Insurer loses exemption but receives retroactivity relief

Plain-English summary

An insurance and reinsurance company asked whether it qualified for exemption under section 501(c)(15) for three tax years and whether it should receive relief from retroactive revocation under section 7805(b). The IRS found that the company's insurance activities represented only 1.36%, 1.41%, and 24% of its total business in the respective years, while most revenue came from property and other investments. The IRS also concluded that the company did not adequately distribute risk because it insured too few parties, concentrated its coverage, and wrote different types of risks that could not be pooled together. The technical advice therefore concluded that the company was not an exempt insurance company for the three years. It nevertheless granted section 7805(b) relief as of a redacted date.

Ruling snapshot

• Question: Did the company qualify as an exempt insurance company, and should the retroactive effect of revocation be limited?
• Outcome: Mixed. The company did not qualify under section 501(c)(15), but it received section 7805(b) relief.
• Key authorities: IRC §§ 501(c)(15), 831, 953(d), and 7805(b); Treas. Reg. §§ 1.801-3(a)(1) and 1.831-3(a); Rev. Ruls. 74-196, 2002-89, 2002-90, 2005-40, and 2007-47.

Full text (IRS public release)

Release Number: 201517018
Release Date: 4/24/2015

INTERNAL REVENUE SERVICE

TE/GE TECHNICAL ADVICE MEMORANDUM

Area Manager –

Date: January 26, 2015

Taxpayer's Name:
Taxpayer's Address

Taxpayer's Identification Number:
Years Involved:

Conference Held: N/A

Uniform Issue List

501.15-00
831.00-00

LEGEND:

Taxpayer =
State =
Z =
B =
C =
D =
E =
F =
G =
H =
I =
J =
K =
L =
M =
N =
O =
P =
Q =
R =
S =
T =
Property 1 =
Property 2 =
Property 3 =
Date 1 =
Date 2 =
Date 3 =
Year 1 =
Year 2 =
Year 3 =
Year 4 =
Year 5 =
a =
b =
c =
d =
e =
f =
g =
h =
i =
j =
k =
l =
m =
n =
o =
p =
q =
r =
s =
t =
u =
v =
w =
x =
y =
z =
aa =
bb =
cc =
dd =
ee =
ff =
gg =
hh =
ii =
jj =
kk =
ll =
mm =
nn =
oo =
pp =
qq =
rr =
ss =
tt =
uu =
vv =
ww =
xx =
yy =
zz =
ux =
zy =
xw =
xy =
ab =
cd =
ef =
gh =
kh =

ISSUE:

1. Whether Taxpayer qualified as an insurance company under § 501(c)(15) of
   the Internal Revenue Code for tax years ending December 31 of Year 3, Year
   4 and Year 5.

2. Whether Taxpayer is entitled to relief pursuant to § 7805(b).

FACTS:

Taxpayer incorporated itself on Date1 in Z. Taxpayer made the election under § 953(d)
for treatment as a U.S. corporation for federal income tax purposes. Taxpayer also
applied for tax-exempt status under § 501(c)(15). On Date 3, IRS granted Taxpayer tax-
exempt status. Accordingly, for the tax years Year 3, Year 4, and Year 5, Taxpayer filed
a Form 990, Return of Organization Exempt from Income Tax. The IRS audited
Taxpayer's Year 3, Year 4, and Year 5 tax years and concluded that IRS should revoke
Taxpayer's tax-exempt status retroactively to include the tax years Year 3, Year 4, and
Year 5. Thereafter, Taxpayer requested a technical advice memorandum.

Facts as Presented on Form 1024 and Supplements

Taxpayer submitted its Form 1024, Application for Recognition of Exemption under §
501(a) (“Form 1024”) in the middle of Year 3 with Taxpayer's business plan enclosed. D
signed the Form 1024.

According to Taxpayer's Memorandum of Association, Taxpayer was established “to
engage in the business of an insurance and reinsurance company, to act as insurance
agents, intermediaries and consultants, to accept risks and to settle claims on its own
behalf and on behalf of others.” Under A's laws, Taxpayer was licensed to engage in the
general insurance business with respect to fire, theft, business interruption, legal liability,
property & casualty insurance, and credit life and credit disability reinsurance.

Taxpayer's principal office is located in State. On Date 2, Taxpayer received its
insurance license from A's Government and employed B to manage Taxpayer's
insurance activities.

Taxpayer revenue for Year 3 totaled $ab. For Years 3, Taxpayer's premium revenue
was less than 2% of Taxpayer's aggregate revenue, 1.36% for Year 3. Net gain from
sale of non-inventory assets was over 90% of Taxpayer's aggregate revenue for Year 3,
95.3% for Year 3.

Pursuant to Taxpayer Form 1024, in the first half of Year 3, Taxpayer wrote direct
insurance that totaled $gh and reinsurance that totaled $kh.

Total direct insurance Taxpayer wrote in Year 3 sum up $tt. One contract provided
“Administrative Actions” coverage, to F for $h, while the other policy provided
“Employment Practices Liability” coverage to L for $i.

F's business operation consisted of (a) owning/retailing petroleum facilities primarily in
State and a neighboring state, (b) real estate speculation and development in State, and
(c) private and public equity investments. F devotes 75% of its business to real estate
speculation. As of the beginning of Year 3, D's brother owned 97% of F and 63.83% by
the end of Year 3.

L devotes 80% of its business operation to owning and retailing petroleum in State and
20% consist of real estate speculation and development in State. D, Taxpayer's
officer/director, is also L's director.

Policies covering “administrative actions” indemnified insureds for a broad variety of
actions, including disciplinary proceedings or governmental actions taken against the
insured pertaining to the business, trade or profession of the insured. Disciplinary
proceedings included any professional review action against the insured by a voluntary
or mandatory trade association or professional organization with which the insured had
privileges, membership or any similar association, which action had the potential to
affect adversely said privileges, membership, or association.

Policies covering “employment practices liability” include a severance pay insurance
coverage that include an event that causes a liability pertaining to the business, trade or
profession of the Insured resulting from the termination of an employee and the granting
of a severance package in accordance with the business, trade or profession of the
Insured.

In Year 3, Taxpayer and O entered into reinsurance arrangement contracts. Taxpayer
assumed from O during Year 3 1.01% pro-rata shares of group disability insurance and
related claims. Both agreed there would be no guarantees to limit Taxpayer's losses.
Total reinsurance for Year 3 was $q.

On October 19, of Year 3, IRS approved Taxpayer's Form 1024 tax-exempt status
application under § 501(c)(15).

Facts as Developed by Agent during the Examination Process

Taxpayer, by common ownership and/or control, has interest in a group of businesses
that includes F, G, H, L, J, and K (collectively, the “Companies”). Companies except L,
are located at the same address/location as Taxpayer, however, Taxpayer's director, D,
is one of L's director and minority owner.

Pursuant to Taxpayer's business plan, Taxpayer will provide non-traditional insurance
coverage to the Companies. 50 percent or more of Taxpayer's business will consists of
providing insurance services to the Companies. The remaining balance of Taxpayer's
business will consists of reinsurance business of unrelated, licensed insurance
companies. Taxpayer represents that it will cover risks not covered by traditional
insurance companies.

Taxpayer revenue for Year 4 and Year 5 total $cd and $ef respectively. For Year 4,
Taxpayer's premium revenue was less than 2% of Taxpayer's aggregate revenue,
1.41% for Year 4. Net gain from sale of non-inventory assets was over 90% of
Taxpayer's aggregate revenue for Year 4, 93.24% for Year 4.

In Year 5, premium revenue accounted for 24% of Taxpayer's total revenue, the
remaining consisted of other investments (58.26%) and net gain from non-securities
sales (18.67%).

Taxpayer's Form 990s reported net gains from sale of non-inventory assets as follows;
$ii for Year 3, $jj for Year 4 and $kk for Year 5.

Pursuant to minutes from Taxpayer's Board meeting, Taxpayer's total asset for Year 4
was $ll compared to $mm for Year 3, this increase was mainly because of sale of
Property 3.

Because of real property sales transactions in Year 4, Taxpayer net income for Year 4
was $nn, However, because there was no real property sale transactions in Year 5,
Taxpayer had a net loss of $oo.

Year 4 total investment income was $pp compared to $qq for Year 5. Year 4 premium
income was $rr compared to $ss for Year 5.

Taxpayer's business plan also noted that Taxpayer wrote most of Taxpayer's direct-
written policies to Companies, companies owned/controlled by D, E and their families.

In Year 4, Taxpayer wrote two direct contracts that total $uu. One direct contract
provided “Administrative Actions” coverage to F for $j, while the other policy provided
“Employment Practices Liability” coverage to L for $k. For Year 4, there is no event
maximum amount or annual maximum amount deductible for L and F.

In Year 5, Taxpayer wrote five direct contracts, one direct contract provided
“Administrative Actions” coverage to F for $l. Another policy provided “Employment
Practices Liabilities” coverage to L for $m. The remaining three provided “Commercial
Excess General Liability” coverage in respective amounts of $n to P, $o to Q and $p to

P, Q and R, devote 80% of their activities towards owning/operating retail petroleum
facilities located mainly in State and 20% towards real estate speculation/development in
State.

Taxpayer wrote direct-written insurance contract that totaled $vv for Year 5. Similar to
Year 4, Taxpayer did not maintain a reserve for policy loss, and did not use actuarial
information to asses the risks Taxpayer insured against for L and F in Year 5.

In Year 4 and Year 5, Taxpayer and O entered into reinsurance arrangement contracts.
During Year 4 and Year 5, Taxpayer assumed from O 1.01% and 0.88%, respectively,
pro-rata share of group disability insurance and related claims. Both agreed there would
be no guarantees to limit Taxpayer's losses. Total revenue from reinsurance premium
for Year 4 was $r, $s for Year 5.

Taxpayer concluded that no reserves were necessary for unpaid losses whenever a
contract period closes with no open-ended claims. Consistent with its business plan,
Taxpayer expected numbers of claims to be low and dealt with claims on an ad hoc
basis. Because Taxpayer deemed itself financially able to meets its claims obligations,
Taxpayers neither reinsured its direct-written policies nor limited its losses through
guarantees, indemnification, or hold harmless agreements.

For Year 5, Taxpayer's Form 990 reported reserve for policy losses and loss-related
expenses of $ww however Taxpayer was unable to locate the documentation to
substantiate this liability claim.

For Year 3, Taxpayer reported a management fee of $xx, 99% of this fee was for real
estate related transactions. Taxpayer paid more than 70% of this fee to G for real estate
management services. Family members of D and E indirectly own G.

For Year 4, Taxpayer reported a management fee of $yy. Taxpayer paid 100% of this
fee to G to manage a real estate property. Family members of D and E indirectly own
this G.

For Year 5, Taxpayer reported a management fee of $zz. More than 90% of this fee was
for asset management however, Taxpayer did not explain what specific assets
management services Taxpayer received to justify the fee.

In Year 3, Taxpayer reported incurred claims of $uy from three transactions arising from
O's quarterly retrocession computations.

In Year 4, Taxpayer incurred and paid claims of $zy. Of this amount, Taxpayer paid $xw
to F, a claim based on the Year 3 policy Taxpayer wrote to F. However, documentations
show that this claim was a portion of an expense that originated from an EPA clean-up
expenses associated with two real properties. Documentation also show the EPA clean-
up occurred in a different state other than the states covered in the policy written to F.
The EPA clean-up also occurred on a date prior to the date Taxpayer wrote F the Year 3

policy. Taxpayer paid the remaining amount as retrocession claims and experience
refunds.

In Year 5, Taxpayer reported incurred claims of $xy to O which consisted of quarterly
retrocession computations.

In the year following Year 5, Taxpayer decided not to write any more direct policies.
Taxpayer also stated its intention to liquidate Taxpayer within 2 years after Year 5.

Facts as Developed from the Revised Joint Statement of Pertinent Facts between
Taxpayer and Internal Revenue Service

Information the IRS gather from the documents Taxpayer submitted indicate Taxpayer
incorporated itself on Date 1. The authorities of Z will regulate Taxpayer. The
Government of Z also granted Taxpayer its insurance license. Taxpayer's business
consists of insurance and reinsurance.

Taxpayer's Year 1 Form 990 includes a copy of Taxpayer's Foreign Insurance Company
Election under § 953(d). Taxpayer elected treatment as a domestic corporation for
federal income tax purposes.

A day after Taxpayer incorporated itself, Taxpayer's Board of Directors passed a
resolution to accept the subscription of 30,000 shares of the authorized capital of
Cambridge and issued 30,000 shares, 10,000 shares each to F, H, and K.

In Year 2, F and K transferred their shares to H. As of the first days of Year 3, Year 4
and Year 5, D and E owned 97%, 64.38% and 44.99% of H respectively.

N, H's general partner, owned 3% of H. From Year 3 through Year 5, D and E owned
49% of N, and D and E's children during the same periods owned not more than 6.38%
of N.

At the time of Taxpayer's formation, Taxpayer had capital, $a, United States currency.

In the last month of Year 2, H contributed one-third interests in two properties, Property
1 and Property 2 to Taxpayer. H's basis in these two properties was $b. From the middle
of Year 3 to the end of Year 3, Taxpayer sold its interests in Property 1 and Property 2 to
5 different buyers for a net gain of $c.

Two other insurance companies owned the remaining two-thirds interests in Property 1
and Property 2 and they sold their interests in Year 3.

On December 31 of Year 3, H contributed one-third interest in Property 3 to Taxpayer.
H's basis in Property 3 was $d. In the third quarter of Year 4, Taxpayer sold its interest in
Property 3 at a gain of $e.

In Year 2, Taxpayer's acquisition targets required cash equity of $f. In Year 4, it required
$g.

During Year 2, Taxpayer and S entered into reinsurance arrangement contracts. S and
Taxpayer agreed there would be no guarantees to limit Taxpayer's losses.

In Year 3, Taxpayer and O entered into reinsurance arrangement contracts. Taxpayer
assumed from O pro-rata share of group disability insurance and related claims, 1.01%
during Year 3 and Year 4 and 0.88% during Year 5. Taxpayer and O agreed there would
be no guarantees to limit Taxpayer's losses.

Total direct written and reinsurance premiums Taxpayer issued in Year 3 were $z ($aa
of reinsurance premium); for Year 4, it was $bb ($cc of reinsurance premium); and for
Year 5, it was $dd ($ee of reinsurance premium).

In Year 4, Taxpayer wrote two direct contracts. One direct contract provided
“Administrative Actions” coverage to F, while the other policy provided “Employment
Practices Liability” coverage to L.

In Year 5, Taxpayer wrote five direct contracts, one direct contract provided
“Administrative Actions” coverage to F. Another policy provided “Employment Practices
Liabilities” coverage to L. The remaining three provided “Commercial Excess General
Liability” coverage to P, Q and R.

Taxpayer consulted various law firms and risk management firms that advised Taxpayer
regarding Taxpayer's direct written contracts drafting, pricing, risks management and
actuarial matters. Taxpayer also retained an independent auditor to prepare Taxpayer's
financial statements.

Pursuant to Taxpayer's Form 990s, Taxpayer's total assets for Year 3 was $t; for Year 4,
it was $u; and for Year 5, it was $v.

Pursuant to Taxpayer's Form 990s, Taxpayer's total liabilities for Year 3 was $w; for
Year 4, it was $x; and for Year 5, it was $y.

Total expenses reported, $ff for Year 3; $gg for Year 4; and $hh for Year 5.

IRS began its examination of Taxpayer in the middle of the year following Year 5, and
concluded the examination the following year. IRS recommended that Taxpayer's tax-
exempt status under § 501(c)(15) be revoked.

LAW AND ANALYSIS:

Neither § 501(c)(15) nor its corresponding regulations define an “insurance company” for
federal tax purposes. Generally, the definitions under Subchapter L apply in addressing
whether a company qualifies as an “insurance company" for purposes of § 501(c)(15).
See Rev. Rul. 74-196, 1974-1 C.B. 140 (applying Subchapter L rules in the context of
determining whether a company is an insurance company under § 501(c)(15)). For the
years at issue, Treas. Reg. § 1.831-3(a) applies. Treas. Reg. § 1.831-3(a) defines
“insurance company" as a company whose primary and predominant business activity is
issuing insurance or annuity contracts and or reinsuring risks underwritten by such
contracts. The determination of whether an arrangement constitutes insurance is made
on a yearly basis and thus, each year must be considered independently. Cardinal Life

Insurance Co. v. United States, 300 F.Supp 387, 392 (N.D. Tex. 1968), rev'd on other
grounds, 425 F.2d 1328 (5th Cir. 1970).

Regulations provide that though the company's name, charter powers, and subjection to
state insurance laws are significant in determining the business that a company is
authorized and intends to carry on, it is the character of the business actually done in the
taxable year that determines whether the company is taxable as an insurance company.
Treas. Reg. § 1.801-3(a)(1); see also Bowers v. Lawyers Mortgage Co., 285 U.S. 182,
188 (1932) (to the same effect as the regulation).

Neither the Code nor the regulations define the terms “insurance” or “insurance
contract.” The standard for evaluating whether an arrangement constitutes insurance is
Helvering v. LeGierse, 312 U.S. 531 (1941), in which the Court stated that “historically
and commonly insurance involves risk-shifting and risk-distributing in a transaction which
involve[s] an actual ‘insurance risk’ at the time the transaction was executed.” Insurance
has been described as “involv[ing] a contract, whereby, for adequate consideration, one
party agrees to indemnify another against loss arising from certain specified
contingencies or perils. Epmeir v. United States, 199 F.2d 508, 509-10 (7th Cir. 1952).
Insurance is contractual security against possible anticipated loss. Id. Cases analyzing
“captive insurance” arrangements have distilled the concept of “insurance” for federal
income tax purposes to three elements, applied consistently with principles of federal
income taxation: (1) involvement of an insurance risk; (2) shifting and distribution of that
risk; and (3) insurance in its commonly accepted sense. See e.g., AMERCO, Inc. v.
Commissioner, 979 F.2d 162, 164-65 (9th Cir. 1992), aff'g. 96 T.C. 18 (1991).

The risk transferred must be risk of economic loss. Allied Fidelity Corp. v.
Commissioner, 572 F.2d 1190, 1193 (7th Cir. 1978). The risk must contemplate the
fortuitous occurrence of a stated contingency, Commissioner v. Treganowan, 183 F.2d
288, 290-91 (2d Cir. 1950), and must not be merely an investment or business risk.
LeGierse, 312 U.S. at 542; Rev. Rul. 89-96, 1989-2 C.B. 114.

Risk shifting occurs if a person facing the possibility of an economic loss transfers some
or all of the financial consequences of the potential loss to the insurer, such that a loss
by the insured does not affect the insured because the loss is offset by a payment from
the insurer. See Rev. Rul. 60-275, 1960-2 C.B. 43 (risk shifting not present where
subscribers, all subject to the same flood risk, agreed to coverage under a reciprocal
flood insurance exchange).

Risk distribution incorporates the statistical phenomenon known as the law of large
numbers. The concept of risk distribution “emphasizes the pooling aspect of insurance:
that it is the nature of an insurance contract to be part of a larger collection of coverages,
combined to distribute risks between insureds.” AMERCO and Subsidiaries v.
Commissioner, 96 T.C. 18, 41 (1991), aff'd, 979 F.2d 162 (9th Cir. 1992). In
Treganowan, 183 F.2d at 291, the court quoting Note, The New York Stock Exchange
Gratuity Fund: insurance That Isn't Insurance, 59 Yale L.J. 780, 784 (1950), explained
that “[b]y diffusing the risks through a mass of separate risk shifting contracts, the insurer
casts his lot with the law of averages. The process of risk distribution, therefore, is the

very essence of insurance.” See also Beech Aircraft Corp. v. United States, 797 F.2d
920, 922 (10th Cir. 1986), (risk distribution “means that the party assuming the risk

distributes his potential liability, in part, among others”); Ocean Drilling & Exploration Co.
v. United States, 988 F.2d 1135, 1153 (Fed. Cir. 1993) (“[r]isk distribution involves
spreading the risk of loss among policyholders”).

Distributing risk allows the insurer to reduce the possibility that a single costly claim will
exceed the amount taken in as premiums and set aside for the payment of such a claim.
By assuming numerous relatively small, independent risks that occur over time, the
insurer smoothes out losses to match more closely its receipt of premiums. Clougherty
Packing Co. v. Commissioner, 811 F.2d 1297, 1300 (9th Cir. 1987). Risk distribution
necessarily entails a pooling of premiums, so that a potential insured is not in significant
part paying for its own risks. See Humana, Inc. v. Commissioner, 881 F.2d 247, 257
(6th Cir. 1989).

The principal concern with Taxpayer's activities is whether Taxpayer's primary and
predominant business during each of the taxable years is insurance as required.
Pursuant to Taxpayer's Form 990s, Taxpayer's total asset for Year 3 was $t, $u for Year
4, and $v for Year 5. Of Taxpayer's total business for the taxable years Year 3, Year 4
and Year 5, only 1.36%, 1.41% and 24%, respectively, were related to its purported
insurance activities. Thus, it is clear that the majority of Taxpayer's business for the tax
years at issue was related to business other than insurance and, therefore, Taxpayer
does not qualify as an insurance company for these years.

As for risk distribution, Taxpayer's “insurance” activities for Year 2, Year 3, and Year 4
can be characterized as follows:

Year 2

“Insured” name | Type of policy | Premium | % of insurance business for tax year (rounded)
F | Administrative actions | $h | 27%
L | Employment Practices Liabilities” | $i | 28%
O | Special risk/medical | $q | 45%
Total | | $z |

Year 3

“Insured” name | Type of policy | Premium | % of insurance business for tax year (rounded)
F | Administrative actions | $j | 31%
L | Employment Practices Liabilities” | $k | 23%
O | Special risk/medical | $r | 46%
Total | | $bb |

Year 4

“Insured” name | Type of policy | Premium | % of insurance business for tax year (rounded)
F | Administrative actions | $l | 17%
L | Employment Practices Liabilities” | $m | 11%
Plan | Commercial excess liability | $n | 13%
Q | Commercial excess liability | $o | 15%
R | Commercial excess liability | $p | 12%
O | Special risk/medical | $s | 32%
Total | | $dd |

Risk distribution requires a sufficient number of insureds such that the Taxpayer
achieves an adequate pooling of premiums and incorporates the statistical phenomenon
known as the law of large numbers. See AMERCO, 96 T.C. 18 at 41. Here, it also
appears that the various risks “insured” are not homogeneous and thus must be
separated from one another and analyzed separately as to whether there is risk
distribution as to that risk. See Rev. Rul. 2002-89, 2002-2 C.B. 984; see also Rev. Rul.
2005-40, 2005-2 C.B. 4.

The Service has taken the following positions with respect to risk distribution. In
Situation 1 of Rev. Rul. 2002-89, supra, S a wholly owned subsidiary of P, a domestic
parent corporation, entered into an annual arrangement with P whereby S provided
coverage for P’s professional liability risks. The liability coverage S provided to P
accounted for 90% of the total risks borne by S. Under the facts of Situation 1, the
Service concluded that insurance did not exist for federal income tax purposes. On the
other hand, in Situation 2 of Rev. Rul. 2002-89, supra, the premiums that S received
from the arrangement with P constituted less than 50% of S’s total premiums for the
year. Under the facts of Situation 2, the Service reasoned that the premiums and risks
of P were pooled with those of unrelated insureds and thus the requisite risk shifting and
risk distribution were present. Accordingly, under Situation 2, the arrangement between
P and S constituted insurance for federal income tax purposes.

In Rev. Rul. 2002-90, 2002-2 C.B. 985, S a wholly owned insurance subsidiary of P,
directly insured the professional liability risks of 12 operating subsidiaries of its parent. S
was adequately capitalized and there were no related guarantees of any kind in favor of

S. Most importantly, S and the insured operating subsidiaries conducted themselves in
a manner consistent with the standards applicable to an insurance arrangement
between unrelated parties. Together, the 12 operating subsidiaries had a significant
volume of independent, homogeneous risks. Under the facts presented, the ruling
concludes the arrangement between S and each of the 12 operating subsidiaries of S's
parent constitute insurance for federal income tax purposes.

Situation 1 of Rev. Rul. 2005-40, supra, describes a scenario where a domestic
corporation operated a large fleet of automotive vehicles in its courier transport business
covering a large portion of the United States. This represented a significant volume of
independent, homogeneous risks. For valid non-tax business purposes, the transport
company entered into an insurance arrangement with an unrelated domestic
corporation, whereby in exchange for an agreed amount of “premiums,” the domestic
carrier “insured” the transport company against the risk of loss arising out of the
operation of its fleet in the conduct of its courier business. The unrelated carrier
received arm's length premiums, was adequately capitalized, received no guarantees
from the courier transport company and was not involved in any loans of funds back to
the transport company. The transport company was the carrier's only “insured.” While
the requisite risk-shifting was seemingly present, the risks assumed by the carrier were
not distributed among other insured’s or policyholders. Therefore, the arrangement
between the carrier and the transport company did not constitute insurance for federal
income tax purposes.

The facts in Situation 2 of Rev. Rul. 2005-40, supra, mirror the facts of Situation 1 except
that in addition to its arrangement with the transport company, the carrier entered into a
second arrangement with another unrelated domestic company. In the second
arrangement, the carrier agreed that in exchange for “premiums,” it would “insure” the
second company against its risk of loss associated with the operation of its own
transport fleet. The amount that the carrier received from the second agreement
constituted 10% of the total amounts it received during the tax year on a gross and net
basis. Thus, 90% of the carrier's business remained with one insured. The revenue
ruling concluded that the first arrangement still lacked the requisite risk distribution to
constitute insurance even though the scenario involved multiple insureds.

In Situation 4 of Rev. Rul. 2005-40, supra, 12 LLCs elected classification as
associations, each contributing between five and 15% of the insurer's total risks. The
Service concluded that this transaction constituted insurance for federal income tax
purposes.

With regard to the instant case, each year must be considered independently to
determine whether adequate risk distribution is present. See Cardinal Life, 300 F.Supp
387 at 392.

Taxpayer's “insurance” activity for tax years Year 3 and Year 4 is almost identical in
terms of number of insureds, types of coverage, and percentage of risk allocation among
insureds. Therefore, these years can be considered together. The various risks
“insured” during Year 3 and Year 4 are not homogeneous and thus must be separated
from one another and analyzed separately as to whether there is risk distribution as to
each risk. It appears that Taxpayer does not sufficiently distribute its risk among each

type of coverage, i.e. Taxpayer maintained one administrative actions policy, one
employment practices liability policy, and a pro-rata share of special risks/medical
coverage. Therefore, Taxpayer has not adequately distributed its risk. Moreover, there
appears to be too much concentration of risk among the two insureds and “reinsurance”
arrangement. See Harper Group & Subsidiaries v. Commissioner, 96 T.C. 45 (1991),
aff'd, 979 F.2d 1341 (9th Cir. 1992) (involving 13 related entities representing
approximately 70% of the insurer's total risk); see also Rev. Rul. 2002-90, supra;
Situation 4 of Rev. Rul. 2005-40, supra.

Taxpayer fails to achieve adequate risk distribution in Year 5 because it has an
insufficient number of insureds in which risk is too concentrated. See Rev. Rul. 2002-90,
supra; see also Situation 4 of Rev. Rul. 2005-40, supra. There is also insufficient
distribution with respect to the coverage for administrative actions and employment
practices liability.

Taxpayer raises Harper Group & Subsidiaries v. Commissioner, 96 T.C. 45 (1991), aff'd,
979 F.2d 1341 (9th Cir. 1992); Amerco & Subsidiaries supra at 96 T.C. 18, in support of
its argument that it qualifies as an insurance company for the years at issue. In Harper
Group, there were 13 entities making up nearly two thirds of the risk concentration in all
of the years at issue.

Therefore, the court's analysis in Harper Group supports the Service's position that
Taxpayer does not qualify as an insurance company.

Harper Group can also be distinguished on the basis that the risks involved in Harper
Group were diverse and widespread—an extensive variety of cargo shipments
throughout the world via a variety of means and vessels. In other words, the various
risks insured were homogeneous and numerous such that risk distribution was
accomplished with respect to each separate risk. See Rev. Rul. 2002-89, supra; see
also Rev. Rul. 2005-40.

With respect to the instant case, no determination has been made as to whether all of
the agreements at issue qualify as insurable risks. See Rev. Rul. 2007-47, 2007-30
I.R.B. 127, in part, holding that an arrangement that provides for the reimbursement of
believed-to-be inevitable future cost does not involve the requisite insurance risk for
purposes of determining whether the assuming entity may account for the arrangement
as an “insurance contract” for purposes of Subchapter L of the Internal Revenue Code.
Furthermore, business risk is not insurable. LeGierse, 312 U.S. at 542.

The Examiner notes that in Year 4, Taxpayer paid claims that total $zy. Of this amount
and based on the Year 3 direct policy Taxpayer wrote to F, Taxpayer paid $xw to F.
However, Taxpayer's records describes the $xw payment as payment for the “EPA
clean-up” associated with two real estate properties. In addition, F incurred the “EPA
clean-up” expense before Taxpayer wrote the Year 3 administrative action policy to F.
This claim is questionable and appears to be a business costs for real estate

development ventures. If so, such “risks” are not fortuitous and expenses for which the
requisite insurance risk exists.

CONCLUSION:

1. Taxpayer is not an insurance company exempt from tax pursuant to §
   501(c)(15) of the Code as of Year 3, Year 4 and Year 5.

2. Taxpayer is entitled to relief pursuant to § 7805(b) as of Date 1

A copy of this technical advice memorandum is to be given to the taxpayer. §
6110(k)(3) provides that it may not be used or cited as precedent.

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