursements of premiums to

consumers for cancellation of the insurance policies. The reimbursements
were reported on the 20XX return as a negative income item instead of
reporting such reimbursements as an expense item. Based on the audit,
gross receipts for 20XX are as follows:

20XX

Premiums -0-
Interest on temporary savings -0-
Dividends and interest from securities -0-
Gain on sale of assets -0-
Other income -0-
Gross Receipts -0-

Form 886-A (1-1994) Catalog Number 20810W Page 6 of 8 publish. no.irs.gov Department of the Treasury-Internal Revenue Service

Schedule number or exhibit

Form 886-A
(Rev. January 1994) EXPLANATIONS OF ITEMS

Name of taxpayer Tax Identification Number Year/Period ended

12/31/20XX

Do Gross Receipts exceed

$600,000 limitation?

50% of Gross Receipts -0-
Premiums -0-

Do Premiums exceed 50%
Of Gross Receipts?

Does Org meet the Gross
Receipts Test?

Does Org Qualify for exemption
Under IRC 501(c) (15)?

Conclusion 1120PC

NOTE: As a stock corporation, the alternative gross receipts test ($150,000/35%) is NOT available to
. Such alternative test is available to mutual insurance companies only.

The principal gross receipts tests consist of two parts. The
corporation must satisfy both parts of the $600,000/50% gross receipts
test. In this case, does meet part-one of the $600,000 gross
receipts limitation permitted for small insurance companies. However,
does not satisfy part-two of the gross receipts test because its premium
income does not exceed 50% of gross receipts for 20XX. must
satisfy both parts of the $600,000/50% gross receipts test in order to
meet the new requirements for tax-exempt status under section 501(c) (15)
of the Code. If fails to meet either component of the two part
test, then it fails to qualify for exemption as a small insurance company.
As a stock corporation, the alternative gross receipts test ($150,000/35%)
is not available to

Based on the above analysis, it is determined that was
properly recognized as a tax-exempt small insurance company for years
prior to December 31, 20XX. However, due to the change in law, the
corporation no longer qualifies for tax-exempt status for the tax year
ended December 31, 20XX, because it fails to comply with the $600,000/50%
gross receipts test imposed by the Pension Fund Equity Act of 2004.

Form 886-A (1-1994) Catalog Number 20810W Page 7 of 8 publish. no.irs.gov Department of the Treasury-Internal Revenue Service

Schedule number or exhibit
Form 886-A EXPLANATIONS OF ITEMS
(Rev. January 1994)
Name of taxpayer Tax Identification Number Year/Period ended
12/31/20XX

As such, it is recommended that tax-exempt status under

IRC 501(c) (15) be revoked, effective January 1, 20XX.
TAXPAYER'S POSITION:

The proposed revocation issue was discussed with , CPA and
representative, for during a telephone call held on May 15,
20XX.

CONCLUSION:

A. is an insurance company pursuant to Subchapter L of
the Code for the taxable year 20XX.

B. Although is an insurance company pursuant to

Subchapter L of the Code, it does not qualify as a tax-exempt small
insurance company because its gross receipts do not consists of adequate
“premiums” to meet the $600,000/50% gross receipts test, as described in
the Pension Funding Equity Act of 2004, required of entities to qualify
for exemption under IRC 501(c) (15) of the Internal Revenue Code.

C. Therefore, revocation of tax-exempt under IRC 501(c) (15) is
proposed, effective January 1, 20XX.

D. is required to file an income tax return for calendar year ended
December 31, 20XX.

Form 886-A (1-1994) Catalog Number 20810W Page 8 of 8 publish. no.irs.gov Department of the Treasury-Internal Revenue Service