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

View official IRS release (PDF)

Plain-English summary

A foreign captive insurer sought recognition as tax exempt under section 501(c)(15). The IRS concluded that its primary and predominant activity was not insurance because most contracts covered business or investment risks and the arrangements lacked adequate risk distribution and economic substance. The organization therefore was not an insurance company within subchapter L and did not qualify for the exemption. The examination report also concluded that its section 953(d) election to be treated as a domestic corporation was ineffective, so it should be treated as a controlled foreign corporation subject to Subpart F.

Ruling snapshot

• Question: Did the captive insurer qualify for exemption under section 501(c)(15), and was its section 953(d) domestic-corporation election effective?
• Outcome: denied
• Key authorities: IRC §§ 501(a), 501(c)(15), 816, 831, 953(d), 7428; Rev. Rul. 2002-89; Rev. Rul. 2005-40

Full text (IRS public release)

Internal Revenue Service
Department of the Treasury
Appeals Office

Employer Identification Number:

Number: 201652030
Release Date: 12/23/2016
Person to Contact:
Employee ID Number:

Date: September 26, 2016
Tel:
Fax:
ORG Tax Period(s) Ended:
ADDRESS
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):

You are not an insurance company within the meaning of subchapter L of the Internal Revenue Code
because your primary and predominant activity is not insurance. The purported insurance and/or
reinsurance transactions lack economic substance.

Organizations that are not exempt under section 501 generally are required to file federal income tax
returns and pay tax, where applicable. For further instructions, forms, and information please visit
www.irs.gov.

If you decide to contest this determination, you may file an action for declaratory judgment under the
provisions of section 7428 of the Code in one of the following three venues: 1) United States Tax Court,
2) the United States Court of Federal Claims, or 3) the United States District Court for the District of
Columbia. A petition or complaint in one of these three courts must be filed within 90 days from the date
this determination letter was mailed to you. Please contact the clerk of the appropriate court for rules and
the appropriate forms for filing petitions for declaratory judgment by referring to the enclosed Publication

892. You may write to the courts at the following addresses:

United States Tax Court
400 Second Street, N.W.
Washington, D.C. 20217

U.S. Court of Federal Claims
717 Madison Place, N.W.
Washington, D.C. 20439

U.S. District Court for the District of Columbia
333 Constitution Ave., N.W.
Washington, D.C. 20001

Processing of income tax returns and assessments of any taxes due will not be delayed if you file a
petition for declaratory judgment under section 7428 of the Internal Revenue Code.

You may also be eligible for help from the Taxpayer Advocate Service (TAS). TAS is an independent
organization within the IRS that can help protect your taxpayer rights. TAS can offer you help if your tax
problem is causing a hardship, or you've tried but haven't been able to resolve your problem with the IRS.
If you qualify for TAS assistance, which is always free, TAS will do everything possible to help you. Visit
www.taxpayeradvocate.irs.gov or call 1-877-777-4778.

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 892

cc:

DEPARTMENT OF THE TREASURY
INTERNAL REVENUE SERVICE
450 Golden Gate Avenue, Stop 7501
San Francisco, CA 94102

TAX EXEMPT AND
GOVERNMENT ENTITIES
DIVISION

Date: July 11, 2013
Taxpayer Identification Number:
Form:
Tax Period(s) Ended:

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 revised 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. This report supersedes our
report dated January 14, 2013. 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

2

(IRS) decision. Publication 3498 also includes information on your rights as
a taxpayer and the IRS collection process.

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.

Thank you for your cooperation.

Sincerely,

Director, EO Examinations

Enclosures:
Publication 892
Publication 3498
Form 6018-A

Report of Examination
Envelope

Form 886-A Schedule number or exhibit
(Rev. January 1994) EXPLANATIONS OF ITEMS
Name of taxpayer Tax identification Number Year/Period ended
12/31/20
12/31/20
12/24/20
ISSUE:

1. Whether the contracts executed by constitute contracts of
   insurance?
2. Whether the arrangement entered into by involves the
   requisite element of risk distribution? ;
3. Whether more than half of the business of 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 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 treatment as an IRC 501(c)(15) tax exempt entity precluded if the organization does not
   have approval of its IRC 953(d) election?

FACTS:

___ ("Taxpayer") was formed and incorporated in _
on December 31, 20 _, 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 taxpayer. The taxpayer is

authorized to issue common shares with a $ par value. The taxpayer actually
issued shares in consideration of $ capital contribution. Each shareholder made
an initial capital contribution of ¢ for common shares.
The taxpayer is co-equally owned by the a
, and by _a US. citizen and resident of the State of
Each shareholder owns a percent interest in the taxpayer. The
is owned by the following entities:
, general partner %
, general partner
, limited partner
, limited partner
, limited partner __
Total 100.00%
of , is a co-trustee of the , general partner;

the and the , limited partner. The trustee of the
is son of ;

Form 886-A (1-1994) Catalog Number 20810W Page 1 of 39 publish. no.irs.gov Department of the Treasury-Internal Revenue Service

Form 886-A Schedule number or exhibit

Form oe

(Rev. January 1994) EXPLANATIONS OF ITEMS

Name of taxpayer Tax identification Number Year/Period ended
12/31/20
12/31/20
12/24/20

The TEGE examining agent obtained a copy of taxpayer's Form 1024 application
administrative file from the Exempt Organizations Records Unit in on February 18,
20 . The administrative file included a copy of the Form 1024 application, Articles of
Incorporation; the IRC 953(d) election; regulatory filings and responses of Insurance
Regulators; insurance underwriting diagrams; organizational owner chart; supplemental
information for the Form 1024; financial information for 20 and subsequent years: forms of
credit reinsurance agreements entered into by the taxpayer; and a copy of the 20 insurance
policies issued by the taxpayer. Other documents were received from , CPA, in
response to Information Document Requests issued by the examining agent to the CPA during
the audit.

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
directors, . , and . represents the
shareholder, . He also serves as Chief

Executive Officer (CEO), President, Treasurer, and Assistant Secretary of
: serves as Vice President, Secretary, and Assistant

Treasurer of the taxpayer.

and are also owners of ; '
and various other business interests collectively referred to as “Affiliated Business Interests.”
According to the taxpayer'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. 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,
President, signed an IRC 953(d) election statement on February 23, 20. It appears that the
election statement was filed with the IRS office on the same day.

On September 18, 20 , the taxpayer 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 revealed that 20' was the
initial tax year of the taxpayer. Prior to filing the Form 1024 application, the taxpayer had filed
Form 990 for the tax year ended December 31,20 , with the Ogden Service Center.

Form 886-A (1-1994) Catalog Number 20810W Page 2 of 39 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
12/31/20
12/31/20
12/24/20

, President, signed the application on September 1,20 . A Form 2848, Power
of Attorney, accompanied the application authorizing , Attorney, and
_ Attorney, to represent the taxpayer during the application process. The attorneys
worked for a law firm in ;

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

The Form 1024 application was referred to Rulings and Agreements in Washington, D.C., on
October 14,20 , for consideration and ruling. The application was assigned to a Tax Law
Specialist on November 13, 20. No action was taken on the application until July 20. On
July 10,20 , the Tax Law Specialist mailed a letter to the taxpayer's registered agent in

, and requested additional information about the operations. The
taxpayer's response to the letter was due by August 21,20. , Attorney,
submitted a letter dated August 19,20 requesting an extension of time to respond until
September 21, 20

Instead of responding to the additional information request of the Tax Law Specialist, the
taxpayer's . _ , submitted a letter on September 16,20 , and
requested that the Form 1024 application be withdrawn from further consideration and ruling.
On September 22, 20 _, the Tax Law Specialist closed the application file and issued a letter
informing the taxpayer 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 22,20 , the TE/GE examining agent requested the effective date of
the IRC 953(d) election from the IRS office. On February 28, 20, the IRS
office informed the examining agent that the Service does 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 a single day.
The tax year began and ended on December 31,20 . The taxpayer also filed Form 990-EZ
for the 20 calendar year, which was its first full year of operation.

The taxpayer operated primarily to provide property and casualty “insurance” coverage to

(‘ ") and (“ ”), which are
owned and controlled by and , Officers and beneficial
owners of . The Financial Services Commission, , issued

a Class ‘B: General Insurance License to the taxpayer effective December 31, 20

Form 886-A (1-1994) Catalog Number 20810W Page 3 of 39 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

12/31/20
12/31/20
12/24/20 . -

In 20 _, the taxpayer wrote ten direct-written “insurance” contracts to and titled: (1)

Special Risk — Commercial General Liability GAP Insurance Policy; (2) Excess Directors &
Officers Liability Insurance Policy; (3) Event Cancellation Insurance Policy; (4) Special Risk —
Expense Reimbursement Insurance Policy; (5) Excess Intellectual Property Package Policy;
(6) Special Risk — Loss of Major Business to Business Relationship Insurance Policy, (7)
Special Risk — Loss of Services Insurance Policy; (8) Special Risk — Punitive Wrap Liability
Insurance Policy; (9) Special Risk — Regulatory Changes Insurance Policy; and (10) Special
Risk — Tax Liability Insurance Policy. Each policy listed and as joint insured. The
taxpayer did not issue separate policies to and . Also, under the terms of each
policy, the annual premium was treated as a combined premium that covered both insured,
and . Each of the above-named policies is described in detail below.

Special Risk - Commercial General Liability GAP Insurance Policy provides
reimbursement for claims which are denied by Employers Fire Insurance Company, under
General Liability Policy Number , effective August 31,20 , through August 31,
20 _, which includes “exclusion/endorsement buy back" or “differences in conditions’
coverage from an underlying commercial property, commercial general liability or other
commercial insurance policy.

Excess Directors & Officer Liability Insurance Policy provides indemnification subject to
certain limitations to and 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 and . 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 and officers and directors.

Event Cancellation Insurance Policy provides indemnification to and for all losses
resulting from the necessary cancellation, postponement, curtailment, or abandonment of any
contracted scheduled events promoted by and , due to adverse weather, the
discovery of pollutants, outbreak of disease, labor disputes, civil unrest, property damage to
venues, non-appearance of artists, and government or civil authority requiring cancellation of
such events.

The Special Risk — Expense Reimbursement Insurance Policy covers public relations
expenses to mitigate adverse publicity to and under certain circumstances,
including: actual or imminent incidents where the insureds potential liability amount is in
excess of $ : 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 %. The policy also covers all expenses for
and defenses to actual or alleged civil liability.

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

Page 4 of 39 publish. no.irs.gov Department of the Treasury-Internal Revenue Service

886 Schedule number or exhibit

Form A

(Rev. January 1994) EXPLANATIONS OF ITEMS

Name of taxpayer Tax Identification Number Year/Period ended
12/31/20
12/24/20

Excess Intellectual Property Package Policy provides indemnification subject to certain
limitations to and 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 — Loss of Major Business to Business Relationship Insurance Policy
provides for the indemnification of and for any business interruption loss of up to 12
months suffered as a result of losing the services of ° and any other

licensees. Business interruption includes the impact of lost revenue and the extra
expenses involved in finding a replacement business to business relationship.

Special Risk — Loss of Services Insurance Policy provides for the indemnification of

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

Special Risk — Punitive Wrap Liability Insurance Policy provides that the taxpayer will pay
claims filed by and _ resulting from the failure of an insurer to cover punitive or
exemplary damages, judgments, or awards, related to the other 9 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.

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 and . 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 and

Special Risk — Tax Liability Insurance Policy provides and with indemnification up
to % of the amount of additional tax liability each may incur on its 20 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.

In each contract, the taxpayer was listed as the “Lead Insurer’ ( %) and

( ) is listed as the “Stop Loss Insurer.” With respect to the above direct written
contracts, the taxpayer did not sale, write or issue separate policies to and . Each
contract listed both parties, and , as the insured. The contracts also listed a single

Form 886-A (1-1994) Catalog Number 20810W Page 5 of 39 publish. no.irs.gov Department of the Treasury-Internal Revenue Service

886-A Schedule number or exhibit

Fe =

(Rev. January 1994) EXPLANATIONS OF ITEMS

Name of taxpayer Tax Identification Number Year/Period ended

12/31/20
12/31/20
12/24/20

premium payment due to cover both parties. and did not pay separate premiums to

the taxpayer in 20 and 20 . The taxpayer did not write direct contracts to unrelated third
parties or the general public during 20. With respect of each of the 10 above referenced
property and casualty contracts, the taxpayer and (“ *) entered
into an agreement titled, “Joint Underwriting Stop Loss Endorsement.” The taxpayer and
are separate independent companies and are not owned and controlled by related

parties. Nor is 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. {f the specified thresholds are met, then becomes liable for
payment of claims up to certain specified limits. If the specified limits for payment of
claims are exceeded, then the taxpayer again becomes liable. Under each of the 10 direct-
written contracts, the taxpayer received % of the total premiums, and received

% 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

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

Therefore, under the terms of the Joint Underwriting Stop Loss Endorsement agreement,

and was required to pay of total premiums of $ for the ten direct written
policies and for the stop loss endorsement. Of the total premiums, and paid ;
$ directly to the taxpayer ( %) as Lead Insurer. In addition, and paid
$ as a reinsurance premium directly to , as the Stop Loss
Insurer.

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

terms of the 20 _— contracts was as follows:
Portion of Premium

Contracts Total Premium To Taxpayer

1. Special Risk-Tax Liability $ $
2. Special Risk-Punitive Wrap
3. Special Risk-Regulatory Changes
4. Excess Directors & Officers
5. Special Risk Expense Reimbursement
6. Special Risk Loss of Services
7. Excess Intellectual Property Package
8. Special Risk-Commercial General Liab.
9. Event Cancellation
10. Loss of Major Business to Business ce ————_—
    Totals $ $

Form 886-A (1-1994) Catalog Number 20810W Page 6 of 39 publish. no.irs.gov Department of the Treasury-Internal Revenue Service

Form 886-A Schedule number or exhibit

Form

(Rev. January 1994) EXPLANATIONS OF ITEMS

Name of taxpayer Tax Identification Number Year/Period ended
12/31/20
12/31/20
12/24/20

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 . 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.
insured a portion of the direct insurance underwritten by the pool participants using a so-called
“stop loss” endorsement. participated in over insurance policies with more than
insureds. 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 20 Quota Share Reinsurance Policy executed with , the
taxpayer was one of _ companies listed as reinsurer. As Reinsurer _, the taxpayer
retained % of a Quota Share Premiums from _ In exchange
for the assumption of % of the risk pool comprised of the stop loss coverages issued
during the policy period by ‘to all stop loss endorsement
policyholders. paid total reinsurance premiums of $
to Reinsurers. Of this total premium, the taxpayer received a quota share reinsurance
premium equal to % or $ , of which $ 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 % of the quota share reinsurance policy premium of
$ . According to the general ledger, the taxpayer reported receiving a reinsurance
premium of $ from in 20

Under the terms of the second arrangement, which is referred to as the
, the taxpayer assumed reinsurance contracts from

. The taxpayer reinsured a % quota share of the risks from vehicle service
contracts reinsured by . The vehicle service contracts were
initially written by in 2C , assumed by , then by

from. - and finally assumed by
. __, The taxpayer received a pro rata share
( %) of the earned premiums received by . The taxpayer was paid a reinsurance
premium of $ from in 20

Under the terms of the contracts reviewed for 20 _, the taxpayer assumed risk exposures as

follows:

Affiliated Interests Direct exposure %

Unrelated & Affiliate Interests Pooled reinsurance exposure

Unrelated Third Party Pooled reinsurance exposure _—
Total risk assumed 100.00%

Form 886-A (1-1994) Catalog Number 20810W Page 7 of 39 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 side
12/31/20
12/24/20

For the tax year ended December 31,20 _, the taxpayer reported gross receipts of $ .
Gross receipts were derived solely from premiums received from the direct written, reinsurance
risk pooling program, and the credit coinsurance reinsurance program. The taxpayer received
gross receipts as follows;

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

400.00%

; 400.00%

The December 31,20 bank statement for its checking account with

reflected three deposits totaling $ . The statement reflected a deposit of

$ on December 26, 20 _, which represented the payment of insurance premiums
received from for the ten direct written insurance policies. and did not pay
separate premiums to the taxpayer for the direct written contracts. The premium payment
received from represented the payment of the combined premium for both insured,

and , The other two deposits of $: each was made on December 24, 20, and
represented the Initial contributions of capital by the two shareholders of the taxpayer

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

generated from the ten direct written policies with the Affiliated Business Interests,
and ; % of the premiums are from the

; and % of the premiums from the

As of December 31, 20 _, the taxpayer's assets totaled $ , and consisted primarily of
cash in its checking account of $

20 Tax Year
The 20 tax year was the first full year of operations for the taxpayer. During the year, the

taxpayer continued to operate as a captive company that insured certain property and casualty
risks of affiliated business interests. The taxpayer participated in the same three programs

Form 886-A (1-1994) Catalog Number 20810W Page 8 of 39 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
12/31/20
12/24/20

that it engaged in during the 20 __ tax year: (1) direct written contracts with affiliated business
interests; (2) quota share risk pool reinsurance; (3) credit coinsurance reinsurance.

The taxpayer wrote six direct contracts to insure certain property and casualty risks of
, and _ The insureds are owned and

controlled by the beneficial owners of the taxpayer, and

The following direct written contracts were executed by the taxpayer with and in
20 :

Event Cancellation Insurance Policy provides indemnification to and for all losses
resulting from the necessary cancellation, postponement, curtailment, or abandonment of any
contracted scheduled events promoted by and , due to adverse weather, the
discovery of pollutants, outbreak of disease, labor disputes, civil unrest, property damage to
venues, non-appearance of artists, and government or civil authority requiring cancellation of
such events.

Special Risk — Expense Reimbursement Insurance Policy covers public relations expenses
to mitigate adverse publicity to and under certain circumstances, including: actual or
imminent incidents where the insureds potential liability amount is in excess of $ i
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 %. The policy also covers all expenses for and defenses fo actual
or alleged civil liability.

Excess Intellectual Property Package Policy provides indemnification subject to certain
limitations to and 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 — Legal Expenses Insurance Policy covers
certain litigation expenses in excess of $ to mitigate costs to and , such as
defense expenses; lost work time; cost to hire independent counsel; and expert witness fees
and travel expenses.

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

Form 886-A (1-1994) Catalog Number 20810W Page 9 of 39 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
12/31/20
12/31/20
12/24/20

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

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 and . 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 and

In each contract, the taxpayer was listed as the “Lead Insurer” and is
listed as the “Stop Loss Insurer.” As Lead Insurer, the taxpayer assumed % of the risks
under the direct written contracts. and the taxpayer executed a Joint Underwriting
Stop Loss Endorsement, in which , as the Stop Loss Insurer, assumed the remaining

% of the risks for four of the six direct written contracts: Event Cancellation, Excess
Intellectual Property Package, Special Risk Loss of Services, and the Special Risks Regulatory
Changes. The effective date of each contract is January 1,20 _, through January 1, 20

Under the terms of each direct written contract, and

, the affiliated business interests, are listed as the only insured parties. The .
taxpayer did not write or issue separate contracts to and
The taxpayer received a direct written premium of$ = — from on December 30. 20

The premium payment was deposited to the taxpayer's investment account with
. The single premium payment covered both insured parties,

and . Information Document Request #2 was issued to , CPA, on
April 25,20 . The CPA was asked to provide a breakdown of the direct written premiums
paid by and . The CPA was also asked to provide a copy of any contract or
agreement between and that addressed the allocation of the direct written premium
attributable to and >. In the August 20,20 response, _ CPA, stated that the
company’s records did not include information that shows the direct written premiums
attributable to two insured entities, and

With respect to each of the six property and casualty contracts written in 20 _, the taxpayer
and (" *) entered into an agreement titled, “Joint Underwriting
Stop Loss Endorsement.” 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

becomes liable for payment of claims up to certain specified limits. If the specified
limits for payment of claims are exceeded, then the taxpayer again becomes liable.
Under each of the 6 direct-written contracts, the taxpayer received % of the total direct
written premiums, and received % of the total direct written premiums.

Form 886-A (1-1994) Catalog Number 20810W Page 10 of 39 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 ve a0
42/31/20
12/24/20

Although page 5, paragraph 4 of the agreement reads as follows:

The premium rate for this Joint Underwriting Stop Loss Endorsement fs

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

Therefore, under the terms of the Joint Underwriting Stop Loss Endorsement agreement,
and was required to pay of total premiums of $ _ _ for the six direct written policies
and for the stop loss endorsement. Of the total premiums, and paid $ _
directly to the taxpayer ( %) as Lead Insurer. In addition, and paid $

as a reinsurance premium directly to , as the Stop Loss Insurer.

Based on the review of the contracts, the premiums paid by the Named insureds under the
terms of the 20 _ contracts was as follows:

Portion of Premium
Contracts Total Premium Due To Taxpayer

1. Special Risk-Regulatory Changes $ $
2. Special Risk-Loss of Services
3. Event Cancellation
4. Excess intellectual Property Package
5. Expense Reimbursement
6. Expense Reimbursement Legal Expense
   Totals $

In addition to writing the direct contracts, the taxpayer continued to participate in the quota
share risk pooling reinsurance agreement with . The risk pool was operated by an
unaffiliated corporation, (“ "), which is a regulated insurer.
Each pool participant had one or more affiliated operating entities for which it underwrites
casualty type insurance coverage, such that for calendar 2C writes a Stop Loss
endorsement on 500+ insurance policies covering more than 300+ insureds. This includes
policies issued by the taxpayer as well as those issued by the other pool participants that are
unrelated insurance companies. As with the typical risk pooling arrangement, blended
together its assumed risk coverages and then reinsured a quota share of these pooled risk
with each of the pool participants. The end result of the pooling process was a more
diversified book of risk coverages held by the taxpayer and by each of the other pool
participants. According to the terms of the 20 Quota Share Reinsurance Policy executed
with , the taxpayer was one of companies listed as reinsurer. As
Reinsurer # the taxpayer retained % of a Quota Share Premiums from

Form 886-A (1-1994) Catalog Number 20810W Page 11 of 39 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
12/31/20

12/31/20

12/24/20

in exchange for the assumption of % of the risk pool comprised of the
Stop loss coverages issued during the policy period by to all stop
loss endorsement policyholders. _ paid total reinsurance premiums of
$ to —_Reinsurers. Of this total premium, the taxpayer received a quota share
reinsurance premium equal to %or$ , of which $ _ is the portion of the
premium retained by taxpayer (as a quota share retained premium) until the final accounting
and settlement of the 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 % of the quota share reinsurance policy
premium of $ . According to the general ledger, the taxpayer reported receiving a
reinsurance premium of $. from in 20

Finally, the taxpayer continued to participate in the credit coinsurance reinsurance program
with in 20: . The program involved the assumption of risks (that is, reinsurance
assumed) from a third-party insurance company, which itself assumed such risks from other
third party insurers, and which ultimately relates to a large pool of policies for vehicle service
contracts that were directly written by a U.S. based insurance company, which served as the
original ceding company. Under the terms of the contract, the taxpayer

reinsured a % quota share of the risks from vehicle service contracts reinsured by
. The vehicle service contracts were initially written by
in 20 , assumed by , and finally assumed by
from . The taxpayer was paid a reinsurance premium
of $ from . Policies reinsured under the pooling arrangement
ceded on a quota share basis provided reinsurance for property and casualty policies for

or more unrelated insureds.

Under the terms of the contracts reviewed for 20 __, the taxpayer assumed risk exposures as

follows:
Direct Written Premiums $ %
Quota Share Reinsurance Assumed
Other Reinsurance Assumed
Total $ 100.00%
The premium received by _ for the six direct written contracts, accounted for approximately

% of the total premiums received and risk assumed by the taxpayer in 20 . The Taxpayer
did not write direct contracts with unrelated third parties or the general public during
. For the tax year ended December 31,20 __ the taxpayer reported gross receipts of $
Gross receipts were derived solely from premiums received from the direct written, reinsurance
risk pooling program, and the credit coinsurance reinsurance program. The taxpayer received
gross receipts as follows:

Form 886-A (1-1994) Catalog Number 20810W Page 12 of 39 publish. no.irs.gov Department of the Treasury-Internal Revenue Service

886-A Schedule number or exhibit
Rev January 1804) EXPLANATIONS OF ITEMS
Name of taxpayer Tax identification Number Year/Period ended
12/31/2C
42/34/20
12/24/2C
20
Program Revenue Service
Direct Written Premiums $
Quota Share Reinsurance Premiums
Credit Coinsurance Reinsurance Premiums
Total Premiums %
Investment Income
Gain of sale of assets
Other income =
Gross Receipts $. 100.00%
The 20 bank statements for its checking account with reflected total
deposits of $ for the year. The statements did not reflect deposit of direct written
premium payments received by the taxpayer in 20 . During 20 , the taxpayer also opened
an investment account with ‘, The taxpayer deposited
$ into the investment account, including a $ wire transfer from the
account to the investment account.
The other two deposits of $: each was made on December 24, 20, and represented
the initial contributions of capital by the two shareholders of the taxpayer
Of the total premiums received by the taxpayer in 20, % of the premiums were
generated for the six direct written policies with the Affiliated Business Interests,
and ; % of the premiums are from the
; and % of the premiums from the
20 =Tax Year

The taxpayer filed Form 990-EZ for the short tax year ended December 24, 20. In the
heading of the return, Item, the taxpayer reported that it terminated the corporation. The
Certificate of Dissolution, approved by the Registrar of Companies, _

indies, on December 24, 20 _, was attached to the Form 990-EZ. Books and records for the
tax year ended December 31,20 were not requested from the taxpayer.

The taxpayer did engage in similar activities in 20 as those conducted in 20 and 20 ,
until the December 24, 20 _, date of termination. In response to the preliminary report, Form
5701, Notice of Proposed Adjustments, issued on September 6, 20, , CPA,
indicated that prior to the date of termination, there was no substantial change in the activities
of the taxpayer. On the 20 Form 990-EZ return, the taxpayer reported gross receipts and
total income of $ , of which $ was derived from premiums. Interest income of
¢ was the only other source of income reported on the return. Of the total premiums

Form 886-A (1-1994) Catalog Number 20810W Page 13 of 39 publish. no.irs.gov Department of the Treasury-Internal Revenue Service

886-A Schedule number or exhibit
Form
Name of taxpayer Tax identification Number Year/Period ended

12/31/20:
42/31/20:
12/24/20 _

received in 20 ,$ was received from direct written contracts and$ = was

received from reinsurance contracts. The direct written premiums represented approximately

% of the total premiums received and risk assumed by during
the year.

As part of the termination and dissolution, the taxpayer equally distributed net assets totaling
$ , on December 23, 20 __, to the following two shareholders:

(Partnership) $:

(Individual) $

As of December 31,20 , and December 31, 20'_, the taxpayer's assets totaled $'
and $ , respectively, and consisted primarily of cash in the taxpayer's
checking account and investment account. As of

December 24, 20 _, the taxpayer had no assets remaining because of the termination and
distribution of the net assets to the shareholders.

With respect to the direct contracts insured in 2C , 20' and 20_, the taxpayer did not sale,
write or issue separate policies to and . Each contract listed both parties, and

, as the insured. The contracts also listed a single combined premium payment due to
cover both parties. and did not pay separate premiums to the taxpayer in 2C and
201 . Nor did and 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.

There is no evidence that the taxpayer engaged in any other activities or programs during the
tax years ended December 31,20 , and December 31, 20
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:

Form 886-A (1-1994) Catalog Number 20810W Page 14 of 39 publish. no.irs.gov Department of the Treasury-Internal Revenue Service

Form 886-A Schedule number or exhibit
(Rev. January 1994) EXPLANATIONS OF ITEMS
Name of taxpayer Tax Identification Number Year/Period ended
12/31/20
12/31/20:
12/24/20

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. In the 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 of 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.

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 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.

Form 886-A (1-1994) Catalog Number 20810W Page 15 of 39 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
12/31/20
12/24/20

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.

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

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

Page 16 of 39 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
12/31/20
12/31/20
42/24/20

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. —

(1) IN GENERAL. —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 ,

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

Page 17 of 39 publish. no.irs.gov Department of the Treasury-Internal Revenue Service

886-A Schedule number or exhibit

Form =,

Name of taxpayer Tax Identification Number Year/Period ended
12/31/20:
12/31/20:
12/24/20.

(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, 20 , seeking retroactive
exemption under IRC 501(c)(15), back to December 31, 20 _, the date of incorporation. The

application was ultimately withdrawn by , President, on September 16,
20 . The examining agent believes that the application was withdrawn bv the company on
the advice on its counsel, ; , and :
who are affiliated with _in . The examining agent

believes the taxpayer was advised by its counsel to withdraw the Form 1024 application
because counsel anticipated EO Rulings and Agreements would deny IRC 501(c)(15) tax-
exempt status to , based on the position taken by Rulings and

Agreements on applications filed by other clients of

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.

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

Page 18 of 39 publish. no.irs.gov Department of the Treasury-Internal Revenue Service

Form 886-A Schedule number or exhibit

Form

(Rev. January 1994) EXPLANATIONS OF ITEMS

Name of taxpayer Tax Identification Number Year/Period ended
12/31
12/31/20
12/24/20

The examining agent believes that the withdrawals of the remaining applications, including the
application filed by 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
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,

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

Page 19 of 39 publish. no.irs.gov Department of the Treasury-Internal Revenue Service

Form 886-A Schedule number or exhibit
Form
(Rev. January 1994) EXPLANATIONS OF ITEMS
Name of taxpayer Tax identification Number Year/Period ended
12/31/20
12/31/20
12/24/20

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
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

" A happening that, because it occurs only by chance or accident, the parties could not reasonably have foreseen. Black's
Law Dictionary, 725 (9th 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.) ("[l]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 20 of 39 publish. no.irs.gov Department of the Treasury-Internal Revenue Service

Form Bd

Name of taxpayer Tax Identification Number Year/Period ended
42/31/20:
12/31/20:
12/24/20

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.

20'__ Policies

1. Special Risk—Tax Liability Insurance Policy

Covers any additional tax liability up to $ subject to a deductible equal to —_% 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.

2. Special Risk—Punitive Wrap Liability Insurance Policy

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.

3. 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.

Form 886-A (1-1994) Catalog Number 20810W Page 21 of 39 publish. no.irs.gov Department of the Treasury-Internal Revenue Service

Schedule number or exhibit
Form 886-A
Name of taxpayer Tax Identification Number Year/Period ended
12/31/20
12/24/20

Not insurance.

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

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

Insurance.

5. 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
or imminent; liability incident that could exceed $ ; 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 %.

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.

We could not conclude that Coverage Form B is insurance in the commonly accepted sense.
It is vague as to what liability/contract underlies the need for defense expenses.

6. Special Risk—Loss of Services Insurance Policy

Covers the involuntary loss of service for 2 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.

Form 886-A (1-1994) Catalog Number 20810W Page 22 of 39 publish. no.irs.gov Department of the Treasury-Internal Revenue Service

886-A Schedule number or exhibit
Form
Name of taxpayer Tax Identification Number Year/Period ended
12/31/20
12/24/20

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.

7. 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.)

8. Special Risk—Commercial General Liability (CGL) Gap Insurance Policy

This policy provides coverage for certain claims which are denied by

, under General Liability Policy Number , effective August 31, 20
through August 31,20 _, as follows: (1) Knowing Violation of Rights of Others exclusion for
Personal and Advertising Injury; (2) Limitations of Coverage to Designated Events; and (3)
Abuse or Molestation Exclusion.

Not insurance.

We could not conclude that this contract is insurance in the commonly accepted sense. The
contract is vague as to the underlying terms of the policy.

Form 886-A (1-1994) Catalog Number 20810W Page 23 of 39 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
12/31/20
42/31/20
12/24/20

9. Event Cancellation insurance Policy

This policy provides coverage for all losses resulting from the necessary cancellation,
postponement, curtailment, or abandonment of any contracted scheduled event promoted by
the insureds.

Insurance.

10.Loss of Major Business-to-Business Relationship Insurance Policy

This is business interruption insurance for the loss of a client.

Not insurance.

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

20__Policies

1. Special Risk—Regulatory Changes Insurance Policy
   Same as 20. Not insurance.
2. Expense Reimbursement Insurance Policy

This policy differs from the 20 insurance policy with the same title. Covers losses in
connection with crisis management public relations expenses.

Not Insurance.

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

3. Loss of Services Insurance Policy
   Same as 20 . Not insurance.
4. Excess Intellectual Property Package Policy

Same as 20 . Not insurance.

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

Page 24 of 39 publish. no.irs.gov Department of the Treasury-Internal Revenue Service

Schedule number or exhibit
Form 886-A
Name of taxpayer Tax Identification Number Year/Period ended
12/31/20
12/31/20
12/24/20

5. Event Cancellation Insurance
   Same as 20__.._ Insurance.
6. Expense Reimbursement—Legal Expenses Insurance Policy

New policy for 20. Covers all litigation expenses incurred by the insured resulting for
insured's actual or alleged civil liability.

Not insurance.

We could not conclude that this contract is insurance in the commonly accepted sense. The
contract is vague as to what liability/contract underlies the need for defense expenses.

20___ Policies.

The 20 contracts were not reviewed during the audit. In the Service's Preliminary Report,
dated September 6, 20 __, the taxpayer was asked if it operated in the same manner in 20

as it did during the 20 and 20 _ tax years, and if so, to submit any documentation to support
changed in operations.

In its October 26,20 response to the Preliminary Report, taxpayer did not submit any
documentation indicating that its operations changed in 20

Thus, the Service contents that the taxpayer operated in the same manner in 20 ; and thus,
was not an insurance company for the 20 ‘tax year because more than half of its business
did not involve the issuance of insurance contracts or annuities or the reinsuring of risks
underwritten by other insurance companies.

Other Insurance Policies

Quota Share Reinsurance Program.

participated in over insurance policies with more than insureds.
blended together its direct written insurance and then reinsured the entire book on a quota
share basis with each of the pool participants. As Reinsurer No. , in the 20 _ reinsurance
program, Taxpayer received % of gross premiums of $ . 2 tn exchange
for the assumption —_% of the risk pool comprised of the stop loss coverage issued to all of
the stop loss endorsement policyholders.

In20 , participated in over insurance policies with more than insureds.
blended together its direct written insurance and then reinsured the entire book on a
quota share basis with each of the pool participants. As Reinsurer No. _, Taxpayer received

Form 886-A (1-1994) Catalog Number 20810W Page 25 of 39 publish. no.irs.gov Department of the Treasury-Internal Revenue Service

886-A Schedule number or exhibit

F 7

(Rev. January 1994) EXPLANATIONS OF ITEMS

Name of taxpayer Tax Identification Number Year/Period ended
12/31/20
42/31/20
12/24/20

% of gross premiums of $ , in exchange for the assumption of %

of the risk pool comprised of the stop loss coverage issued to all of the stop loss endorsement
policyholders.

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 do include the
contracts written by . Therefore, it is highly likely that the entire
pool, which is insured by 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 March 30,20 response to IDR #1 for 20 , the CPA provided a copy of

letters from ; 3 and
, 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 was a party to during 20 , 20 , and 20 . 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).

Form 886-A (1-1994) Catalog Number 20810W Page 26 of 39 publish. no.irs.gov Department of the Treasury-Internal Revenue Service

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Form

(Rev. January 1994) EXPLANATIONS OF ITEMS

Name of taxpayer Tax identification Number Year/Period ended
12/31/20:
12/31/20:
12/24/20

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,
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.

Form 886-A (1-1994) Catalog Number 20810W Page 27 of 39 publish. no.irs.gov Department of the Treasury-Internal Revenue Service

886-A Schedule number or exhibit

Form es

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12/31/20
12/31/20
12/24/20

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
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

Form 886-A (1-1994) Catalog Number 20810W Page 28 of 39 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
12/31/20)
12/31/20
12/24/20 _-

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.

In the instance case, the facts therein are analogous to the analysis under Situation1 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.”

The current position of the Service with respect to captive insurance arrangements is
expressed in Revenue Ruling 2005-40. In Situation 2 of the ruling, the Service concluded that
insurance did not exist because the captive arrangement with a single-insured lacked risk
distribution. However, in Situation 4, the Service concluded that the captive arrangement with
12 LLC's did result in insurance. The main point of Revenue Ruling 2005-40, Situations 2 and
4, is the Service established a range between a single-insured and twelve-insured entities that
might or might not meet the requisite risk distribution needed to qualify as insurance. The
closer the number of insured parties in the captive arrangement approaches 12 insured, the
more likelihood adequate risk distribution exist, and the arrangement will qualify as insurance.
However, the closer the number of insured parties in the captive arrangement approaches one
insured, the more likelihood the arrangement lacks adequate risk distribution and will not
qualify as insurance.

With respect to the contracts reviewed during the tax years under audit, the Service concluded

that the agreements between the taxpayer and and
, the insureds, do 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 affiliated businesses. The affiliated businesses are owned by the
beneficial owners, and . Of total risk insured by the
taxpayer, approximately % percent of the risk assumed during the years under audit is that
of the affiliated businesses.” In addition, of the total premiums received during the year, %
percent of the premiums were derived from the direct written contracts that insure the risk of
the affiliated business. Approximately % of all premiums and = % of the direct written
premiums were paid by a single entity, , even though the direct
contracts covered two related insured. did not write or issue
separate contracts to the affiliated insured. Nor did the two affiliated businesses make
separate premium payments to the taxpayer. In affect, the direct written contracts were sold to

? Average of risk assumed in 20 and 20 ( %+ %= divided by 2 years= %)

Form 886-A (1-1994) Catalog Number 20810W Page 29 of 39 publish. no.irs.gov Department of the Treasury-Internal Revenue Service

886-A Schedule number or exhibit

F ,

Rev. 3 1994) EXPLANATIONS OF ITEMS

Name of taxpayer Tax identification Number Year/Period ended

12/31/20
12/31/20
12/24/20

a single affiliated entity, ; , but covered both affiliated

businesses. Even if the affiliated insured did pay separate premiums to the taxpayer, this still
would not create a pool large enough to adequately distribute insurance 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 a
single policyholder, _ insuring the two affiliated business
interests. 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 years 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
assuming entity may account for the arrangement as an “insurance contract" for purposes of
Subchapter L of the Internal Revenue Code.

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

, 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, nine of the twelve 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 for those nine direct
written contracts are not considered insurance premiums. Amounts received by taxpayer for
three of the twelve direct written contracts were deemed to be premiums because only for
those contracts included an insurance risk.

Form 886-A (1-1994) Catalog Number 20810W Page 30 of 39 publish. no.irs.gov Department of the Treasury-Internal Revenue Service

Schedule number of exhibit
(Rev. January 1994) EXPLANATIONS OF ITEMS
Name of taxpayer Tax Identification Number Year/Period ended
12/31/20:
12/31/20:
12/24/20
During the taxable years under consideration, received amounts that the Service
deemed to be direct written and reinsurance premiums as follows:
20 ;
Contract Premium
Excess Directors & Officers Liability $:
Event Cancellation —_———__—
Amount Deemed Premiums from Direct Written Contracts $:
Quota Share Premiums
Credit Coinsurance Reinsurance
Total Premiums for 20 $°
Gross Receipts for 20
Percentage of Premiums to Gross Receipts %
20 ;
Contract . Premium
Event Cancellation
Amount Deemed Premiums from Direct Written Contracts $.
Quota Share Premiums
Credit Coinsurance Reinsurance
Total Premiums for 20 $:
Gross Receipts for 20 $. ,
Percentage of Premiums to Gross Receipts %o

For 20, no analysis of the gross receipts computation was completed by the Service
because the policies and financial records were not reviewed.

The amounts received by 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 would not qualify as an insurance
premium.

Form 886-A (1-1994) Catalog Number 20810W Page 31 of 39 publish. no.irs.gov Department of the Treasury-Internal Revenue Service

i 886-A Schedule number or exhibit

Form

(Rev. January 1994) EXPLANATIONS OF ITEMS

Name of taxpayer Tax identification Number tat ended
12/31/20:
12/31/20
12/24/20

In addition, although we question whether the Quota Share 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

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.

Although gross receipts were less than the $600,000 for the 20 and 20 tax years, the
amounts deemed to be premiums were more than 50% of gross receipts for the 20: tax year
only. Premiums were not more the 50% of gross receipts for 20 . Therefore, we are
revising our position on the gross receipts test as stated in our Preliminary Report issued to
taxpayer on September 6,20 . Based on further analysis of the contracts, we concluded
that the taxpayer did not meet the 50% gross receipts test described in IRC 501(c)(15) and
Notice 2006-42 for the 20 _ tax year, but did meet the gross receipts test for 20

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 agreements
with and lacks risk distribution.

Therefore, the taxpayer does not qualify as an insurance company.

A Preliminary Report, Form 5701, Notice of Proposed Adjustments, was mailed to the
taxpayer's CPA, _ ,on September 6, 20 _, proposing denial of tax-exempt
treatment under section 501(c)15) of the Internal Revenue Code, for the tax years ending
December 31,20 , December 31,20 , and December 31, 20

TAXPAYER’S POSITION:

A response to the Preliminary Report was received from , CPA, on October 26,
20 . In the response, the CPA summarized that the taxpayer disagreed with the Service's
conclusion that the contracts issued by lack adequate risk distribution, and that
primary and predominant business Is insurance; qualifies for IRC
501(c)(15) tax-exempt status; and is not a controlled foreign corporation.

The CPA argued the following points:

1. The audit of appears to be outcome determinative as evidenced by the
   fact that records for the 20 tax year were not even reviewed prior

to the insurance of the proposed adjustment.

2. In reaching its incorrect conclusion that insurance operations lacked
   the requisite risk distribution, the Service ignored more than thirty years of well-

Form 886-A (1-1994) Catalog Number 20810W Page 32 of 39 publish. no.irs.gov Department of the Treasury-Internal Revenue Service

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(Rev. January 1994) EXPLANATIONS OF ITEMS

Name of taxpayer Tax identification Number Year/Period ended
12/31/20
12/31/20
12/24/20

established tax law, as well as hundreds of prior favorable rulings issued by the
Service.

. 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.

. The taxpayer stated that the Service conducted no meaningful examination of risk
distribution in Its audit of 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 cg” Cir. Nov. 5, 1992).

. 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.

. 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.

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

. Rather than engage in a meaningful analysis of the number of independent risk
exposures insured by 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.

. 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 There has been no
intervening change in law to account for the Service's disparate tax treatment
between 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).

Form 886-A (1-1994) Catalog Number 20810W Page 33 of 39 publish. no.irs.gov Department of the Treasury-Internal Revenue Service

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Form vs

(Rev. January 1994) EXPLANATIONS OF ITEMS

Name of taxpayer Tax identification Number Year/Period ended
12/34/20
12/24/20

10. 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 ', CPA, on
September 6, 20 _,, the Service's initial position is unchanged. s

primary and predominant business in tax years 20, 20 ', and 2C , was not insurance
because the contracts issued by the company lacked the requisite risk distribution.

Taxpayer's Position:
In the initial paragraph of the October 16,20 response to the agent's preliminary report, the

CPA stated that the audit of appear to be outcome determinative as evidenced
by the fact that records for the 2C tax year were not even reviewed prior to

the issuance of the proposed adjustment.

Government’s Response:
The outcome of the examination was not outcome determinative even though the books and

records for the 20 _ tax year were not examined. The examining agent did examine the books
and records for the 20 and 20 tax years. During the examination, the examining agent
also inspected the Form 990-EZ return filed by the taxpayer for the 20° tax years. The
examining agent concluded that the only significant change in operations was the dissolution
of the taxpayer on December 24, 20 . Between the period of January 1, 20 , through
December 23, 20 , the taxpayer conducted the same business in the same manner as in

20 and 20 . Therefore, the examining agent concluded that examining the 20 books
and records was not necessary.

in addition, on three page of the Preliminary Report, dated September 6,20 ., the CPA was
given an opportunity to provide any information that might show that the taxpayer's operations
were significantly different in 20 +, than those conducted in 20. and 20 The CPA did not
provide any information to support his position.

Taxpayer's Position: a
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

qualifies as an insurance company. The CPA sites the court's holding, when a significant
percentage (_ 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

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Name of taxpayer Tax Identification Number Year/Period ended
12/31/20:
12/31/20
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the remaining _ 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 September 6, 20° response:

In its preliminary report, the Service merely states, that due to percent
of premiums being direct written premiums paid by certain insureds that
owned no interest in there is a lack of adequate risk
distribution. This ignores the fact that more than —_ 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 % of the risk assumed by was from unrelated or
unaffiliated insureds, 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 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.

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12/24/20:

Taxpayer’s Position:
On page 3, paragraph 1, of the taxpayer's position, the CPA stated that the Service conducted

no meaningful examination of risk distribution in its audit of 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.

Government's Response:
In Question 10, of IDR #2, issued to CPA on March, 9,20, 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,
assumed risk exposures as follows:

Affiliated Business Interests Direct exposure % %

Unrelated & Affiliate Interests Pooled reinsurance exposure

Unrelated & Affiliate Interests Pooled reinsurance exposure a —_____
Total risk assumed % 100.00%

In the June 20, 20 response to IDR #2, ,_ CPA, provided the following comments:

The percentages listed in your question are incorrect. The percentages
were 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

the various contracts. The Income Statement included under Tab 17 of
the initial IDR response shows the following:

20
Direct Written Premiums $: %
Other Reinsurance Assumed %
Pooled Reinsurance Assumed %
Total $ 100.00%
20
Direct Written Premiums $ %
Other Reinsurance Assumed %
Pooled Reinsurance Assumed %
Total $ 100,00%

Form 886-A (1-1994) Catalog Number 20810W Page 36 of 39 publish. no.irs.gov Department of the Treasury-Internal Revenue Service

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(Rev. January 1994) EXPLANATIONS OF ITEMS
Name of taxpayer Tax identification Number Year/Period ended
12/31/20
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20
Direct Written Premiums $ %
Reinsurance premiums a %
Total $ 100.00%

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
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 percent of the
business (and premiums) during the three years under audit..

Taxpayer's Position:
On page 4, paragraph 1, 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 _ 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 4, 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

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

Page 37 of 39 publish. no.irs.gov Department of the Treasury-Internal Revenue Service

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that it has issued. These favorable determination letters were issued to taxpayers substantially

similar, or less favorable, facts to those of There has been no intervening

change in law to account for the Service's disparate tax treatment between 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.

Government's Response: .
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 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 simply because the Service issued favorable ruling letters to other
applicants in the past.

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

made by the Service.

Taxpayer's Position:
In paragraph 2 on page 5, the CPA stated that qualified for tax-exempt status as

an insurance company described in IRC Section 501(c)(15) during all of the years under
review. As made a valid election under IRC Section 953(d) to be treated as a
domestic corporation, the Service’s conclusion that is a controlled foreign
corporation is incorrect.

Government's Response:
According to the Form 1024, Application for Recognition of Tax-Exempt Status, administrative

file, the taxpayer filed its IRC 953(d) election with the office of the Service
on February 23, 20

IRS records reveal that the IRC 953(d) election was not 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 16,20,
after its Counsel anticipated that the Service would issue a final adverse ruling letter denying
IRC 501(c)(15) exemption.

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Name of taxpayer Tax Identification Number Year/Period ended
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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 tax years ended
December 31,20 , December 31,20 , and December 24, 20 .

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 39 of 39 publish. no.irs.gov Department of the Treasury-Internal Revenue Service