Captive insurer denied section 501(c)(15) exemption

Plain-English summary

A foreign captive insurance company sought exemption as a small nonlife insurance company under section 501(c)(15). The IRS examination concluded that most of its direct-written contracts covered business or investment risks rather than insurance risks, and that the arrangements lacked adequate risk distribution because the related businesses supplied most of the risk and premiums. The IRS also concluded that the company failed the requirement that more than half of its gross receipts consist of premiums. Because the company did not qualify as an insurance company under subchapter L, the IRS treated its section 953(d) domestic-corporation election as unavailable. Appeals issued a final adverse determination requiring the organization to file corporate income tax returns for the examined years and later years.

Ruling snapshot

• Question: Did the captive qualify as an insurance company exempt under section 501(c)(15), with a valid section 953(d) election?
• Outcome: Denied for the three examined tax periods.
• Key authorities: IRC §§ 501(c)(15), 816, 831, 951, 953(d), and 957; Rev. Ruls. 2002-89, 2002-90, and 2005-40

Full text (IRS public release)

Internal Revenue Service                         Department of the Treasury
Appeals Office

                                                 Employer Identification Number:

Release Number: 201609008                        Person to Contact:
Release Date: 2/26/2016
Date: December 03, 2015                          Employee ID Number:
                                                 Tel:
                                                 Fax:
UIL Code: 501.15-00

ORG                                              Tax Period(s) Ended:
ADDRESS                                          December 31, 20XX
                                                 December 31, 20XX
                                                 December 31, 20XX

Certified Mail
UIL: 0501.15-00

Dear                    :

This is a final determination that you do not qualify for exemption from Federal income tax under Internal
Revenue Code (the “Code”) section 501(a) as an organization described in Code section 501(c)(15) for
the tax periods listed above.

The final adverse determination of your exempt status was made for the following reason(s):

Taxpayer is not an insurance company exempt from tax pursuant to Code § 501(c)(15) as of 20XX, 20XX
and 20XX.

You are required to file Federal income tax returns on Forms 1120 for the tax periods stated in the
heading of this letter and for all tax years thereafter. File your return with the appropriate Internal
Revenue Service Center per the instructions of the return. For further instructions, forms, and information
please visit www.irs.gov.

Please show your employer identification number on all returns you file and in all correspondence with
Internal Revenue Service.

We will make this letter and the proposed adverse determination letter available for public inspection
under Code section 6110 after deleting certain identifying information. We have provided to you, in a
separate mailing, Notice 437, Notice of Intention to Disclose. Please review the Notice 437 and the
documents attached that show our proposed deletions. If you disagree with our proposed deletions, follow
the instructions in Notice 437.

If you have any questions about this letter, please contact the person whose name and telephone number
are shown in the heading of this letter.

Sincerely Yours,

Appeals Team Manager

Enclosure: Publication 556


DEPARTMENT OF THE TREASURY
INTERNAL REVENUE SERVICE
TAX EXEMPT AND
GOVERNMENT ENTITIES
DIVISION

Date: January 15, 2013
Taxpayer Identification Number:
ORG
ADDRESS
Form: 990-EZ/990
Tax Period(s) Ended:
12/31/20XX; 12/31/20XX; 12/31/20XX
Person to Contact/ID Number:
Contact Numbers:
Telephone:
Fax:
Dear                    :

During our examination of the returns indicated above, we determined that
your organization was not described in Internal Revenue Code section
501(c) for the tax periods listed above and therefore, it does not qualify for
exemption from federal income tax. This letter is not a determination of
your exempt status under section 501 for any periods other than the tax
periods listed above.

The attached Report of Examination, Form 886-A, summarizes the facts,
the applicable law, and the Service's position regarding the examination of
the tax periods listed above. You have not agreed with our determination,
or signed a Form 6018-A, Consent to Proposed Action, accepting our
determination of non-exempt status for the periods stated above. You have
not agreed to file the required income tax returns. You may appeal your
case. The enclosed Publication 3498, The Examination Process, and
Publication 892, Exempt Organizations Appeal Procedures for Unagreed
Issues, explain 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.

2

If you request a conference with Appeals, you must submit a written protest
within 30 days of the date of this letter. An Appeals officer will review your

case. The Appeals Office is independent of the Director, EO Examinations.
Most disputes considered by Appeals are resolved informally and promptly.

You may also request that we refer this matter to IRS Headquarters for
technical advice as explained in Publication 892. If you do not agree with
the conclusions of the technical advice memorandum, no further
administrative appeal is available to you within the IRS on the issue that
was the subject of the technical advice.

If we do not hear from you within 30 days of the date of this letter, we will
issue a Statutory Notice of Deficiency based on the adjustments shown in
the enclosed report of examination.

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 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

In the future, if you believe your organization qualifies for tax-exempt status,
and would like to establish its status, you may request a determination from
the IRS by filing Form 1024, Application for Recognition of Exemption under
Section 501(a), and paying the required user fee.

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.

3

Thank you for your cooperation.

Sincerely,

Director, EO Examinations

Enclosures:
Publication 892
Publication 3498
Form 6018-A
Report of Examination
Envelope

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
ORG 12/31/20XX
12/31/20XX
ISSUES:

1. Whether the contracts executed by ORG constitute contracts of insurance?

2. Whether the arrangement entered into by ORG involves the requisite element of risk
distribution?

3. Whether more than half of the business of ORG during each of the taxable years under
consideration is the issuing of insurance or annuity contracts or the reinsuring of risks
underwritten by insurance companies?

4. If ORG is not an insurance company, does it qualify for treatment as a tax-exempt entity
under section 501(c)(15) of the Internal Revenue Code?

5. Is the IRC 953(d) election valid if the taxpayer is not an insurance company, and the
election was never approved by the Service?

FACTS:

ORG (hereinafter “Taxpayer”) was formed and incorporated in Country, Territory on December
3, 20XX, under the provisions of Section 9 of the Companies Act, 2000. The taxpayer was
formed to provide certain property and casualty insurance type services. The taxpayer is
formed as a foreign captive insurance company. The taxpayer is authorized to issue 0
common shares with a $0 par value, and actually issued 0 shares in consideration of $0 capital
contribution from its sole shareholder.

The taxpayer is wholly owned by CO-1, a State Limited Liability Company. CO-1 is not
engaged in any business activity and does not file Federal income tax returns. CO-1, is co-
equally owned and controlled by Owner and Co-Owner. Both individuals are United States
citizen and residents of the State of State.

The TEGE examine agent obtained a copy of ORG’s Form 1024 application administrative file
from the Exempt Organizations Records Unit in City on February 18, 20XX. The administrative
file included a copy of the Form 1024 application; Articles of Incorporation; the IRC 953(d)
election statement; a copy of the insurance licenses for 20XX and 20XX; regulatory filings and
responses of Insurance Regulators; insurance underwriting diagrams, organizational owner
chart; supplemental information for the Form 1024; financial forecasts for years 20XX through
20XX; forms of credit reinsurance agreements entered into by the company, and a copy of the
20XX insurance policies issued by the company.

Other documents were received from CPA, CPA, in response to Information Document
Requests issued by the examining agent during the audit process.

According to the Articles of Incorporation, the taxpayer is to be governed by a board of
directors composed of one to seven directors. The board is actually composed of two

Form 886-A (1-1994) Catalog Number 20810W Page 1 of 42 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

ORG 12/31/20XX
12/31/20XX

directors, Owner and Co-Owner. Owner also serves as Chief Executive Officer (CEO),
President, Treasurer, and Assistant Secretary of ORG Co-Owner serves as Vice President,
Secretary, and Assistant Treasurer of the company.

Owner and Co-Owner are also equally co-owners of CO-2, located in City, State. The
company is engaged in commercial machinery repair & maintenance service. Owner and Co-
Owner also own CO-3 and CO-4. The exact nature of the business conducted by these
entities is unknown. These business interests are collectively referred to as “Affiliated
Business Interests.” According ORG’s Business Plan,

The Affiliated Business Interests desired to insure certain of their property
and casualty exposures, and are unwilling, or in some cases, unable to do
so through the conventional insurance marketplace. The Affiliated
Business Interests looked at alternative methods of arranging such
insurance coverage and have found that providing such coverage through
a captive insurance company offers the best method for satisfying its
needs. ORG will be operated primarily to accomplish this objective.

The taxpayer was created as a controlled foreign corporation. The taxpayer is not a member
of a controlled group of corporations. As a controlled foreign corporation, Owner, President,
signed an IRC 953(d) election statement on February 23, 20XX. It appears that the election
statement was filed with the IRS [illegible], State office on the same day.

On September 18, 20XX, the company filed Form 1024, Application for Recognition of
Exemption Under Section 501(a), seeking exemption as a small insurance company under
section 501(c)(15) of the Internal Revenue Code. The application was received by TEGE in
City on September 21, 20XX. The application revealed that 20XX was the initial tax year of the
company. As of the filing of the Form 1024 application, the taxpayer had filed Form 990 for the
tax year ended December 31, 20XX, with the Ogden Service Center. Owner, President,
signed the application on September 15, 20XX. A Form 2848, Power of Attorney, accompanied
the application authorizing Attorney-1, Attorney, and Attorney-2, Attorney, to represent the
company during the application process. The attorneys worked for a law firm in

The application revealed that the taxpayer employed CO-5, to serve as its resident insurance
manager in Country, Territory. The taxpayer agreed to pay compensation of less than $0
annually.

The Form 1024 application was referred to Rulings and Agreements in Washington, D.C., on
October 23, 20XX, for consideration and ruling. The application was assigned to a Tax Law
Specialist on or around November 13, 20XX. No action was taken on the application until July
20XX. On July 26, 20XX, the Tax Law Specialist mailed a letter to the company’s domestic
address, at Address, Suite, City, State Zip code, to request additional information about the

Form 886-A (1-1994) Catalog Number 20810W Page 2 of 42 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
ORG 12/31/20XX
12/31/20XX

operations. The taxpayer's response to the letter was due by August 26, 20XX. Attorney-2, .
Attorney, submitted a letter dated August 19, 20XX, requesting an extension of time to respond
until September 26, 20XX.

Instead of responding to the additional information request of the Tax Law Specialist, the
company’s President, Owner, submitted a letter on September 16, 20XX, to request that the
Form 1024 application be withdrawn from further consideration and ruling.

On September 28, 20XX, the Tax Law Specialist closed the application file and issued a letter
informing the company that their request to withdraw the application was accepted and no
further action would be taken on the application.

Thus, the taxpayer did not receive a favorable or final adverse ruling letter from TEGE, Rulings
and Agreements. In addition to not completing the exemption application process, there is no
evidence that its IRC 953(d) election statement was approved by the Internal Revenue
Service. On February 22, 20XX, the TE/GE examining agent requested the effective date of
the IRC 953(d) election from the IRS , State office. On February 28, 20XX, the IRS

- , State office informed the examining agent that the Service did not have record that
the IRC 953(d) election was approved.

The taxpayer filed a Form 990-EZ return for its initial tax year that consisted of the period
December 3, 20XX, through December 31, 20XX. The company also filed Form 990 returns
for the 20XX and 20XX calendar years.

The taxpayer operated primarily to provide property and casualty “insurance” coverage to CO-
2., CO-3; and CO-4 (“hereinafter called “Affiliated Businesses”), which are owned and
controlled by Owner and Co-Owner, officers and beneficial owners of ORG The Financial
Services Commission, Country, issued a Class ‘B: General Insurance License to the taxpayer,
effective December 3, 20XX.

In 20XX, the taxpayer wrote thirteen direct-written “insurance” contracts to CO-2 titled: (1)
Special Risk — Loss of Services Insurance Policy; (2) Special Risk — Product Recall Insurance
Policy; (3) Special Product — Weather Related Business Interruption Insurance Policy; (4)
Special Risk — Regulatory Changes Insurance Policy; (5) Special Risk — Tax Liability Insurance
Policy; (6) Special Risk — Punitive Wrap Liability Insurance Policy; (7) Excess Pollution
Insurance Policy; (8). Special Risk — Loss of Major Customer Insurance Policy; (9) Excess
Intellectual Property Package Policy; (10) Special Risk — Expense Reimbursement Insurance
Policy; (11) Excess Employment Practices Liability Insurance Policy; (12) Excess Directors &
Officers Liability Insurance Policy; and (13) Excess Cyber Risk. Each of the above-named

policies is described in detail below.

Special Risk — Loss of Services Insurance Policy provides for the indemnification of the
Affiliated Businesses for an involuntary loss of services of a key employee, Owner, for

Form 886-A (1-1994) Catalog Number 20810W Page 3 of 42 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

ORG 12/31/20XX
12/31/20XX

sickness, disability, death, loss of license, termination of employment; resignation; retirement;
or any other occurrence that deprives the Affiliated Businesses from the receipt in a material
and substantial way of his services.

Special Risk — Product Recall Insurance Policy provides for the indemnification of the
Affiliated Businesses for expenses involved in the recall of “all products manufactured and/or
sold by the Affiliated Businesses during 20XX.

Special Risk — Weather Related Business Interruption Insurance Policy provides for the
indemnification of the Affiliated Businesses for any business interruption loss of up to 12
months suffered as a result of any Weather Event such as significant flooding, catastrophic
snow, hail, freezing, rain, tornados, and tsunamis, that has an adverse impact on the normal
on-going business operations.

Special Risk — Regulatory Changes Insurance Policy covers actual compliance expenses
and business interruptions suffered as a result of any regulatory change having an adverse
impact on the normal on-going business operations of the Affiliated Businesses. The policy
does not cover adverse regulatory changes resulting from substantial noncompliance with
regulations or guidelines or those changes initiated in direct response to negligent acts,
omissions, or errors by the Affiliated Businesses.

Special Risk — Tax Liability Insurance Policy provides the Affiliated Businesses with
indemnification up to 0% of the amount of additional tax liability each may incur on its 20XX
federal income tax return. No coverage is provided for additions to tax, civil penalties, or
criminal penalties for delinquent returns or criminal or fraudulent acts.

Special Risk — Punitive Wrap Liability Insurance Policy provides that ORG will pay claims
filed by the Affiliated Businesses, resulting from the failure of an insurer to cover punitive or
exemplary damages, judgments, or awards, related to the other 0 policies, solely due to the
enforcement of any law or judicial ruling that precludes the insuring of such damages and that
but for such law or judicial ruling would otherwise be covered.

Excess Pollution Liability Insurance Policy provides for the indemnification of the Affiliated
Businesses against clean up cost and diminution of property value due to any pre-existing and
new on-site pollution and environmental contamination.

Special Risk — Loss of Major Customer Insurance Policy provides for the indemnification of
the Affiliated Businesses for any business interruption loss of up to 12 months suffered as a
result of losing the services of any Major Customer. A major customer is defined as “any
customer who represents 0% of more of annual sales for the six months preceding the loss.

Form 886-A (1-1994) Catalog Number 20810W Page 4 of 42 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

ORG 12/31/20XX
12/31/20XX

Excess Intellectual Property Package Policy provides indemnification subject to certain
limitations to the Affiliated Businesses for all damages legally obligated to pay for litigation
expenses, mitigation expenses, investigation expenses, costs to replace, restore, or re-create
intellectual property, additional damages and rewards resulting from wrongful acts committed
during the policy period. Wrongful acts include infringement of copyright, plagiarism, invasion
or interference of right of privacy or publicity; libel; slander; piracy or unfair competition; breach
of contract; patent infringement; and malicious prosecution with regard to intellectual property.

Special Risk — Expense Reimbursement Insurance Policy covers public relations expenses
to mitigate adverse publicity to the Affiliated Businesses under certain circumstances,
including: actual or imminent incidents where the insureds potential liability amount is in
excess of $0; product recalls; layoffs and labor disputes; government or regulatory litigation;
bankruptcy or other major financial crisis; loss of intellectual property rights; unsolicited
takeover bids; terrorism; or any other adverse incident expected to reduce the insureds annual
gross revenue by at least 0%. The policy also covers all expenses for the Affiliated
Businesses defenses to actual or alleged civil liability.

Excess Employment Practices Liability Insurance Policy provides for the indemnification of
the Affiliated Businesses against all costs and expenses incurred as a result of claims filed by
employees for wrongful termination, dismissal, discharge, sexual harassment, unlawful
employment discrimination and employment related invasion of privacy and defamation.

Excess Directors & Officer Liability Insurance Policy provides indemnification subject to
certain limitations to the Affiliated Businesses for their indemnification of its officers and
directors for wrongful acts, including any error, misstatement, misleading statement, act,
omission, neglect, or breach of duty committed, attempted, or allegedly committed or
attempted by an officer or director of the Affiliated Businesses. The policy also covers similar
acts in relation to mergers and acquisitions. Moreover, the policy includes liability for pollution.
The policy also provides direct and executive liability coverage for similar acts to the Affiliated
Businesses officers and directors.

Excess Cyber Risk Insurance Policy provides indemnification to the Affiliated Businesses
against claims resulting from content liability and interruption of business due to cyber crimes
such as corruption of computer systems dues to viruses and other malicious codes.

With respect of each of the 13 above referenced property and casualty contracts, the taxpayer
and CO-6. (“CO-6”) entered into an agreement titled, “Joint Underwriting Stop Loss
Endorsement.” The taxpayer and CO-6 are separate independent companies and are not
owned and controlled by related parties. Nor is CO-6 related to shareholders, directors, or
officers of the taxpayer. Under the terms of the agreement, the taxpayer is responsible for
payment of claims up to certain specified thresholds. If the specified thresholds are met, then
CO-6 becomes liable for payment of claims up to certain specified limits. If the specified limits

Form 886-A (1-1994) Catalog Number 20810W Page 5 of 42 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

ORG 12/31/20XX
12/31/20XX

for CO-6’s payment of claims are exceeded, then the taxpayer again becomes liable. It also
appears that for each of the 13 direct-written contracts, the taxpayer received 0% of the total
premiums, and CO-6 received 0% of the total premiums. Page 5, paragraph 4 of the
agreement reads as follows:

The premium rate for this Joint Underwriting Stop Loss Endorsement is
0% of the combined gross direct written premiums for the specified
policies due directly from the Insured(s). This endorsement premium of
$0 out of the total premiums of $0 is payable directly from the Insured(s)
to the Stop Loss Insurer.

Therefore, under the terms of the Joint Underwriting Stop Loss Endorsement agreement, the
Affiliated Businesses were required to pay of total premiums of $0 for the thirteen direct written
policies and for the stop loss endorsement. Of the total premium, the Affiliated Businesses
paid $0 directly to the taxpayer (0%) as Lead Insurer. In addition, the Affiliated Businesses
paid $0 as a reinsurance premium directly to CO-6., as the Stop Loss Insurer.

Based on the review of the contracts, the premiums paid by the Named Insureds under the
terms of the 20XX contracts was as follows:
Contracts                                      Total Premium    Portion of Premium To Taxpayer (0%)

1. Special Risk-Loss of Services               $ 0              $ 0
2. Special Risk-Product Recall                   0                0
3. Special Risk-Weather Related Bus. Interruption 0               0
4. Regulatory Changes                            0                0
5. Special Risk Tax Liability                    0                0
6. Special Risk Punitive Wrap Liability          0                0
7. Excess Pollution Liability                    0                0
8. Special Risk-Loss of Major Customer           0                0
9. Excess Intellectual Property                  0                0
10. Special Risk-Expense Reimbursement           0                0
11. Excess Employment Practices Liability        0                0
12. Excess Directors & Officers Liability        0                0
13. Excess Cyber Risk                             0                0
Totals                                          $ 0              $ 0

The taxpayer also entered into two types of reinsurance arrangements. The first arrangement
is referred to as a “reinsurance risk pooling program.” Under this arrangement, the taxpayer
participated in a “reinsurance risk pool” with several other unrelated insurance companies
(‘pool participants”). The risk pool was operated by CO-6. Each pool participant had one or
more affiliated operating entities for which it underwrote insurance coverage, generally
casualty type coverage such as credit life and credit disability. CO-6 insured a portion of the

Form 886-A (1-1994) Catalog Number 20810W Page 6 of 42 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

ORG 12/31/20XX
12/31/20XX

direct insurance underwritten by the pool participants using a so-called “stop loss”
endorsement. CO-6 participated in over 0 insurance policies with more than 0 insureds. CO-6
blended together its direct written insurance, and then reinsured the entire book on a quota
share basis with each of the pool participants.

According to the terms of the 20XX Quota Share Reinsurance Policy executed with CO-6., the
taxpayer was one of 0 companies listed as reinsurer. As Reinsurer #0, the taxpayer was to
retained 0% of its Quota Share Retained Premiums from CO-6. in exchange for the
assumption of 0% of the risk pool comprised of the stop loss coverages issued during the
policy period by CO-6 Insurance Company to all stop loss endorsement policyholders. CO-6.
paid total reinsurance premiums of $0 to 0 Reinsurers. Of this total premium, the taxpayer
received a quota share reinsurance premium equal to 0% or $0, of which $0 is the portion of
the premium retained by taxpayer (as a quota share retained premium) until the final
accounting and settlement of the Risk Pool was completed. The final accounting and
settlement generally occurs 180 days following the expiration date shown in the Policy
Declaration. The quota share retained premium was calculated at 0% of the quota share
reinsurance policy premium of $0. The risk pool insured by CO-6 and reinsured by the 0 pool
participants included the thirteen direct written policies written and sold by the taxpayer to the
Affiliated Business Interests. According to the general ledger, the taxpayer reported receiving
a reinsurance premium of $0 from CO-6 in 20XX.

Under the terms of the second reinsurance arrangement, which is referred to as the Credit
Coinsurance Reinsurance Program, the taxpayer assumed reinsurance contracts from CO-6.
The taxpayer reinsured a 0% quota share of the risks from vehicle service contracts reinsured
by CO-6. The vehicle service contracts were initially written by CO-7 Company in 20XX,
assumed by CO-8, then by CO-9 from CO-8; and finally assumed by CO-6. from CO-9 The
taxpayer received a pro rata share (0%) of the earned premiums received by CO-6. The
taxpayer was paid a reinsurance premium of $0 from CO-6. in 20XX.

For the tax year ended December 31, 20XX, the taxpayer reported gross receipts and total

revenue of $0. Total revenue was derived primarily from premiums received from the direct
written, reinsurance risk pooling program, and the credit coinsurance reinsurance program.

The taxpayer received gross receipts as follows:

20XX
Program Revenue Service
Direct Written Premiums $ 0 0%
Quota Share Reinsurance Premiums 0 0
Credit Coinsurance Reinsurance Premiums 0 0
Investment Income 0 0
Gain of sale of assets -0- -0-
Other income -0- -0-
Total Revenue $ 0 0%

Form 886-A (1-1994) Catalog Number 20810W Page 7 of 42 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

ORG 12/31/20XX
12/31/20XX

The checking account (# ) bank statement for December 31, 20XX, with Bank, reflected
three deposits totaling $0. The statement reflected a deposit of $0 on December 29, 20XX,
which represented the payment of insurance premiums received from the Affiliated Businesses
from the thirteen direct written insurance policies. Another deposit of $0 was made on
December 10, 20XX, which represented the initial contribution of capital made by CO-1, the
sole shareholder of the taxpayer. The only other deposit made during 20XX was interest
income credited to the account on December 31, 20XX, in the amount of $0.

As of December 31, 20XX, the taxpayer's assets totaled $0, which consisted primarily of cash
in its checking account of $436,056 and reinsurance premiums receivable of $0.

20XX and 20XX Tax Years

During the tax periods ending December 31, 20XX, and December 31, 20XX, the taxpayer
wrote 11 contracts insuring risks of the Affiliated Businesses, which are owned and controlled
by Owner and Co-Owner, officers and beneficial owners of ORG The taxpayer insured risks
for the same 11 contracts in 20XX and 20XX. The contracts in effect for both years are as
follows:

Excess Directors & Officers Liability provides indemnification subject to certain limitations to
the Affiliated Businesses for their indemnification of its officers and directors for wrongful acts,
including any error, misstatement, misleading statement allegedly committed or attempted by
an officer or director of the Affiliated Businesses. The policy also covers similar acts in relation
to mergers and acquisitions. Moreover, the policy, act, omission, neglect, or breach of duty
committed, attempted, or includes liability for pollution. The policy also provides direct and
executive liability coverage for similar acts to the Affiliated Businesses officers and directors.

Special Risk — Loss of Major Customer provides for the indemnification of the Affiliated
Businesses for any business interruption loss of up to 12 months suffered as a result of losing
the services of any Major Customer. A major customer is defined as “any customer who
represents 0% of more of annual sales for the six months preceding the loss.

Special Risk — Expense Reimbursement covers public relations expenses to mitigate
adverse publicity to the Affiliated Businesses under certain circumstances, including: actual or
imminent incidents where the insureds potential liability amount is in excess of $0; product
recalls; layoffs and labor disputes; government or regulatory litigation; bankruptcy or other
major financial crisis; loss of intellectual property rights; unsolicited takeover bids; terrorism; or
any other adverse incident expected to reduce the insureds annual gross revenue by at least
0%. The policy also covers all expenses for the Affiliated Businesses defenses to actual or
alleged civil liability.

Form 886-A (1-1994) Catalog Number 20810W Page 8 of 42 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

ORG 12/31/20XX
12/31/20XX

Expense Reimbursement — Legal Expense covers defense expenses where the company
has no underlying insurer, or the company has exhausted all defense expenses covered under
their primary insurance policy; lost of work time resulting from responding to discovery
requests and travel expenses to meetings, dispositions, and trials; costs of hiring independent
counsel in addition to that provided by the primary liability insurer in order to ensure that the
interests of the company are met and to provide additional assistance in the litigation; and
expert witness fees and travel expenses.

Special Risk — Loss of Services provides for the indemnification of the Affiliated Businesses
for an involuntary loss of services of a key employee, Owner, for sickness, disability, death,
loss of license, termination of employment; resignation; retirement; or any other occurrence
that deprives the Affiliated Businesses from the receipt in a material and substantial way of his
services.

Excess Pollution Liability provides for the indemnification of the Affiliated Businesses against
clean up cost and diminution of property value due to any pre-existing and new on-site
pollution and environmental contamination.

Special Risk — Tax Liability provides the Affiliated Businesses with indemnification up to
[illegible]% of the amount of additional tax liability each may incur on its 20XX federal income tax
return. No coverage is provided for additions to tax, civil penalties, or criminal penalties for
delinquent returns or criminal or fraudulent acts.

Excess Intellectual Property Package provides indemnification subject to certain limitations
to the Affiliated Businesses for all damages legally obligated to pay for litigation expenses,
mitigation expenses, investigation expenses, costs to replace, restore, or re-create intellectual
property, additional damages and rewards resulting from wrongful acts committed during the
policy period. Wrongful acts include infringement of copyright, plagiarism, invasion or
interference of right of privacy or publicity; libel; slander; piracy or unfair competition; breach of
contract; patent infringement; and malicious prosecution with regard to intellectual property.

Special Risk — Regulatory Change covers actual compliance expenses and business
interruptions suffered as a result of any regulatory change having an adverse impact on the
normal on-going business operations of the Affiliated Businesses. The policy does not cover
adverse regulatory changes resulting from substantial noncompliance with regulations or
guidelines or those changes initiated in direct response to negligent acts, omissions, or errors
by the Affiliated Businesses.

Special Risk — Punitive Wrap provides that ORG will pay claims filed by the Affiliated
Businesses, resulting from the failure of an insurer to cover punitive or exemplary damages,
judgments, or awards, related to the other 0 policies, solely due to the enforcement of any law

Form 886-A (1-1994) Catalog Number 20810W Page 9 of 42 publish.no.irs.gov Department of the Treasury-Internal Revenue Service


886-A 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

ORG 12/31/20XX
12/31/20XX

or judicial ruling that precludes the insuring of such damages and that but for such law or
judicial ruling would otherwise be covered. .

Special Risk — Product Recall provides for the indemnification of the Affiliated Businesses for
expenses involved in the recall of “all products manufactured and/or sold by the Affiliated
Businesses during 20XX and 20XX.

With respect of each of the 11 above referenced property and casualty contracts, the taxpayer
and CO-6. (“CO-6”) entered into an agreement titled, “Joint Underwriting Stop Loss
Endorsement” in 20XX and 20XX. The taxpayer and CO-6 are separate independent
companies and are not owned and controlled by related parties. Nor is CO-6 related to
shareholders, directors, or officers of the taxpayer. Under the terms of the agreement, the
taxpayer is responsible for payment of claims up to certain specified thresholds. If the
specified thresholds are met, then CO-6 becomes liable for payment of claims up to certain
specified limits. If the specified limits for CO-6’s payment of claims are exceeded, then the
taxpayer again becomes liable. In 20XX, the taxpayer assumed 0% of the risk and received
0% of the direct written premiums. CO-6 received 0% of the total premiums. In 20XX, the
taxpayer assumed 0% of the risk and received 0% of the direct written premiums. CO-6
received 0% of the direct written premiums in 20XX. The 20XX and 20XX Joint Underwriting
Agreements include the following terms:

The premium rate for this Joint Underwriting Stop Loss Endorsement is
0% (0% for 20XX) of the combined gross direct written premiums for the
specified policies due directly from the Insured(s). For 20XX and 20XX,
endorsement premiums of $0 and $0 out of the total premiums of $0 and
$0, respectively, is payable directly from the Insured(s) to the Stop Loss
Insurer.

Therefore, under the terms of the Joint Underwriting Stop Loss Endorsement agreement, the
Affiliated Businesses were required to pay of total premiums of $0 for the eleven direct written
policies written in 20XX, and total premiums of $0 for the same eleven policies renewed for
20XX. Of the total premiums, the Affiliated Businesses paid $0 in 20XX and $0 in 20XX,
directly to the taxpayer (0%) as Lead Insurer. The Affiliated Businesses also paid $0 and $0,
in 20XX and 20XX, as reinsurance premiums directly to CO-6., as the Stop Loss Insurer.

Based on the review of the contracts, the premiums paid by the Named Insureds under the

terms of the 20XX contracts was as follows:
Portion of Premium

Contracts Total Premium To Taxpayer ([illegible]%)

1. Excess Directors & Officers Liability $ 0 $ 0
2. Special Risk-Loss of Major Customer 0 0
3. Special Risk-Expense Reimbursement 0 0

Form 886-A (1-1994) Catalog Number 20810W Page 10 of 42 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

ORG 12/31/20XX

12/31/20XX

4. Expense Reimbursement-Legal Expenses 0 0
5. Special Risk-Loss of Services 0 0
6. Excess Pollution Liability 0 0
7. Special Risk-Tax Liability 0 0
8. Excess Intellectual Property 0 0
9. Special Risk-Regulatory Changes 0 0
10. Special Risk-Punitive Wrap 0 0
11. Special Risk-Product Recall 0 0
Totals $ 0 0

Based on the review of the contracts, the premiums paid by the Named Insureds under the
terms of the 20XX contracts was as follows:
Portion of Premium

Contracts Total Premium To Taxpayer ([illegible]%)

1. Excess Directors & Officers Liability $ [illegible] $ [illegible]
2. Special Risk-Loss of Major Customer 0 0
3. Special Risk-Expense Reimbursement 0 0
4. Expense Reimbursement-Legal Expenses 0 0
5. Special Risk-Loss of Services 0 0
6. Excess Pollution Liability 0 0
7. Special Risk-Tax Liability 0 0
8. Excess Intellectual Property 0 0
9. Special Risk-Regulatory Changes 0 0
10. Special Risk-Punitive Wrap 0 0
11. Special Risk-Product Recall 0 0
Totals $ 0 $0

The taxpayer also entered into two types of reinsurance arrangements in 20XX and 20XX.
The first arrangement is referred to as a “reinsurance risk pooling program (also called CO-
10).” Under this arrangement, the taxpayer participated in a “reinsurance risk pool” with
several other unrelated insurance companies (“pool participants”). The risk pool was operated
by CO-6. Each pool participant had one or more affiliated operating entities for which it
underwrites insurance coverage, generally casualty type coverage such as credit life and credit
disability. CO-6 insured a portion of the direct insurance underwritten by the pool participants
using a so-called “stop loss” endorsement. CO-6 participated in over 0 insurance policies with
more than 0 insureds. CO-6 blended together its direct written insurance, and then reinsures
the entire book on a quota share basis with each of the pool participants. In 20XX, the
taxpayer was one of 63 reinsurers participating in the risk pool. The taxpayer, as Reinsurer
#0, retained 0% of a Quota Share Premium from CO-6. in exchange for the assumption of 0%
of the risk pool comprised of the stop loss coverages issued during the policy period by CO-6

Form 886-A (1-1994) Catalog Number 20810W Page 11 of 42 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
ORG 12/31/20XX
12/31/20XX

Insurance Company to all stop loss endorsement policyholders. CO-6. paid total reinsurance
premiums of $0 to 0 Reinsurers. Of this total premium, the taxpayer received a quota share
reinsurance premium equal to 0% or $0 of which $0 is the portion of the premium retained by
taxpayer (as a quota share retained premium) until the final accounting and settlement of the
Risk Pool was completed. The quota share retained premium was calculated at 0% of the
quota share reinsurance policy premium of $0. The risk pool insured by CO-6 and reinsured
by the 0 pool participants included the eleven direct written policies written and sold by the
taxpayer to the Affiliated Business Interests. According to the general ledger, the taxpayer
reported receiving a reinsurance premium of $0 from CO-6 in 20XX.

In 20XX, the risk pool consisted of 0 reinsurers. As Reinsurer #0, the taxpayer retained 0% of
a Quota Share Premium, from CO-6., in exchange for the assumption of 0% of the risk pool
comprised of the stop loss coverages issued during the policy period by CO-6 Insurance
Company to all stop loss endorsement policyholders. CO-6. paid total reinsurance premiums
of $0 to 0 Reinsurers. Of this total premium, the taxpayer received a quota share reinsurance
premium equal to 0% or $0 of which $0 is the portion of the premium retained by taxpayer (as
a quota share retained premium) until the final accounting and settlement of the Risk Pool was
completed. The quota share retained premium was calculated at 0% of the quota share
reinsurance policy premium of $0. The risk pool insured by CO-6 and reinsured by the 0 pool
participants included the eleven direct written policies written and sold by the taxpayer to the
Affiliated Business Interests. According to the general ledger, the taxpayer received
reinsurance premiums of $0 from CO-6 in 20XX.

The second reinsurance arrangement is called “Credit Coinsurance Reinsurance Program.”
Under the terms of the 20XX and 20XX contracts, the taxpayer assumed reinsurance contracts
from CO-6. The taxpayer reinsured a 0% and 0% quota share of the risks, respectively, from

vehicle service contracts reinsured by CO-6. The vehicle service contracts were initially
written by [illegible] in 20XX, assumed by CO-8, then by CO-9
from [illegible], and finally assumed by CO-6. from CO-9 The taxpayer received a pro rata

share (0%) of the earned premiums received by CO-6. The taxpayer received a reinsurance
premium of $0 in 20XX, and $0 in 20XX, from CO-6.

For the tax years ended December 31, 20XX, the taxpayer reported gross receipts and total -
revenue of $0. Total revenue was derived primarily from premiums received from the direct
written, reinsurance risk pooling program, and the credit coinsurance reinsurance program.

The taxpayer received total revenue as follows:

20XX
Program Revenue-Service
Direct Written Premiums $ 0 0%
Quota Share Reinsurance Premiums 0 0
Credit Coinsurance Reinsurance Premiums 0 0

Form 886-A (1-1994) Catalog Number 20810W Page 12 of 42 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
ORG 12/31/20XX
12/31/20XX
Investment Income 0 0
Gain of sale of assets -0- -0-
Other income: Premium Finance Charge 0 0
Total Revenue $ 0 0%

Of the total premiums received by the taxpayer in 20XX, [illegible]% of the premiums were
generated from the eleven direct written policies with the affiliated Business Interests, CO-2.,
CO-3, and CO-4, [illegible] 0% of the premiums are from the Reinsurance Risk Pooling Program;
and 0% of the premiums from the Credit Coinsurance Reinsurance Program.

As of December 31, 20XX, the taxpayer’s assets totaled $0, which consisted primarily of cash
in its checking account of $0 and investment in publicly traded securities of $0.

For the tax years ended December 31, 20XX, the taxpayer reported gross receipts of $0, and
total revenue of $0. Total revenue was derived primarily from premiums received from the
direct written, reinsurance risk pooling program, and the credit coinsurance reinsurance
program. The taxpayer received total revenue as follows:

20XX
Program Revenue Service
Direct Written Premiums $ [illegible] [illegible]%
Quota Share Reinsurance Premiums [illegible] [illegible]
Credit Coinsurance Reinsurance Premiums [illegible] [illegible]
Investment Income [illegible] [illegible]
Gain of sale of assets [illegible] [illegible]
Other income: Premium Finance Charge [illegible] [illegible]
Total Revenue $ [illegible] 100.00%

Of the total premiums received by the taxpayer in 20XX, 0% of the premiums were generated

from the eleven direct written policies with the Affiliated Business Interests, CO-2., CO-3, and

CO-4. [illegible]% of the premiums are from the Reinsurance Risk Pooling Program; and
[illegible]% of the premiums from the Credit Coinsurance Reinsurance Program.'

As of December 31, 20XX, the taxpayer's assets totaled $0, which consisted primarily of cash
in its checking and investment accounts of $0 and investment in publicly traded securities of

$0.

' Actuarial studies were completed by CO-11; CO-12; CO-13; and CO-14, for pricing of coverages provided by ORG.

Form 886-A (1-1994) Catalog Number 20810W Page 13 of 42 publish.no.irs.gov Department of the Treasury-Internal Revenue Service

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

ORG 12/31/20XX
12/31/20XX

With respect to the direct contracts insured in 20XX, 20XX and 20XX, the taxpayer did not
sale, write or issue separate policies to CO-2., CO-3, and CO-4, Each contract listed all
three parties as the insured. The contracts also listed a single combined premium payment
due to cover all three parties. The three named insured did not pay separate premiums to the
taxpayer in 20XX, 20XX or 20XX. Nor did the parties have an agreement to show how the
premium payments were to be allocated between them.

Based on the analysis of premiums received during the years under audit, two-thirds of the
risks insured by the taxpayer was the risk from Affiliated Business Interests.

LAW:

Section 501(c)(15) of the Internal Revenue Code provides insurance companies [as defined in
section 816(a)] other than life (including inter-insurers and reciprocal underwriters) can qualify
for tax-exempt status if:

1. The gross receipts for the taxable year do not exceed $600,000, and more than 50% of
such gross receipts consist of premiums, or

2. Inthe case of a mutual insurance company, the gross receipts of which for the taxable
year do not exceed $150,000, and more than 35% of such gross receipts consist of premiums.

Section 831(c) defines the term “insurance company,” for purposes of section 831, as having
the same meaning as the terms is given under section 816(a). Section 816(a) provides that
the term “insurance company” means any company more than half of the business of which
during the taxable year is the issuing of insurance or annuity contracts or reinsuring the risks
underwritten by insurance companies.

Pursuant to:

Helvering v. LeGierse, 312 U.S. 531 (1941), the United States Supreme Court in defining the
term “insurance contract” held that in order for a contract to amount to an insurance contract, it
must shift and distribute a risk of loss and that risk must be an “insurance” risk.

AMERCO, Inc. v. Commissioner, 979 F.2d 162, 164-65 (9th Cir. 1992), affg. 96 T.C. 18 (1991),
“risk-shifting” means one party shifts his risk of loss to another, and “risk-distributing” means
that the party assuming the risk distributes his potential liability, in part, among others. An
arrangement without the elements of risk-shifting and risk-distributing lacks the fundamentals
inherent in a true contract of insurance.

Form 886-A (1-1994) Catalog Number 20810W Page 14 of 42 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

ORG 12/31/20XX
12/31/20XX

Allied Fidelity Corp. v. Commissioner, 572 F. 2d 1190, 1193 (7th Cir. 1978), the common
definition for insurance is an agreement to protect the insured against a direct or indirect
economic loss arising from a defined contingency whereby the insurer undertakes no present
duty of ORG but stands ready to assume the financial burden of any covered loss.

Commissioner v. Treganowan, 183 F.2d 288, 290-91 (2d Cir. 1950), the risk must contemplate
the fortuitous occurrence of a stated contingency.

Beech Aircraft Corp. v. United States, 797 F.2d 920, 922 (10th Cir. 1986), historically and
commonly insurance involves risk —shifting and risk distributing. “Risk-shifting” means one
party shifts his risk of loss to another, and “risk-distributing” means that the party assuming the
risk distributes his potential liability, in part, among others. An arrangement without the
elements of risk-shifting and risk-distributing lacks the fundamentals inherent in a true contract
of insurance.

Ocean Drilling & Exploration Co. v. United States, 988 F.2d 1135, 1153 (Fed. Cir. 1993), for
insurance purposes, “risk-shifting” means one party shifts his risk of loss to another, and “risk-
distributing” means that the party assuming the risk distributes his potential liability, in part,
among others.

Clougherty Packing Co. v. Commissioner, 811 F.2d 1297, 1300 (9th Cir. 1987), a true
insurance agreement must remove the risk of loss from the insured party.

Humana, Inc. v. Commissioner, 881 F.2d 247, 257 (6th Cir. 1989), risk distribution involves
shifting to a group of individuals the identified risk of the insured. The focus is broader and
looks more to the insurer as to whether the risk insured against can be distributed over a larger
group rather than the relationship between the insurer and any single insured.

Revenue Ruling 89-96, 1989-2 C.B. 114, an insurance agreement or contract must involve the
requisite risk shifting necessary for insurance.

Revenue Ruling 2002-89, 2002-2 C.B. 984, it is not insurance where a parent company formed
a subsidiary insurance company and 90% of the subsidiary’s earned premium was paid by the
parent company. The Rev. Rul. Further held that such arrangement between a parent and a
subsidiary would constitute insurance if less than 50% of the premium earned by the
subsidiary is from the parent company.

Revenue Ruling 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.

Form 886-A (1-1994) Catalog Number 20810W Page 15 of 42 publish.no.irs.gov Department of the Treasury-Internal Revenue Service


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

Revenue Ruling 2002-90, 2002 C.B. 985, a wholly owned subsidiary that insured 12
subsidiaries of its parent constitute insurance for federal income tax purposes.

Revenue Ruling 2005-40, 2005-40 I.R.B. 4, an arrangement that purported to be an insurance
contract but lacked the requisite risk distribution was characterized as a deposit arrangement,
a loan, a contribution to capital, an indemnity arrangement that was not an insurance contract.

Revenue Ruling 2007-47, 2007-30 I.R.B. 127, an arrangement that provides for the
reimbursement of inevitable future costs does not involve the requisite insurance risk.

Foreign Corporation Tax Provisions

IRC SEC. 951. AMOUNTS INCLUDED IN GROSS INCOME OF UNITED STATES
SHAREHOLDERS.
951(a) AMOUNTS INCLUDED. —

(1) IN GENERAL. —If a foreign corporation is a controlled foreign corporation for an
uninterrupted period of 30 days or more during any taxable year, every person who is a United
States shareholder (as defined in subsection (b)) of such corporation and who owns (within the
meaning of section 958(a)) stock in such corporation on the last day, in such year, on which
such corporation is a controlled foreign corporation shall include in his gross income, for his
taxable year in which or with which such taxable year of the corporation ends —

(A) the sum of —

(i) his pro rata share (determined under paragraph (2)) of the corporation's
subpart F income for such year,

(ii) his pro rata share (determined under section 955(a)(3) as in effect before
the enactment of the Tax Reduction Act of 1975) of the corporation's previously
excluded subpart F income withdrawn from investment in less developed countries

for such year, and

(iii) his pro rata share (determined under section 955(a)(3)) of the
corporation's previously excluded subpart F income withdrawn from foreign base
company shipping operations for such year; and

IRC SEC. 953. INSURANCE INCOME.

953(a) INSURANCE INCOME. —

Form 886-A (1-1994) Catalog Number 20810W Page 16 of 42 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

ORG 12/31/20XX
12/31/20XX

(1) INGENERAL. —For purposes of section 952(a)(1), the term “insurance income” means
any income which —
(A) is attributable to the issuing (or reinsuring) of an insurance or annuity contract,
and

(B) would (subject to the modifications provided by subsection (b)) be taxed under
subchapter L of this chapter if such income were the income of a domestic
insurance company.

(2) EXCEPTION. —Such term shall not include any exempt insurance income (as defined in
subsection (e)).

IRC SEC. 953. INSURANCE INCOME.

953(d) ELECTION BY FOREIGN INSURANCE COMPANY TO BE TREATED AS DOMESTIC CORPORATION.
(1) IN GENERAL. — If

(A) a foreign corporation is a controlled foreign corporation (as defined in section
957(a) by substituting “25 percent or more” for “more than 50 percent” and by using the
definition of United States shareholder under 953(c)(1)(A)),

(B) such foreign corporation would qualify under part I or II of subchapter L for the
taxable year if it were a domestic corporation,
(C) such foreign corporation meets such requirements as the Secretary shall
prescribe to ensure that the taxes imposed by this chapter on such foreign corporation are
paid, and

(D) such foreign corporation makes an election to have this paragraph apply and
waives all benefits to such corporation granted by the United States under any treaty, for
purposes of this title, such corporation shall be treated as a domestic corporation.

GOVERNMENT’S POSITION:
Form 1024 Application

The taxpayer filed a Form 1024 application on September 18, 20XX, seeking retroactive
exemption under IRC 501(c)(15), back to December 3, 20XX, the date of incorporation. The
application was ultimately withdrawn by Owner, President, on September 16, 20XX. The
examining agent believes that the application was withdrawn by the taxpayer on the advice on
its counsel, Attorney-3, Attorney-1, and Attorney-2, who are affiliated with The Law Firm, in

Form 886-A (1-1994) Catalog Number 20810W Page 17 of 42 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

ORG 12/31/20XX
12/31/20XX

City, State. The examining agent believes that its counsel advised the taxpayer to withdraw
the Form 1024 application because counsel anticipated EO Rulings and Agreements would
deny IRC 501(c)(15) tax-exempt status to ORG based on the position taken by Rulings and
Agreements on applications filed by other clients of The Law Firm.

The Law Firm represented many captive insurance companies that filed Form 1024
applications seeking tax-exempt status under IRC 501(c)(15). All of the applications included
basically identical fact patterns, and organizational and operational structure. However, after
EO Rulings and Agreements received an adverse opinion from the IRS, Office of Chief
Counsel, Financial Institutions & Products Division, concluding that the applicants were not
insurance companies within the meaning of Subchapter L of the Code, because the contracts
executed by the companies lack adequate risk distribution, Rulings and Agreements began
issuing adverse denial letters to these companies. The remaining companies suddenly
withdrew their Form 1024 applications, probably anticipating that their applications would also
be denied tax-exempt status by EO Rulings and Agreements.

The examining agent believes that the withdrawals of the remaining applications, including the
application filed by the taxpayer, is more than mere coincidence. In addition, the examining
agent believes the taxpayer withdrew its Form 1024 application upon advice from its counsel in
order to avoid receiving an adverse denial letter from Rulings and Agreements.

Qualification as Insurance Company

Neither the Internal Revenue Code nor the Income Tax Regulations define the terms
“insurance” or “insurance contract.” The standard for evaluating whether an arrangement
constitutes insurance for federal tax purposes has evolved over the years and is, at best, a
nonexclusive facts and circumstances analysis. Sears, Roebuck and Co. v. Commissioner,
972 F.2d 858, 861-64 (7th Cir. 1992). The most frequently cited opinion on the definition of
insurance is Helvering v. LeGierse, 312 U.S. 531 (1941), in which the Court describes
“insurance” as an arrangement involving risk-shifting and risk-distributing of an actual
“insurance risk” at the time the transaction was executed. Cases analyzing “captive insurance”
arrangements have described the concept of “insurance” for federal income tax purposes as
containing three elements: (1) involvement of an insurance risk; (2) shifting and distributing 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), affg. 96 T.C. 18 (1991). The test,
however, is not a rigid three-prong test.

There is also no single definition of insurance for non-tax purposes. “[T]he subject has no
useful, or fixed definition. There is neither a universally accepted definition or concept of
‘insurance’ nor a [sic] exclusive concept or definition that can be persuasively applied in
insurance lawyering.” 1 APPLEMAN ON INSURANCE 2d, § 1.3 (2005). While “it seems
appropriate that any concept and meaning of insurance be sufficiently broad and flexible to

Form 886-A (1-1994) Catalog Number 20810W Page 18 of 42 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

ORG 12/31/20XX
12/31/20XX

meet the varying and innovative transactions which humankind perpetually produces,” care
must be used to describe insurance because “overbroad definitions are not useful and may
cause many commercial relationships erroneously to constitute insurance.” Id. Moreover, a
state’s determination of whether a product is insurance for state law purposes does not control
whether the product is insurance for federal tax law. See AMERCO, 96 T.C. 18, 41 (1991).
There is no need for parity between a state law definition and federal definition as the objective
for state purposes is company solvency. Solvency is not a concern for determining whether an
arrangement qualifies as insurance for federal income tax purposes.

Not all contracts that transfer risk are insurance policies even where the primary purpose of the
contract is to transfer risk. For example, a contract that protects against the failure to achieve
a desired investment return protects against investment risk, not insurance risk. LeGierse, 312
U.S. at 542 (the risk must not be merely an investment risk); Securities and Exchange
Commission v. United Benefit Life Insurance Co., 387 U.S. 202, 211 (1967) (the transfer of an
investment risk cannot by itself create insurance). See also, Rev. Rul. 89-96, 1989-2 C.B. 114
(risks transferred were in the nature of investment risk, not insurance risk); Rev. Rul. 68-27,
1968-1 C.B. 315 (although an element of risk existed, it was predominantly a normal business
risk of an organization engaged in furnishing medical services on a fixed price basis rather
than an insurance risk) and Rev. Rul. 2007-47, 2007-2 C.B. 127 (the arrangement lacked the
requisite insurance risk to constitute insurance because the arrangement lacked fortuity and
the risk at issue was akin to the timing and investment risks of Rev. Rul. 89-96).

The line between investment risk and insurance risk, however, is pliable.

[t]he finance and insurance industries have much in common. The different tools these
industries provide their customers for managing financial insurable risks rely on the same two
fundamental concepts: risk pooling and risk transfer. Further, the valuation techniques in both
financial and insurance markets are formally the same: the fair values of a security and an
insurance policy are the discounted expected values of the cash flows they provide their
owners. Scholars and practitioners recognize these commonalities. Not surprisingly the
markets have converged recently; for example, some insurance companies offer mutual funds
and life insurance tied to stock portfolios, and some banks sell annuities.

FINANCIAL ECONOMICS WITH APPLICATIONS TO INVESTMENTS, INSURANCE AND
PENSIONS 1 (Harry H. Panier, ed., 2001).

Insurance risk requires a fortuitous event or hazard and not a mere timing or investment risk.
A fortuitous event? (such as a fire or accident) is at the heart of any contract of insurance. See

2A happening that, because it occurs only by chance or accident, the parties could not reasonably have foreseen. Black's

Law Dictionary, 725 (9" ed. 2009). See also, First Restatement of Contracts § 291, cmt. a (1932); American Law
institute, Restatement (Second) Contracts § 379, cmt. a (1981). See Generally, Jeffery W. Stempel, Stempel on

Insurance Contracts, § 1.06A[4] (2007 Supp.) ("[I]n the past 20 years, a "modern" view of fortuity as a matter of law has

emerged in United States courts, one that largely embraces the notions of fortuity held by the American Law Institute

when it adopted the Restatement of Contracts, first in 1932 and again in the Second Restatement published in 1981."

Form 886-A (1-1994) Catalog Number 20810W Page 19 of 42 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

ORG 12/31/20XX
12/31/20XX

Commissioner v. Treganowan, 183 F.2d 288, 290-91 (2d Cir. 1950) (the risk must contemplate
the fortuitous occurrence of a stated contingency not an expected event).

Lack of Insurance Risk
The Service analyzed the risk of the contracts to determine whether the contracts qualify as
contracts of insurance, annuity contracts or reinsurance contracts: In deciding whether the
contracts qualify as insurance contracts for federal tax purposes, we have considered all of the
facts and circumstances associated with the parties in the context of the captive arrangement.
When deciding that a specific contract is not insurance because it does not have an insurance
risk but deals with a business or investment risk, we have considered such things as the
ordinary activities of a business enterprise, the typical activities and obligations of running of a
business, whether an action that might be covered by a policy is in the control of the insured
within a business context, whether the economic risk involved is a market risk that is part of the
business environment, whether the insured is required by a law or regulation to pay for the
covered claim, and whether the action is question is willful or inevitable.

20XX Policies

1. Special Risk - Loss of Services Insurance Policy

Covers the involuntary loss of service for key employees. The covered cause of loss must be
involuntary and includes sickness, disability, death, loss of license, resignation or retirement
after 14 days. Coverage does not include any loss of services if the insured terminated the
employment of the employee. Also excluded is any claim if the insured does not attempt to
replace the employee timely. Claims costs can include costs incurred by existing employees,
costs of temporary employees, training costs, and lost net revenue.

Not insurance.

The policy is not insurance in the commonly accepted sense. Although a policy only covering
death or disability of a key employee is insurance, the policy here covers many non-insurance
risks, that is investment or business risks.

2. Special Risk — Product Recall

Covers the mandatory or voluntary recall of all products manufactured or sold by the Affiliated
Business Interests in 20XX, due to a known or specific defect, deficiency of dangerous
condition.

Not insurance.

Form 886-A (1-1994) Catalog Number 20810W Page 20 of 42 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

ORG 12/31/20XX
12/31/20XX

The policy is not insurance in the commonly accepted sense. There is no insurance risk but
only investment or business risk.

3. Special Risk — Weather Related Business Interruption

The policy covers loss of income from interruptions in business due to certain weather related
events.

Insurance.

4. Special Risk—Regulatory Changes Insurance Policy

Covers actual compliance expenses and any business interruption loss up to 12 months as a
result of any regulatory change that has an adverse impact on insured’s normal on-going
business operations. Regulatory changes include governmental, administrative agency, or
legislative changes, changes to environmental, zoning, transportation, or safety laws or
regulations, changes to import/export laws, regulatory changes due to foreign political risk
including the collapse of a foreign economy, and any regulatory change due to the insured’s
reorganization, such as changing from a corporation to a limited partnership. The policy
excludes any claim for an adverse regulatory change due to the insured’s substantial non-
compliance with regulations or other guidelines.

Not insurance.

The policy is not insurance in the commonly accepted sense. There is no insurance risk but
only investment or business risk.

5. Special Risk—Tax Liability Insurance Policy

Covers any additional tax liability up to $0 subject to a deductible equal to 0% of the actual
filed IRS tax liability provided return prepared and signed by CPA. Policy also covers defense
expenses incurred in determining the final tax liability. Several IRS penalties are excluded

from coverage.

Not insurance.

The policy is not insurance in the commonly accepted sense. There is no insurance risk but
only investment or business risk.

6. Special Risk—Punitive Wrap Liability Insurance Policy

Form 886-A (1-1994) Catalog Number 20810W Page 21 of 42 publish.no.irs.gov Department of the Treasury-Internal Revenue Service


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

Covers claims for punitive or exemplary damages upon the failure of the insurer under policies
listed that are issued to the insured to cover punitive or exemplary damages, judgments, or
awards solely due t the enforcement of any law or judicial ruling that precludes the insuring of
punitive or similar damages and that but for such law or ruling would otherwise be covered,
and for which an insured is legally obligated to pay. The schedule of covered policies lists the
other 9 direct written policies described in this part of this report.

Not insurance.

The policy is not insurance in the commonly accepted sense. There is no insurance risk but
only investment or business risk.

7. Excess Pollution Liability

Insuring Agreement 1 and 2 cover clean-up costs and diminution in value costs resulting from
pre-existing or new on-site pollution conditions. Coverage is conditioned on an affirmative
obligation to report on site pollution conditions to a governmental agency so as to be in
compliance with environmental laws. Various laws covering solid waste disposal, super funds,
clean air, clean water, and toxic substances are listed in a non-exclusive list provided the
insured has or may have a legal obligation to incur clean up costs for pollution conditions or
pollution release. Clean up costs cover the expenses of investigation or removal of, or
rendering non-hazardous pollution conditions to the extent required by environmental laws.
Diminution in value means the difference in the fair market value of the property when the
remedial action plan is approved and the fair market value of the property had there been no
on site pollution conditions.

Insuring Agreements 3 to 12 provide for third party claims for on site or off site clean up and
diminution in value costs for pre-existing or new on site or off site pollution conditions, as well
as bodily and property damage, as well as non-owned locations.

Insuring Agreement 0 covers pollution release from transported cargo carried by covered
autos. No covered auto is identified in the declarations.

Insuring Agreement 0 covers third party claims from transporting of a product or waste.

Insuring Agreement 0 covers actual loss resulting from the interruption of the business
operations caused solely and directly by on site pollution conditions. Actual loss means the
net income the insured would have earned had there been no interruption. Coverage also
includes loss of rental value, which generally means the anticipated rental income from tenant
occupancy of insured property.

Not insurance. The policy is not insurance in the commonly accepted sense. There is no
insurance risk but only investment or business risk.

Form 886-A (1-1994) Catalog Number 20810W Page 22 of 42 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

ORG 12/31/20XX
12/31/20XX

8. Special Risk —- Loss of Major Customer

Covers any Business Interruption suffered as a result of losing the service of a Major
Customer(s). Business Interruption includes the impact of lost revenue and the extra
expenses involved in finding a replacement customer(s). The policy will not cover the
voluntary loss of a Major Customer where the insured initiates the termination of the
agreement; the loss of a Major Customer that insured did not attempt or intent to replace; or
the loss of a Major Customer due to insured’s substantial non-compliance with the terms and
conditions of its contractual agreement with the customer.

Not Insurance. The policy is not insurance in the commonly accepted sense. There is no
insurance risk but only business risk.

9. Excess Intellectual Property Package Policy

Insuring Agreement 1: Covers, damages, defense expenses, and compliance redesign
expense for listed wrongful acts: infringement of copyrights, trademark etc; plagiarism or
unauthorized use of ideas characters, plots etc; invasion of privacy or publicity; libel, slander,
or product disparagement; piracy or unfair competition, misappropriation of advertising ideas,
etc; breach of contract resulting from the alleged submission of material used by insured;
patent infringement; malicious prosecution with regard to intellectual property. Compliance
redesign expense covers expense to recall and/or redesign the insured’s intellectual property
to comply with a judgment or settlement. The policy excludes any intentional act by a director,
officer or employee.
Insuring Agreement 2: Covers wrongful acts (listed above) committed by third parties against
insured’s intellectual property. It pays for litigation expenses, mitigation expense to mitigate
the extent of the claim, costs to replace, restore, or re-create the covered intellectual property,
and finally additional damages to the insured’s business operations such as business
interruption, loss of clients or market share, or public relations damage control efforts. The
policy excludes loss due to insured’s cyber presence.

Not insurance.

Insuring Agreement 1 and 2 are not insurance in the commonly accepted sense. There is no
insurance risk but only investment or business risks. (It is not clear what intellectual property
the insured possesses.)

10. Special Risk - Expense Reimbursement Insurance Policy

Coverage Form A deals with crisis management public relations expenses. This covers all
public relations expenses to mitigate the insured’s adverse publicity generated from an actual

Form 886-A (1-1994) Catalog Number 20810W Page 23 of 42 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

ORG 12/31/20XX
12/31/20XX

or imminent; liability incident that could exceed $0; product recall; employee layoff or labor
dispute; government litigation; financial crisis; loss of intellectual property rights; unsolicited
takeover bid; security incident; or any incident expected to reduce annual gross revenue by at
least 0%. .

Coverage Form B deals with uninsured defense. This covers all defense expense for actual
or alleged civil liability where there is no insurer to provide such coverage or where such
coverage has been exhausted under an existing insurance contract.

Not insurance as to Coverage A. Coverage Form A is not insurance in the commonly
accepted sense. There is no insurance risk but only investment or business risk.

Coverage B may be insurance in the commonly accepted sense. It is vague as to what
liability/contract underlies the need for defense expenses. More information needed as to

Coverage B.

11. Excess Employment Practices Liability

Covers 11 categories of wrongful acts including wrongful termination, refusal to hire or
promote, sexual harassment, unlawful discrimination based on age, gender, etc., invasion of
privacy, failure to create employment policies or procedures, retaliatory treatment, violation of
civil rights, violation of Family and Medical Leave Act, breach of employment contract, failure
to provide safe work environment, violations listed herein against a non-employee. There is
excluded from coverage claims related to employee's entitlements under various listed non-
specific laws, rules or regulations. Also excluded are claims under various listed laws such as
the Occupational Safety and Health Act. These exclusions shall not apply to claim for any
actual or alleged retaliatory, discriminatory, or other employment practices-related treatment.

Not insurance. Policy is not insurance in its commonly accepted sense. There is no insurance
risk but only investment or business risk.

12. Excess Directors & Officers Liability Insurance Policy
Covers wrongful acts or directors and officers.

Insurance.

13. Excess Cyber Risk

Insuring Agreement 1 — Cyber Risk Liability covers all damages that insured becomes legally
obligated to pay and defense expenses as a result of any claim made against insured for a
Wrongful Act. Wrongful Acts may include, but are not limited to the following: defamation;

Form 886-A (1-1994) Catalog Number 20810W Page 24 of 42 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

ORG 12/31/20XX
12/31/20XX

infringement of intellectual property; and failure to prevent unauthorized access to, use of,
tampering with, or introduction of malicious code into data or systems.

Insuring Agreement 2 — 1st Party Property Loss & Business Interruption covers loss of or
damages to insured’s covered property caused by, but not limited to the following: a computer
virus; a cyber attack, theft of computer system resources; and computer crimes. Insuring
Agreement 2 also covers business interruption expenses, monies surrendered or costs
incurred as a result of Cyber-Extortion, and reward money for information leading to the arrest
and conviction of individuals committing or attempting to commit illegal acts related to
coverage under the policy.

Insuring Agreement 3 — Post-Loss Systems Crisis Management covers the cost of public
relations services required to protect insured’s image and reputation following a covered loss.
Insuring Agreement 3 also covers service fees of consultants hired to identify and/or
implement ways to prevent or decrease the possibility of a further or future loss similar to the
covered loss.

Insuring Agreement 1 and 2 is insurance.

Insuring Agreement 3 is too vague and broad and not insurance in the commonly accepted
sense. There is no insurance risk but only business risk.

Not insurance.

The policy is not insurance in the commonly accepted sense. There is no insurance risk but
only investment or business risk.

20XX Policies

1. Loss of Services Insurance Policy

Same as 20XX. Not insurance.

2. Special Risk — Product Recall

Same as 20XX. Not insurance.

3. Special Risk—Regulatory Changes Insurance Policy

Same as 20XX. Not insurance.

Form 886-A (1-1994) Catalog Number 20810W Page 25 of 42 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

ORG 12/31/20XX
12/31/20XX

4. Special Risk- Tax Liability

Same as 20XX. Not insurance.

5. Special Risk — Punitive Wrap

Same as 20XX. Not insurance.

6. Excess Pollution Liability Insurance Policy

Same as 20XX. Not insurance.

7. Special Risk — Loss of Major Customer

Same as 20XX. Not insurance.

8. Excess Intellectual Property

Same as 20XX. Not insurance.

9. Expense Reimbursement Insurance Policy

This policy differs from the 20XX insurance policy with the same title. Covers losses due to an
actual or imminent liability incident, product recall, employee layoff or labor dispute.

Not insurance.

The policy is not insurance in the commonly accepted sense. There is no insurance risk but
only investment or business risk.

10. Excess Directors & Officers Liability Insurance Policy

Same as 20XX. Insurance.

11. Expense Reimbursement—Legal Expenses Insurance Policy

Form 886-A (1-1994) Catalog Number 20810W Page 26 of 42 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

ORG 12/31/20XX
12/31/20XX

New policy for 20XX. Policy covers litigation expenses from actual or alleged civil liability.
Not insurance.
This is not insurance in the commonly accepted sense. There is no insurance risk but only

investment or business risk.

20XX Policies

Same 11 direct written contracts were issued to the Affiliated Business Interests in 20XX as in
20XX.

Therefore, only the Excess Directors & Officers Liability contract was deemed to be a valid
insurance contract for 20XX.

Other Insurance Policies

CO-10.

CO-6 participated in over 0 insurance policies with more than 0 insureds. CO-6 blended
together its direct written insurance and then reinsured the entire book on a quota share basis
with each of the pool participants. Taxpayer was one of 0 reinsurers listed in the agreement
for 20XX. As Reinsurer No. [illegible], in the 20XX reinsurance program, Taxpayer received [illegible]%
of CO-6’s gross premiums of $0, in exchange for the assumption [illegible]% of the risk pool
comprised of the stop loss coverage issued to all of the stop loss endorsement policyholders.

In 20XX, CO-6 participated in over 0 insurance policies with more than 0 insureds. CO-6
blended together its direct written insurance and then reinsured the entire book on a quota
share basis with each of the pool participants. Taxpayer was one of 0 reinsurers listed in the
agreement for 20XX. As Reinsurer No. 0, Taxpayer received 0% of CO-6’s gross premiums of
$0, in exchange for the assumption of 0% of the risk pool comprised of the stop loss coverage
issued to all of the stop loss endorsement policyholders.

Finally, in 20XX, CO-6 participated in over 0 insurance policies with more than 0 insureds.
CO-6 blended together its direct written insurance and then reinsured the entire book on a
quota share basis with each of the pool participants. Taxpayer was one of 0 reinsurers listed
in the agreement for 20XX. As Reinsurer No. 0, Taxpayer received 0% of CO-6's gross
premiums of $0, in exchange for the assumption of 0% of the risk pool comprised of the stop
loss coverage issued to all of the stop loss endorsement policyholders.

Form 886-A (1-1994) Catalog Number 20810W Page 27 of 42 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

ORG 12/31/20XX
12/31/20XX

We do not have any understanding of the risks insured by Taxpayer. We do not know whether
the policies "reinsured" are similar to the several policies that we have concluded above are
not insurance. However, the direct written contracts insured by CO-6 do include the 0
contracts written by ORG Therefore, it is highly likely that the entire pool, which is insured by
CO-6 and reinsured on a quota share basis with each of the pool participants, is primarily
comprised of direct written contracts that the Service would deem not be insurance in the
commonly accepted sense. Thus all or a portion of the premiums received by taxpayer, during
the taxable years under consideration, would not be for reinsuring insurance risks.

Credit Coinsurance Reinsurance Program.

The policy reinsures risks on vehicle service contracts. Again, we do not know what risks are
being insured and reinsured.

Pricing of Contracts
The Service also has concern about whether the premiums charged for the contracts were
reasonable. A premium for an insurance contract is based on actuarial calculations and
factors. Even if an insurance contract is deem to be “insurance” for federal tax purposes, the
premium paid pursuant to that contract must be determined based on actuarial factors and
principles. In the February 10, 20XX response to IDR #4 for 20XX, the CPA provided a copy
of letters from CO-13; CO-11; and CO-12, which was purpose to address the method used for
pricing the direct written and reinsurance contracts for the taxable years under consideration.
However, the Service concluded that the letters did not address the method of pricing the
specific direct written and reinsurance contracts that ORG was a party to during 20XX, 20XX,
and 20XX. Thus, the Service concluded that the premiums received by taxpayer were not
reasonable because they were not based on actuarial calculations and factors.

Risk Shifting
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 (risk shifting not present where subscribers, all subject to the same flood
risk, agreed to coverage under a reciprocal flood insurance exchange).

Risk Distribution
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,

Form 886-A (1-1994) Catalog Number 20810W Page 28 of 42 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

ORG 12/31/20XX
12/31/20XX

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 “by 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.” Also see 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, 1135 (Fed. Cir. 1993) (“risk 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 receipts 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).

In Situation 1 of Rev. Rul. 2002-89, 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,
the premiums that S received from the arrangement with P constituted less than 50% of total
premiums received by S 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, 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 the parent of S constitute insurance for federal income tax purposes.

Situation 1 of Rev. Rul. 2005-40, 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

Form 886-A (1-1994) Catalog Number 20810W Page 29 of 42 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

ORG 12/31/20XX
12/31/20XX

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. Ruling 2005-40 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, 12 LLC’s elected classification as associations, each
contributing between 5 and 15% of the insurer's total risks. The Service concluded that this
transaction constituted insurance for federal income tax purposes.

The principal concern with regard to your activities is whether there is sufficient risk
distribution. As discussed above, the idea of risk distribution involves some mathematical
concepts. For example, risk distribution is said to incorporate the statistical phenomenon
known as the “law of large numbers” whereby distributing risks allows the insurer to reduce the
possibility that a single costly claim will exceed the amount taken in as premiums. The
concept hinges on the assumption of “numerous relatively small” and “independent risks” that
“occur randomly over time.” Clougherty Packing Co., 811 F.2d 1297 at 1300.

As discussed, the Service in Rev. Rul. 2002-90, concluded that insurance existed where 12
insureds each contributed between five and 15% to the insured’s total risks. Similarly, in
Situation 4 of Rev. Rul. 2005-40, the Service concluded that insurance existed where 12 LLCs,
electing classification as associations, each contributed between five and 15% of the insurer's
total risks. Moreover, in Situation 2 of Rev. Rul. 2002-89, supra, the Service concluded that
insurance existed where a wholly owned subsidiary insured its parent, but the arrangement
represented less than 50% of the insurer’s total risk for the year.

Form 886-A (1-1994) Catalog Number 20810W Page 30 of 42 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

ORG 12/31/20XX
12/31/20XX

In the instance case, the facts therein are analogous to the analysis under Situation’ of Rev.
Rul. 2002-89, supra, the liability coverage provided to the parent corporation by its wholly
owned subsidiary accounted for 90% of the total risks borne by the subsidiary. Similarly, in
Situation 2 of Rev. Rul. 2005-40, supra, a second insurer contributing 10% of the insured’s
risks was added to the single-insured scenario of Situation1. The Service concluded in both of
the above scenarios that insurance did not exist because there lacked a sufficient number of
insureds. The small number of insureds produced an insufficient pool of premiums to
distribute any insurance risk.

With respect to the contracts reviewed during the tax year under audit, the Service concluded
that the agreements between the taxpayer and the Affiliated Businesses, CO-2., CO-3, and
CO-4, the insured, did not constitute contracts of insurance because they lack the essential
element of risk distribution. Most of the risk insured by the taxpayer is under the direct written
contracts with related entities. All of total risk insured by the company, approximately 0% to
0% of the risk is from the related entities. The taxpayer did not write or issue separate
contracts to the affiliated insured. In addition, of the total premiums received during the years
under audit, 100% of the direct written premium (and 0% to 0% of total premiums) was paid by
a single entity, CO-2., even though the direct written contracts covers all three related insured.
There is no evidence that each of the related insured paid separate premiums to ORG for its
coverage. Nor did the parties have an agreement showing the amount of premium allocable to
each of insured. Even if related of affiliated insured did pay premiums separately to the
taxpayer, the fact pattern still would not create a pool large enough to adequately distribute the
taxpayer's risk. Rev. Rul. 2005-40 cited several court decisions that have recognized that risk
distribution necessarily entails a pooling of premiums, so that a potential insured is not in
significant part paying for its own risks. In this case, the large concentration of insurance risks
in one insured does not constitute risk distribution because of the very high likelihood of the
insured paying for any of its claims with its own premiums. Such an arrangement is not
insurance but a form of self-insurance.

The Service concluded that the contracts resulted in risk that was too heavily concentrated in
the three related insured. Because the risk was heavily concentrated in the Affiliated
Businesses, it is highly probable that any losses paid by the taxpayer are those of the Affiliated
Businesses and not from an unrelated third party. In addition, since the Affiliated Businesses
paid the majority of premiums received by the taxpayer during the year under audit, the
Service concluded that losses incurred by the Affiliated Businesses were paid from the
premiums paid to the taxpayer by the Affiliated Businesses. In other words, the arrangement
between the taxpayer and the Affiliated Businesses represented a form of self-insurance, and
no court has held that self-insurance is insurance for federal tax purposes.

Also, an arrangement that provides for the reimbursement of believed-to-be inevitable future
costs does not involve the requisite insurance risk for purposes of determining whether the

Form 886-A (1-1994) Catalog Number 20810W Page 31 of 42 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
ORG 12/31/20XX
12/31/20XX

assuming entity may account for the arrangement as an “insurance contract” for purposes of
Subchapter L of the Internal Revenue Code.

Furthermore, it 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, supra; also see Rev. Rul. 2005-40.

Assuming that all of the agreements do constitute insurable risks or that a significant majority
of the contracts qualify as insurable risks, over 0% of the total risks assumed by the company
are with affiliated entities that are owned and controlled by Owner and Co-Owner, the
beneficial owners of the taxpayer.

Gross Receipts Test

Section 501(c)(15) of the Internal Revenue Code provides exemptions for insurance
companies, other than life insurance companies (including inter-insurers and reciprocal
underwriters), if the gross receipts for the taxable year do not exceed $600,000, and more than
50% of such gross receipts consist of premiums.
Based the Service's analysis of the contracts, twelve of the fourteen direct written contracts
were deemed not to be insurance (or we could definitively determine whether the contract
included an insurance risk). Therefore, the amounts received by ORG for those twelve direct
written contracts are not considered insurance premiums. Amounts received by taxpayer for
two of the fourteen direct written contracts were deemed to be premiums because only for
those contracts included an insurance risk. During the taxable years under consideration,
ORG received amounts that the Service deemed to be direct written and reinsurance
premiums as follows:

20XX
Contract Premium
Special Risk — Weather Related Business Interruption $0
Excess Directors & Officers Liability 0
Amount Deemed Premiums from Direct Written Contracts $ 0
Quota Share Premiums 0
Credit Coinsurance Reinsurance 0
Total Premiums for 20XX $ 0
Gross Receipts for 20XX 0
Percentage of Premiums to Gross Receipts 0%
20XX
Contract Premium
Excess Directors & Officers Liability $0

Form 886-A (1-1994) Catalog Number 20810W Page 32 of 42 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
ORG 12/31/20XX
12/31/20XX
Amount Deemed Premiums from Direct Written Contracts $ 0
Quota Share Premiums 0
Credit Coinsurance Reinsurance 0
Total Premiums for 20XX $ 0
Gross Receipts for 20XX $ 0
Percentage of Premiums to Gross Receipts 0%
20XX
Contract Premium
Excess Directors & Officers Liability $ 0
Amount Deemed Premiums from Direct Written Contracts $ 0
Quota Share Premiums 0
Credit Coinsurance Reinsurance 0
Total Premiums for 20XX $ 0
Gross Receipts for 20XX $ 0
Percentage of Premiums to Gross Receipts 0%

The amounts received by ORG under the remaining direct written contracts were not
premiums for insurance contracts in the commonly accepted sense. The terms of the
contracts did not include insurance risk but covered investment or business risks. The
remaining contracts lacked the requisite insurance risk to constitute insurance because the
contracts lacked fortuity, and the risk at issue is akin to the timing and investment risks of Rev.
Rul. 89-96.

An arrangement that provides for the reimbursement of believed-to-be inevitable future costs
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. For the contracts that are deemed not to qualify as insurable
risks, then the amount paid for each contract, by CO-2. to the TP, would not qualify as an
insurance premium.

In addition, although we question whether the CO-10 contracts are actually valid reinsurance
contracts, and whether the amounts received by taxpayer under the contracts are valid
reinsurance premiums, the amounts received by taxpayer from CO-6 Insurance Company
were included as “premium income” for purposes of the gross receipts computation shown
above. Even after given the taxpayer the benefit of the doubt, the taxpayer still failed the
gross receipts for the years under audit.

During the tax years under consideration, the premium income received by taxpayer did not
exceed [illegible]% of its gross receipts. Although gross receipts are less than the $[illegible]
limitation, the amount deemed to be premiums, for each taxable year, is not more than [illegible]% of
gross receipts. Therefore, we are revising our position on the gross receipts test as stated in

Form 886-A (1-1994) Catalog Number 20810W Page 33 of 42 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

ORG 12/31/20XX
12/31/20XX

our Preliminary Report issued to taxpayer on September 26 20XX. Based on further analysis
of the contracts, we concluded that the taxpayer did not meet the’ % gross receipts test
described in IRC 501(c)(15) and Notice 2006-42 for any tax year under audit.

As described in Situation 1 of Rev. Rul. 2002-89, supra, and Situation 2 of Rev. Rul. 2005-40,
supra, there exists an inadequate premium pooling base for insurance to exist. The addition of
the two other reinsurance arrangements does not change the conclusion that the contracts
with the Affiliated Business Interests lack the requisite risk distribution. Therefore, the taxpayer
does not qualify as an insurance company.

Application of Foreign Corporation Tax Provisions

The administrative file for the original Form 1024 application filed by ORG included a copy of
the IRC 953(d) election filed by the Company on February 23, 20XX. However, the IRS has
no record that. the election was approved. In the July 28, 20XX response to Information
Document Request #2, issued by the examining agent on April 28, 20XX, ,
CPA, stated that it is her understanding that the Internal Revenue Service recently changed its
internal procedures to postpone review of an IRC 953(d) election until the Form 1024
application was reviewed. It appears that the Service still has not completed processing the
IRC 953(d) election filed years ago. ORG withdrew the initial Form 1024 application on
September 16, 20XX.°

IRC 953(a)(1) defines insurance income to mean income which is attributable to the issuing or
reinsuring of an insurance or annuity contract, and would be taxed under subchapter L if such
income were the income of a domestic insurance company. Therefore, any premium income
received by a CFC could qualify

IRC 953(d) allows foreign insurance company to elect to be treated as a domestic company for
tax purposes if it meets certain requirements. One such requirement is that the foreign
company must be a company that would qualify under part I or II of subchapter L for the
taxable year if it were a domestic corporation. See IRC 953(d)(1)(B).

Since the Service determined that the taxpayer is not an insurance company within the
meaning of Subchapter L of the Code for the year under audit, it fails to meet the requirements
for the election under IRC 953(d) to be treated as a domestic corporation.

In addition, because the company does not meet the requirements to make the IRC 953(d)
election, and thus, is not a domestic corporation, the company should be treated as a
“controlled foreign corporation,” and the provisions of Subpart F of the Internal Revenue Code
(sections 951-965) should apply. However, the Company did not generate any passive

3 Taxpayer filed a new Form 1024 application with Rulings and Agreements in September 20XX.

Form 886-A (1-1994) Catalog Number 20810W Page 34 of 42 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

ORG 12/31/20XX
12/31/20XX

sources of income such as dividends, interest, royalties, rents or annuities, during the tax year
under audit.

The subpart F provisions apply to foreign corporations that qualify as controlled foreign
corporations (“CFCs”). IRC 957 defines a CFC as a foreign corporation with regard to which
more than [illegible]% of the total combined voting power of all classes of stock entitled to vote or the
total value of the stock is owned by U.S. shareholders. A U.S. shareholder, in turn, is defined
under IRC 951(d) as a U.S. person who owns [illegible]% or more of the total combined voting power
of all classes of stock entitled to vote of the foreign corporation. Therefore, a corporation with
regard to which more than [illegible]% of the vote or value is owned by U.S. persons who individually
own [illegible]% or more or the vote will qualify as a CFC under IRC 957.

IRC 953(a)(1) defines insurance income to mean income which is attributable to the issuing or
reinsuring of an insurance or annuity contract, and would be taxed under subchapter L if such
income were the income of a domestic insurance company. Therefore, any premium income
received by a CFC could qualify as insurance income for purposes of IRC 953 even though the
CFC fails to qualify as an insurance company under subchapter L.

IRC 953(a)(2) of the Code excepts “exempt insurance income (as defined in subsection (e)”
from the definition of insurance income. However, to qualify as exempt insurance income,
such income must be derived by a qualifying insurance company. A qualifying insurance
company is defined as a company that “is engaged in an insurance business and would be
subject to tax under subchapter L if it were a domestic corporation.

IRC 953(e)(3)(C) states that income derived from U.S. sources does not qualify for exemption.

If a CFC does not qualify as an insurance company under subchapter L.,,. it will not meet the
definition of a qualifying insurance company for purposes of IRC 953(e). Thus, none of its
insurance income will be exempt insurance income.

A Preliminary Report, Form 5701, Notice of Proposed Adjustments, was mailed to the
taxpayer's CPA, , on September 26, 20XX, proposing denial of tax-exempt
treatment under section 501(c)(15) of the Internal Revenue Code, for the tax years ending
December 31, 20XX, December 31, 20XX, and December 31, 20XX.

Finally, the Government contends that although the operations and financial records for the tax
years subsequent to 20XX were not examined by TEGE, the taxpayer would also fail to qualify
an insurance company for any future year, if taxpayer operated in the same manner as that
during the years audited.

Form 886-A (1-1994) Catalog Number 20810W Page 35 of 42 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

ORG 12/31/20XX
12/31/20XX

TAXPAYER’S POSITION:

A response to the Preliminary Report was received from CPA, CPA, on November 12, 20XX.
In the response, the CPA summarized that the taxpayer disagreed with the Service’s
conclusion that the contracts issued by ORG lack adequate risk distribution, and that ORG’s
primary and predominant business is insurance; ORG qualifies for IRC 501(c)(15) tax-exempt
status; and ORG is not a controlled foreign corporation.

The CPA argued the following points:

1. The Service's incorrect conclusion is based solely upon its unsupported position that
ORG'’s insurance operations lacked the requisite risk distribution. In reaching its
incorrect conclusion that ORG’s insurance operations lacked the requisite risk
distribution, the Service ignored more than thirty years of well-established tax law, as
well as hundreds of prior favorable rulings issued by the Service.

2. The taxpayer indicated that “in analyzing captive insurance arrangements for the
presence of risk distribution, courts have looked at the level of unrelated risk as a
metric for the presence of risk distribution.” The Service ignores the Tax Court
ruling in The Harper Group and Includible Subs. v Commissioner, 96 T.C. 45
(1991), aff'd 979 F.2d 1342 (9th Cir. 1992), where 30% unrelated risks was
determined to be sufficient to meet the risk distribution requirement.

3. The taxpayer stated that the Service conducted no meaningful examination of risk
distribution in its audit of ORG. Rather, the Service simply claims that the direct
written contracts lack the requisite risk distribution. The nature of insurance is the
number of underlying risk exposures present, not an artificial entity count or an
artificial count of the number of policies written. The Taxpayer cites AMERCO, Inc.
v. Commissioner, No. 91-70732, slip op. 13187 (9th Cir. Nov. 5, 1992).

4. The taxpayer argues that the 30% outside business principle and the decision in
Harper are recognized in the Service’s own Foreign Insurance Excise Tax Audit

Technique Guide.

5. The Service appears to ignore Revenue Ruling 2001-31, in which the Service
conceded that it would no longer assert the economic family theory due to its
rejection by the courts.

6. The taxpayer argues risk distribution can occur even with a single insured. The
taxpayer cited, Malone & Hyde v. Commissioner.

Form 886-A (1-1994) Catalog Number 20810W Page 36 of 42 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

ORG 12/31/20XX
12/31/20XX

7. Rather than engage in a meaningful analysis of the number of independent risk
exposures insured by ORG, the Service merely asserts that risk distribution is
lacking. The Service has recognized the principle of looking-through the insurance
policy to the actual risks insured in several revenue rulings. See Rev. Rul. 2009-26,
Rev. Rul. 92-93, and Rev. Rul. 80-95.

8. Taxpayer argues the Service’s current position is directly contrary to the position it
has taken in hundreds of prior Section 501(c)(15) tax-exempt determination letters
that it has issued. These favorable rulings were issued to taxpayer on substantially
similar, or less favorable, facts to those of ORG. There has been no intervening
change in law to account for the Service’s disparate tax treatment between ORG
and such similarly situated taxpayers. Accordingly, the Service has violated its own
procedures and mandate to provide a uniform application of existing tax law (Rev.

Proc. 2012-9).

9. Taxpayer argues that it qualifies for tax-exempt status as an insurance company
described in IRC 501(c)(15) during all of the years under review. Taxpayer made a
valid election under IRC Section 953(d) to be treated as a domestic corporation, and
the Service’s conclusion that the taxpayer is a controlled foreign corporation is
incorrect.

Government’s Response to Taxpayer’s Position:
After reviewing the response to the Preliminary Report received from: [illegible], CPA, on
November 12, 20XX, the Service's initial position is unchanged. ORG’s primary and
predominant business in tax years 20XX, 20XX, and 20XX, was not insurance because the
contracts issued by the company lacked the requisite risk distribution.

Taxpayer’s Position:

In the initial paragraph of the November 12, 20XX response to the agent's preliminary report,
the CPA stated that the audit conclusion reached by the Service was solely based on an
unsupported position that ORG’s insurance operations lacked the requisite risk distribution.

Government’s Response:

The conclusion reached by the Service was based on an examination of the direct written and
reinsurance contracts executed by ORG, and books and records for the 20XX, 20XX, and
20XX tax years. Based on the review of the contracts, the Service concluded that the primary
activity of ORG was to assume risks of affiliated businesses owned and controlled by officers
of ORG and beneficial owners of the affiliated businesses. Approximately 0% of the risk
assumed by ORG was that of the affiliated businesses. ORG did not assume risk of or receive:
premiums from non-affiliated businesses or unrelated general public under the terms of the
direct written contracts. The Service concluded that the direct written contracts lack the
requisite risk distribution because arrangement does not include an adequate pool of related or

Form 886-A (1-1994) Catalog Number 20810W Page 37 of 42 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

ORG 12/31/20XX
12/31/20XX

unrelated insured for the law the large numbers to operate. The pool consisted of a single
policyholder and payer of direct written premiums. Thus, ORG’s primary and predominant
activity is not insurance as described in Subchapter L of the Internal Revenue Code.

Taxpayer’s Position:

On page 2 of the Taxpayer's position, the CPA cites the Harper Group & Subsidiaries v.
Commissioner, 96 T.C. 45 (1991) to support the argument that ORG qualifies as an insurance
company. The CPA sites the court’s holding, when a significant percentage (29 percent) of an
insurance company’s income is received from a relatively large number of unrelated insureds,
the requirement of risk distribution is satisfied. The source of the remaining 71 percent is
irrelevant on the issue whether sufficient risk distribution is present because of the significant
presence of unrelated risks. The CPA made the following statement in paragraph 2 on page 2
of the November 12, 20XX response:

In its preliminary report, the Service merely states, that due to 0 percent of
premiums being direct written premiums paid by certain insureds that
owned no interest in ORG, there is a lack of adequate risk distribution.
This ignores the fact that more than 0 percent of premiums were
attributable to unrelated insurance arrangements involving many
thousands of independent, unrelated risks of hundreds or thousands of
unrelated insureds.

Government's Response:

The Service disagrees with the CPA’s assertion that the determining factor of whether the
requisite risk distribution is present is identifying the percentage of business with unrelated
insureds. Instead, the current Service’s position on captive insurance arrangements is
expressed in Revenue Ruling 2005-40, which emphasizes the number of policyholders and
percentage of business with the related or affiliated insureds as the determining factor of
whether risk distribution is present. The Rev. Rul. emphasizes that an arrangement where an
issuer received premiums from a single policyholder lacks the requisite risk distribution. The
ruling further emphasized that an issuer with contracts with a small number of policyholders
can be insurance if the percentage of business exceeds 50 percent of the total insurance
business conducted.

Even if the CPA claimed that insurance exists under the rationale in the Harper case, where
approximately 30% of the risk assumed by ORG - was from unrelated or unaffiliated
insured, the Service believes that this conclusion would be based on a misunderstanding of
the Harper Case. In the Harper Case, 67% to 71% of the total premiums received for the
years at issue were not related to a single policyholder. Rather, the 67% to 71% were the total
percentages received from all related policyholders, including brother-sister corporations (a
total of 13 entities). The court’s analysis in Harper Group must be read in its entirety and all

Form 886-A (1-1994) Catalog Number 20810W Page 38 of 42 publish.no.irs.gov Department of the Treasury-Internal Revenue Service

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

the facts and circumstances must be considered, i.e. that there are 13 entities making up the
nearly two thirds risk concentration in all the years at issue.

The Service's interpretation of the Harper Group is consistent with the conclusions reached by
the Service in Situation 2 of Revenue Ruling 2002-89 and Situation 4 of Revenue Ruling 2005-
40.

Taxpayer’s Position:

On page 3, paragraph 4, the CPA stated that in reaching its incorrect conclusion in the
preliminary report, the Service appears to ignore Revenue Ruling 2001-31, in which the
Service conceded that it would no longer assert the economic family theory due to its rejection
by the courts.

Government’s Response:

The current Service position is expressed in Ruling Revenue 2005-40, I.R.B. 2005-27 (June
17, 2005), which provides IRS issued guidance emphasizing that the requirement of risk
distribution must be met. The ruling demonstrated that this risk distribution requirement cannot
be satisfied if the issuer of the contract enters into such a contract with only one policyholder. If
the contract fails to constitute insurance, then the premiums paid are not deductible business
expenses under Code Sec. 162, and the issuing company is not an insurance company for
federal tax purposes. Rev. Rul. 2005-40 cited several court decisions that have recognized
that risk distribution necessarily entails a pooling of premiums, so that a potential insured is not
in significant part paying for its own risks. In this case, the large concentration of insurance
risks in one insured does not constitute risk distribution because of the very high likelihood of
the insured paying for any of its claims with its own premiums. Such an arrangement is not
insurance but a form of self-insurance.

However, when the arrangements between the companies do constitute insurance for federal
income tax purposes and assuming these arrangements represented more than 50 percent of
the insuring company's business, the company will be an insurance company within the
meaning of IRC Sections 816 and 831, and the premium payments may be deductible under
Code Sec. 162, assuming the requirements for deduction are otherwise satisfied

Taxpayer’s Position:

On page 4, paragraph 2, of the taxpayer's position, the CPA stated that the Service conducted
no meaningful examination of risk distribution in its audit of ORG. Rather, the Service simply
claims that the direct written contracts lack the requisite risk distribution. The nature of
insurance is the number of underlying risk exposures present, not an artificial entity count or an
artificial count of the number of policies written.

Form 886-A (1-1994) Catalog Number 20810W Page 39 of 42 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

ORG 12/31/20XX
12/31/20XX

Government's Response:

In Question 7, of IDR #2, issued to the CPA on April 28, 20XX, an analysis of risk assumed by
the taxpayer was presented by the examining agent to the CPA for comment. Under the terms
of the contracts reviewed during the audit, ORG assumed risk exposures as follows:

Affiliated Interests Direct exposure 0% 0%

Affiliate Interests Pooled reinsurance exposure 0 0

Unrelated & Affiliate Interests Pooled reinsurance exposure 0 0
Total risk assumed 0% 0%

In the July 28, 20XX response to IDR #2, CPA, CPA, provided the following comments:*

The percentages listed in your question are incorrect. The percentages
set forth in IDR #2 were apparently derived from simply adding together
the company’s participation rates in various direct insurance and °
reinsurance contracts. This method does not take into account relative
value of the different contracts and is, therefore, invalid. The proper
method for determining the amount of risk being assumed by the company
is to compare the premiums received on the various contracts.. The
Income Statement included under Tab 17 of the initial IDR response
shows the following:

20XX
Direct Written Premiums $ O 0%
Other Reinsurance Assumed 0 0%
Pooled Reinsurance Assumed 0 0%
Total $ 0 0%
20XX
Direct Written Premiums $ O 0%
Other Reinsurance Assumed 0 0%
Pooled Reinsurance Assumed 0 0
Total $ O 0%
20XX
Direct Written Premiums $ O 0%
Other Reinsurance Assumed 0 0%
Pooled Reinsurance Assumed 0 0

4 Only the premiums analysis was included in the RAR prepared by the examining agent.

Form 886-A (1-1994) Catalog Number 20810W Page 40 of 42 publish.no.irs.gov Department of the Treasury-Internal Revenue Service


Form 886-A
(Rev. January 1994)

EXPLANATIONS OF ITEMS

Schedule number or exhibit

Name of taxpayer

ORG

Tax Identification Number

Year/Period ended
12/31/20XX
12/31/20XX
12/31/20XX

Total

0%

Based on the CPA’s own statement, the proper way to determine the percentage of risk

assumed by the taxpayer is to compare the premium income received under the

Taxpayer’s Position:

Government’s Response:

the past.

made by the Service.

Taxpayer's Position:

Government’s Response:

contracts issued. Using this method, the Service concluded that the taxpayer’s the primary
and predominant activity conducted is assuming risk under the direct written contracts with the
affiliated business interests, because the activity accounted for more than 50 percent of the
business (and premiums) during the three years under audit.

On page 4, paragraph 3, the CPA stated that the Service's position is directly contrary to the
position it has taken in hundreds of prior Section 501(c)(15) tax-exempt determination letters
that it has issued. These favorable determination letters were issued to taxpayers substantially
similar, or less favorable, facts to those of ORG. There has been no intervening change in law
to account for the Service's disparate tax treatment between ORG and such similarly situated
taxpayers. Accordingly, the Service has violated its own procedures and mandate to provide a
uniform application of existing tax law. See Rev. Rul. 2012-9, Section 9.

The Service’s current position on captive arrangements is expressed in Revenue Ruling 2005-
40, I.R.B. 2005-27 (June 17, 2005). Although the service has issued favorable rulings to
similar captive arrangements in the past, many of the rulings were issued prior to the

publishing of Revenue Ruling 2005-40, and subsequent clarification of the revenue ruling
received from the Office of Chief Counsel.

In addition, the Service is not precluded from proposing denial of IRC 501(c)(15) tax-exempt
status to ORG simply because the Service issued favorable ruling letters to other applicants in

Furthermore, the Service was not provided adequate opportunity to rule on the taxpayer's
Form 1024 application filed with Rulings & Agreements in September 20XX, because the
taxpayer withdrew the application, in September 20XX, before a final determination could be

On page 5, paragraph 2, the CPA stated that ORG qualified for tax-exempt status as an
insurance company described in IRC Section 501(c)(15) during all of the years under review.
As ORG made a valid election under IRC Section 953(d) to be treated as a domestic
corporation, the Service’s conclusion that ORG is a controlled foreign corporation is incorrect.

Service

Form 886-A (1-1994) Catalog Number 20810W Page 41 of 42 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

ORG 12/31/20XX
12/31/20XX

According to the Form 1024, Application for Recognition of Tax-Exempt Status, administrative
file, the taxpayer filed its IRC 953(d) election with the Plantation, State office of the Service on
February 23, 20XX.

IRS records reveal that the IRC 953(d) election was never approved by the Service because
the taxpayer did not submit proof of IRC 501(c)(15) tax-exempt status. The taxpayer could not
provide proof of IRC 501(c)(15) tax-exempt status because it did not complete the Form 1024
application process. The taxpayer withdrew its Form 1024 application on September 16,
20XX, after its Counsel anticipated that the Service would issue a final adverse ruling letter
denying IRC 501(c)(15) exemption.

IRC 953(d) allows foreign insurance company to elect to be treated as a domestic company for
tax purposes if it meets certain requirements. One such requirement is that the foreign
company must be a company that would qualify as an insurance company, under part I or II of
subchapter L, for the taxable year if it were a domestic corporation. See IRC 953(d)(1)(B).

Since the Service determined that the taxpayer is not an insurance company within the
meaning of Subchapter L of the Code for the year under audit, it fails to meet the requirements
for the election under IRC 953(d) to be treated as a domestic corporation.

In addition, because the taxpayer does not meet the requirements to make the IRC 953(d)
election, and thus, is not a domestic corporation, the taxpayer should be treated as a
“controlled foreign corporation,” and the provisions of Subpart F of the Internal Revenue Code

(sections 951-965) should apply.

CONCLUSION:

Because taxpayer did not qualify as an insurance company for federal income tax purposes,
taxpayer failed to meet the requirements of section 501(c)(15) of the Code. Thus, taxpayer did
not qualify for recognition of exemption under section 501(a) of the Code as an organization
described in section 501(c)(15) of the Internal Revenue Code for the 20XX, 20XX, and 20XX

tax years.

Since the IRC 953(d) election filed by taxpayer was not been approved by the IRS, the
taxpayer should be treated as a controlled foreign corporation, and the subpart F provisions

should apply.

Form 886-A (1-1994) Catalog Number 20810W Page 42 of 42 publish.no.irs.gov Department of the Treasury-Internal Revenue Service