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

View official IRS release (PDF)

Plain-English summary

A foreign captive insurance company claimed exemption as a small property and casualty insurer under section 501(c)(15). The IRS found that the company's direct-written contracts concentrated risk in affiliated businesses, with most premiums paid by a single affiliated policyholder, and therefore lacked adequate risk distribution. The report also concluded that the arrangement functioned as self-insurance and that adding two reinsurance arrangements did not supply the missing risk distribution. The IRS determined that the company's primary and predominant activity was not insurance, so it did not qualify as an insurance company under subchapter L or for the section 501(c)(15) exemption. The IRS further concluded that the company did not qualify for treatment as a domestic corporation under section 953(d) and should instead be treated as a controlled foreign corporation subject to subpart F.

Ruling snapshot

• Question: Did the captive qualify as a tax-exempt small insurance company under section 501(c)(15)?
• Outcome: revocation, the company was not an insurance company because its arrangements lacked adequate risk distribution
• Key authorities: IRC §§ 501(c)(15), 816, 831, and 953(d); Rev. Ruls. 2002-89, 2002-90, and 2005-40

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Appeals Office

Employer Identification Number:

Number: 201713012
Release Date: 3/31/2017

Person to Contact:

Employee ID Number:

Tel:
Fax:

Date: September 15, 2016
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

TAX EXEMPT AND
GOVERNMENT ENTITIES
DIVISION

Date: June 10, 2013
Taxpayer Identification Number:

ORG Form:
ADDRESS
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 15, 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

(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
7850 SW 6th Court, Room 265
Plantation, FL 33326

Ph: (954) 423-7677

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

Schedule number or exhibit

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

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

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 the primary and predominant business of is insurance?

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. Whether the IRC 953(d) election is invalid if is not an insurance company as

described in Subchapter L of the Code?

FACTS:

(“Taxpayer”) was formed and incorporated in the Territory of the ,on
December 6, 20XX, under the provisions of the . 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 0 common shares with a $0 par value. The taxpayer actually issued 0 shares in
consideration of $0 capital contribution. During 20XX and 20XX, the taxpayer was legally
formed as a corporation.

In 20XX, the taxpayer filed a Certificate of Continuance to move its legal domicile from ,

to ; . The Certificate of Continuance was approved by the Registrar of
Companies, ; , on July 1, 20XX.
Thus, since July 1, 20XX, the taxpayer is legally formed as an ; corporation,

under the provisions of the Companies Act, 2000, Section 197(1).

The taxpayer is wholly owned by ,a limited liability company, located
at , as the sole shareholder, purchased 0 shares of the taxpayer's
stock for $0 in December 20XX. is owned by (0% interest) and
(0% interest). are husband and wife. Both individuals are U.S. citizens, who
reside in ;

The TEGE examining agent obtained a copy of taxpayer's Form 1024 application
administrative file from Rulings and Agreements in Washington, D. C., on October 29, 20XX .
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 20XX and subsequent years; forms of credit reinsurance
agreements entered into by the taxpayer; and a copy of the 20XX insurance policies issued by

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

Schedule number or exhibit

Form 886-A EXPLANATIONS OF ITEMS

(Rev. January 1994)

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

the taxpayer. Other documents were received from , CPA, in response to Information

Document Requests issued by the examining agent to the CPA during the current 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 . serves as Chief Executive Officer (CEO),
President, Treasurer, and Assistant Secretary of serves as Vice President,
Secretary, and Assistant Treasurer.

also co-equally own , and various other business
interests collectively referred to as “Affiliated Businesses Interests.” According to the 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.

In addition to ; also equally co-own ___, , ,and

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, signed an IRC
953(d) election statement on April 21, 20XX. It appears that the election statement was filed
with the IRS —,_ office on the same day. The IRC 953(d) election was approved by the IRS
on July 10, 20XX, and commenced on December 10, 20XX.

On September 22, 20XX, 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 20XX was the
initial tax year of the taxpayer. Prior to filing the Form 1024 application, the taxpayer had filed
Form 1120-PC for its initial short tax year ended December 31, 20XX, with the Ogden Service

Center. , President, signed the application on September 21, 20XX. 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
$0 annually.

Form 886-A (1-1994) Catalog Number 20810W Page 2 of 32 publish. no.irs.gov Department of the Treasury-Internal Revenue Service

Schedule number or exhibit

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

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

The Form 1024 application was referred to Rulings and Agreements in Washington, D.C., on
October 29, 20XX, for consideration and ruling. The application was assigned to a Tax Law
Specialist for review. On January 7, 20XX , the Tax Law Specialist issued a letter to the
taxpayer requesting additional information about its operations to supplement the responses
shown in the Form 1024 application. , President, submitted the requested information to
the Tax Law Specialist on February 15, 20XX . No further action was taken on the application
until September 20XX . Then, on September 20, 20XX , , President, sent a letter to the
Tax Law requesting that the Form 1024 be withdrawn from consideration and ruling. The Tax
Law Specialist closed the Form 1024 application file without making a final determination
whether the taxpayer did or did not qualify for IRC 501(c)(15) tax-exempt status.

Thus, the taxpayer did not receive a favorable or final adverse ruling letter from TEGE, Rulings
and Agreements.

The taxpayer filed Form 990-EZ for 20XX, claiming that it qualified as a tax-exempt small
insurance company as described in IRC 501(c)(15). Calendar year 20XX was the taxpayer's
first full tax year of operations. Form 990 returns were also filed for the 20XX and 20XX tax
years.

The ' , issued an initial Class ‘B: General Insurance License to the taxpayer on
December 10, 20XX. The license was renewed annually, thereafter. During the years under
audit, the taxpayer operated primarily to provide property and casualty “insurance” coverage to
the Affiliated Business Interests, which are co-owned by and , Officers and
beneficial owners of Supplemental information submitted with the Form 1024
application by the taxpayer revealed that own 0% co-equal ownership in the
Affiliated Business Interests.

In 20XX, the taxpayer wrote nine (9) direct-written contracts to as
follows: (1) Special Risk — Tax Liability, (2) Special Risk — Punitive Wrap; (3) Special Risk —
Regulatory Changes, (4) Excess Pollution, (5) Special Risk — Loss of Major Customer, (6)
Excess Employment Practices, (7) Excess Directors & Officers Liability, (8) Special Risk —
Expense Reimbursement, and (9) Special Risk — Loss of Services. Each policy listed the
Named Insureds as ;and_s, , located at . Each of the
above-named policies is described i in detail below.

Special Risk - Tax Liability

The Company is at risk from any adverse decision from an unexpected tax audit as regard
positions taken on tax returns, e.g., deductibility of captive premiums, methods of accounting,
etc.

Form 886-A (1-1994) Catalog Number 20810W Page 3 of 32 publish. no.irs.gov Department of the Treasury-Internal Revenue Service

Schedule number or exhibit

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

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

Special Risk — Punitive Wrap Liability

Although the Company carries General Liability and Auto Liability coverage, those policies
typically have numerous exclusions the insurers use to decline coverage. Any investigation,
even if no negligence is found, could prove very costly. A policy to reimburse the Company for
this type of insured defense expense may prove attractive to the Company.

Special Risk - Regulatory Changes

The Company is at risk of external factors such as regulatory changes in the construction
sector. The Company could incur a significant outlay of monies to come into compliance with
rules and regulations regarding its operations.

Excess Pollution Liability
The company is at risk for external factors relating to the disposal of hazardous waste at its
principal place of business and at various construction job sites.

Loss of Major Business to Business Relationships

The Company’s major business relationship is with . With such a high
concentration of business tied to one business, the Company is at risk of significantly lower
revenues if it loses this relationship during the time it arranges for alternate sources of income.
Another area of concern is the additional expense needed to keep qualified independent
contractors from moving to other companies during such a period.

Employment Practices Liability

The Company is potentially at risk for employment practices liability for discrimination,
harassment, wrongful termination, or other similar inappropriate act. In some jurisdictions,
actions related to civil rights allegations can come from third parties such as customers and
independent contractors.

Directors & Officers Liability

An action against the directors and officers can come from a variety of sources, including the
Company's primary customer, independent contractors, or other third parties if the Company's
policies and procedures are alleged to be inappropriate or not followed adequately.

Expense Reimbursement

The Company may confront unanticipated expenses for public relations crisis management
and uninsured defense expense. In the event of an allegation of liability for completed
operations (similar to products liability for contractors), suspension of the Company’s license,
or other adverse event, significant monies could be required for public relations crisis
management to avert and offset negative publicity which could ultimately lead to a loss of
business.

Form 886-A (1-1994) Catalog Number 20810W Page 4 of 32 publish. no.irs.gov Department of the Treasury-Internal Revenue Service

Schedule number or exhibit

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

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

Loss of Services

As a closely held corporation, the Company is highly dependent on the services of , the
President, and , the Secretary. If the Company lost the services of either officer for an
extended period of time, it would risk the loss of important business opportunities and face
extensive costs finding a suitable replacement.

In each contract, the taxpayer is listed as the “Lead Insurer” (0%) and (0%) is
listed as the “Stop Loss Insurer.” Each contract listed . ,and_ , , as the
Named insureds. The contracts also listed policy period, premium payment due, aggregate
risk insured, and coverages insured. The taxpayer did not write, issue, or sell direct contracts
to unrelated third parties or the general public during 20XX. With respect of each of the 9
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. 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 9 direct-written
contracts, the taxpayer received 0% of the total premiums, and received 0% of the total
premiums. Page 5, paragraph 4 of the agreement reads as follows:

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

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

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 0 insurance policies with more than 0 insurers.

Form 886-A (1-1994) Catalog Number 20810W Page 5 of 32 publish. no.irs.gov Department of the Treasury-Internal Revenue Service

Schedule number or exhibit

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

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

blended together its direct written insurance and then reinsured the entire book on a quota
share basis with each of the pool participants. The contract reflected a total of 0 reinsurers
participating in the Quota Share Reinsurance Program in 20XX. As Reinsurer# __, the
taxpayer received 0% of the Quota Share Retained Premium from in exchange
for the assumption of 0% of the risk pool comprised of the stop loss coverages issued during
the policy period by to all stop loss endorsement policyholders. In
20XX, paid total reinsurance premiums of $0 to 0 reinsurers. Of
this amount, paid a quota share reinsurance premium of $0 to the
taxpayer based on its 0% of the risk pool assumed. According to the general ledger, the
taxpayer received reinsurance premiums of $0 from in 20XX. The risk
assumed under the quota share contract accounts for approximately 0% of the total risk
assumed by the taxpayer.

Under the terms of the second arrangement, which is referred to as the , the taxpayer
assumed reinsurance contracts from . The taxpayer reinsured a 0% quota share of
the risks from vehicle service contracts reinsured by . The vehicle service contracts
were initially written by in 20XX, assumed by , then by from - and
finally assumed by from The taxpayer received a pro rata share of the
earned premiums received by . The taxpayer was paid a reinsurance premium of $0 from
in 20XX.

Under the terms of the contracts reviewed for 20XX, the taxpayer assumed risk exposures as
follows:

Direct Written Premiums $ 0 0%

Quota Share Reinsurance Assumed 0 0

Other Reinsurance Assumed 0 0
Total $ 0 0.00%

Based on the current audit, the taxpayer’s gross receipts were $0 for the 20XX tax year.
Gross receipts were derived solely from premiums received from the direct written, reinsurance
risk pooling program, and the . The taxpayer received gross receipts as follows:

20XX
Program Revenue Service
Direct Written Premiums $ 0 0%
Quota Share Reinsurance Premiums 0
Credit Coinsurance Reinsurance Premiums _ 0
Total Premiums 0
Investment Income 0 0
Gain of sale of assets -0-
Other income _0

Form 886-A (1-1994) Catalog Number 20810W Page 6 of 32 publish. no.irs.gov Department of the Treasury-Internal Revenue Service

Schedule number or exhibit

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

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

Gross Receipts $ 0 0.00%
The 20XX bank statements for taxpayer’s checking account with revealed that the
account was opened prior to 20XX, because the January 20XX statement reported a beginning
balance. The premiums for the nine direct written contracts were paid by monthly.
The taxpayer deposited the direct written premiums into the account. The bank

statements reflected monthly deposits of $0 as direct written premiums.

Of the total premiums received by the taxpayer in 20XX, 0% of the premiums were generated
from the nine direct written policies with the Affiliated Business Interests, ; 0% of the
premiums are from the ; and 0% of the premiums from the

As of December 31, 20XX, the taxpayer's assets totaled $0, and consisted primarily of cash
and securities in its investment account ($0) and cash in its checking account ($0).

20XX Tax Year

The taxpayer filed Form 990, Return of Organization Exempt From Income Tax, for the tax
year ended December 31, 20XX, claiming to be tax-exempt under IRC 501(c)(15). During the
year, the taxpayer continued to operate as a captive company that insured certain property
and casualty risks of affiliated business interests. As of July 1, 20XX, the taxpayer legally
moved its operations from the to the . The taxpayer wrote and issued ten
contracts during the year. The ten contracts included the same nine contracts written in 20XX:
(1) Special Risk — Tax Liability, (2) Special Risk — Punitive Wrap; (3) Special Risk — Regulatory
Changes, (4) Excess Pollution, (5) Special Risk — Loss of Major Customer, (6) Excess
Employment Practices, (7) Excess Directors & Officers Liability, (8) Special Risk — Expense
Reimbursement, and (9) Special Risk — Loss of Services. The last contract written in 20XX
was (10) Special Risk — Legal Expense contract. Each policy listed the Named Insureds as

; and , located at All of the Named Insured continued to be
Affiliated Business Interests owned and controlled by and ,
beneficial owners of the taxpayer. Each of the above-named policies is described in detail
below.

Special Risk - Tax Liability

The Company is at risk from any adverse decision from an unexpected tax audit as regard
positions taken on tax returns, e.g., deductibility of captive premiums, methods of accounting,
etc.

Special Risk — Punitive Wrap Liability
Although the Company carries General Liability and Auto Liability coverage, those policies
typically have numerous exclusions the insurers use to decline coverage. Any investigation,

Form 886-A (1-1994) Catalog Number 20810W Page 7 of 32 publish. no.irs.gov Department of the Treasury-Internal Revenue Service

Schedule number or exhibit

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

Name of taxpayer Tax Identification Number Year/Period ended

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

even if no negligence is found, could prove very costly. A policy to reimburse the Company for
this type of insured defense expense may prove attractive to the Company.

Special Risk - Regulatory Changes

The Company is at risk of external factors such as regulatory changes in the construction
sector. The Company could incur a significant outlay of monies to come into compliance with
rules and regulations regarding its operations.

Excess Pollution Liability
The company is at risk for external factors relating to the disposal of hazardous waste at its
principal place of business and at various construction job sites.

Loss of Major Business to Business Relationships

The Company’s major business relationship is with . With such a high
concentration of business tied to one business, the Company is at risk of significantly lower
revenues if it loses this relationship during the time it arranges for alternate sources of income.
Another area of concern is the additional expense needed to keep qualified independent
contractors from moving to other companies during such a period.

Employment Practices Liability
The Company is potentially at risk for employment practices liability for discrimination,

harassment, wrongful termination, or other similar inappropriate act. In some jurisdictions,
actions related to civil rights allegations can come from third parties such as customers and
independent contractors.

Directors & Officers Liability

An action against the directors and officers can come from a variety of sources, including the
Company's primary customer, independent contractors, or other third parties if the Company’s
policies and procedures are alleged to be inappropriate or not followed adequately.

Expense Reimbursement

The Company may confront unanticipated expenses for public relations crisis management
and uninsured defense expense. In the event of an allegation of liability for completed
operations (similar to products liability for contractors), suspension of the Company's license,
or other adverse event, significant monies could be required for public relations crisis
management to avert and offset negative publicity which could ultimately lead to a loss of
business.

Loss of Services
As a closely held corporation, the Company is highly dependent on the services of , the
President, and , the Secretary. If the Company lost the services of either officer for an

Form 886-A (1-1994) Catalog Number 20810W Page 8 of 32 publish. no.irs.gov Department of the Treasury-Internal Revenue Service

Schedule number or exhibit

Form 886-A
(Rev, Jenvary 1984) EXPLANATIONS OF ITEMS

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

extended period of time, it would risk the loss of important business opportunities and face
extensive costs finding a suitable replacement.

Legal Expenses Reimbursement
The contract covers all litigation expenses incurred by the Company resulting from actual of
alleged civil liability.

In each contract, the taxpayer is listed as the “Lead Insurer” and is listed as the
“Stop Loss Insurer.” As Lead Insurer, the taxpayer assumed 0% of the risks under the
contracts. and the taxpayer executed a Joint Underwriting Stop Loss Endorsement, in
which , as the Stop Loss Insurer, assumed the remaining 0% of the risks under the thirteen
direct written contracts. The policy period for each contract is January 1, 20XX, through
January 1, 20XX .

Under the terms of the direct written contracts, paid a total premium of $0. Of the total
premium, $0 (or 0%) was paid directly to the taxpayer as a premium for the 10 direct written
contracts and the $0 was paid directly to for the Stop Loss Coverage under the
Joint Underwriting contract.

; ‘and _, the Affiliated Business Interests, are the only insured parties listed in
each of the direct written contracts. During 20XX, the taxpayer did not write direct contracts
with unrelated or unaffiliated parties. Nor did the taxpayer write direct contracts with the
general public.

The direct written premiums received by the taxpayer were deposited into the account
(# ). In response to IDR #1, Question 7, for the 20XX and 20XX tax years, , CPA,
provided a schedule listing the deposits of direct written premiums received by taxpayer from
Construction, Inc., in 20XX, as follows:

Total Direct Written Premium Finance
Date of Deposit Deposit Premium Charge
02/24/20XX $ 0 $ 0 $ 0
04/03/20XX 0 0 0
07/08/20XX 0 0 0
10/02/20XX e) 0 0
Totals $ 0 $ 0 $ 0

Each deposit included a premium finance charge of $0 (totaling $0) that was assessed by the
taxpayer because the Insured paid premiums monthly instead of on a single lump-sum
payment. The examining agent verified the deposits with the 20XX statements during the
audit. was the only payer of the quarterly direct written premiums and premium finance
charges received by the taxpayer in 20XX.

Form 886-A (1-1994) Catalog Number 20810W Page 9 of 32 publish. no.irs.gov Department of the Treasury-Internal Revenue Service

Schedule number or exhibit

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

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

The direct written premiums received by the taxpayer, under the ten direct written contracts in
20XX, accounted for approximately 0% of the total premiums received and assumed risk
assumed by the taxpayer in 20XX.

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 20XX, writes a Stop Loss endorsement on 0
insurance policies covering more than 0 insured. This includes policies issued by the taxpayer
as well as those issued by the other poo! 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 20XX Quota Share Reinsurance Policy executed with
, the taxpayer was one of 0 companies listed as reinsurer. As Reinsurer # , the taxpayer
receive 0% of its Quota Share Retained Premiums from in exchange for the
assumption of 0% of the risk pool comprised of the stop loss coverages issued during the
policy period by Insurance Company to all stop loss endorsement policyholders. paid
total reinsurance premiums of $0 to 0 Reinsurers. Of this total premium, the taxpayer received
a quota share reinsurance premium of $0, which was based on 0% of its share of risk
assumed. According to the general ledger, the taxpayer reported receiving a reinsurance

‘ premium of $0 from in 20XX. The risk assumed under the quota share contract accounts
for approximately 0% of the total risk assumed by the taxpayer

Finally, the taxpayer continued to participate in the credit coinsurance reinsurance program
with in 20XX. 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 0% quota

share of the risks from vehicle service contracts reinsured by . The
vehicle service contracts were initially written by in 20XX, assumed by , and
finally assumed by from . The taxpayer received a reinsurance premium of $0
from

Under the terms of the contracts reviewed for 20XX, the taxpayer assumed risk exposures as
follows:

Form 886-A (1-1994) Catalog Number 20810W Page 10 of 32 publish. no.irs.gov Department of the Treasury-Internal Revenue Service

Schedule number or exhibit

Form 886-A EXPLANATIONS OF ITEMS

(Rev. January 1994)

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

Direct Written Premiums $ 0 0%

Quota Share Reinsurance Assumed 0 0

Other Reinsurance Assumed 0 _0
Total $ 0 0.00%

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

20XX

Program Revenue Service

Direct Written Premiums $ 0

Quota Share Reinsurance Premiums 0

Credit Coinsurance Reinsurance Premiums 0

Total Premiums 0 0%

Investment Income 0 0
Gain of sale of assets -0- -0-
Other income 0 0

Gross Receipts $ 0 0.00%

The 20XX bank statements for its checking account with reflected total deposits of $0 for

the year. The statements did reflect deposit of direct written premium payments received by
the taxpayer during the year.

Of the total premiums received by the taxpayer in 20XX, 0% of the premiums were generated
for the ten direct written policies with the Affiliated Business Interest, 0% of the
premiums are from the Quota Share Reinsurance Risk Pooling Program ; and 0% of the
premiums from the Credit Coinsurance Reinsurance Program .

20XX Tax Year
The taxpayer filed Form 990, Return of Organization Exempt From Income Tax, for the tax
year ended December 31, 20XX , claiming to be tax-exempt under IRC 501(c)(15). 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 was a party to the
same ten direct contracts as in the 20XX tax year: (1) Special Risk — Tax Liability, (2) Special
Risk — Punitive Wrap; (3) Special Risk — Regulatory Changes, (4) Excess Pollution, (5) Special
Risk — Loss of Major Customer, (6) Excess Employment Practices, (7) Excess Directors &
Officers Liability, (8) Special Risk — Expense Reimbursement, and (9) Special Risk — Loss of
Services. The last contract written in 20XX was (10) Special Risk — Legal Expense contract.

Form 886-A (1-1994) Catalog Number 20810W — Page 11 of 32 publish. no.irs.gov Department of the Treasury-Internal Revenue Service

Schedule number or exhibit

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

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

As was the case in 20XX and 20XX, all of the direct written contracts issued by the taxpayer in

20XX named : ‘and , located at , as the Named
Insured. All of the Named Insured continued to be Affiliated Business Interests owned and
controlled by and , beneficial owners of the taxpayer.

The following direct written contracts were executed by the taxpayer with the Affiliated
Business Interests in 20XX :

Special Risk - Tax Liability

The Company is at risk from any adverse decision from an unexpected tax audit as regard
positions taken on tax returns, e.g., deductibility of captive premiums, methods of accounting,
etc.

Special Risk — Punitive Wrap Liability

Although the Company carries General Liability and Auto Liability coverage, those policies
typically have numerous exclusions the insurers use to decline coverage. Any investigation,
even if no negligence is found, could prove very costly. A policy to reimburse the Company for
this type of insured defense expense may prove attractive to the Company.

Special Risk - Regulatory Changes

The Company is at risk of external factors such as regulatory changes in the construction
sector. The Company could incur a significant outlay of monies to come into compliance with
rules and regulations regarding its operations.

Excess Pollution Liability
The company is at risk for external factors relating to the disposal of hazardous waste at its
principal place of business and at various construction job sites.

Loss of Major Business to Business Relationships

The Company's major business relationship is with _ With such a high concentration
of business tied to one business, the Company is at risk of significantly lower revenues if it
loses this relationship during the time it arranges for alternate sources of income. Another
area of concern is the additional expense needed to keep qualified independent contractors
from moving to other companies during such a period.

Employment Practices Liability

The Company is potentially at risk for employment practices liability for discrimination,
harassment, wrongful termination, or other similar inappropriate act. in some jurisdictions,
actions related to civil rights allegations can come from third parties such as customers and

independent contractors.

Form 886-A (1-1994) Catalog Number 20810W Page 12 of 32 publish. no.irs.gov Department of the Treasury-Internal Revenue Service

Schedule number or exhibit

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

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

Directors & Officers Liability

An action against the directors and officers can come from a variety of sources, including the
Company’s primary customer, independent contractors, or other third parties if the Company's
policies and procedures are alleged to be inappropriate or not followed adequately.

Expense Reimbursement

The Company may confront unanticipated expenses for public relations crisis management
and uninsured defense expense. In the event of an allegation of liability for completed
operations (similar to products liability for contractors), suspension of the Company's license,
or other adverse event, significant monies could be required for public relations crisis
management to avert and offset negative publicity which could ultimately lead to a loss of
business.

Loss of Services

As a closely held corporation, the Company is highly dependent on the services of , the
President, and , the Secretary. If the Company lost the services of either officer for an
extended period of time, it would risk the loss of important business opportunities and face
extensive costs finding a suitable replacement.

Legal Expenses Reimbursement
The contract covers all litigation expenses incurred by the Company resulting from actual of
alleged civil liability.

In each contract, the taxpayer is listed as the “Lead Insurer” and is listed as the “Stop
Loss Insurer.” As Lead Insurer, the taxpayer assumed 0% of the risks under the contracts.
and the taxpayer executed a Joint Underwriting Stop Loss Endorsement, in which , as the
Stop Loss Insurer, assumed the remaining 0% of the risks under the thirteen direct written
contracts. The policy period for each contract is January 1, 20XX , through January 1, 20XX.

Under the terms of the direct written contracts, paid a total premium of $0. Of the total
premium, $0 (or 0%) was paid directly to the taxpayer as a premium for the 0 direct written
contracts and the $0 was paid directly to for the Stop Loss Coverage under the Joint

Underwriting contract.

; ; and , the Affiliated Business Interests, are the only insured parties
listed in each of the direct written contracts. During 20XX , the taxpayer did not write direct
contracts with unrelated or unaffiliated parties. Nor did the taxpayer write direct contracts with
the general public.

Form 886-A (1-1994) Catalog Number 20810W Page 13 of 32 publish. no.irs.gov Department of the Treasury-Internal Revenue Service

Schedule number or exhibit

Form 886-A EXPLANATIONS OF ITEMS

(Rev. January 1994)

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

The direct written premiums received by the taxpayer were deposited into the account
(# )In response to IDR #1, Question 7, for the 20XX and 20XX tax years, , CPA,

provided a schedule listing the deposits of direct written premiums received by taxpayer from
, in 20XX, as follows:

Total Direct Written Premium Finance
Date of Deposit Deposit Premium Charge

02/26/20XX $ $ $

03/15/20XX .
04/30/20XX
05/07/20XX
06/23/20XX
07/29/20XX
08/24/20XX
09/30/20XX
10/27/20XX
11/19/20XX

Totals $

eolleieketokeokokokokoke)
e1looocoeoeoeooeoo°coeo
oIlooo0o0co°de°co°cooo

Each deposit included a premium finance charge of $0 (totaling $0) that was assessed by the
taxpayer because the Insured paid premiums monthly instead of on a single lump-sum
payment. The examining agent verified the deposits with the 20XX statements during the
audit. was the only payer of the quarterly direct written premiums and premium finance
charges received by the taxpayer in 20XX .

The direct written premiums received by the taxpayer, under the ten direct written contracts in
20XX, accounted for approximately 0% of the total premiums received and assumed risk
assumed by the taxpayer in 20XX.

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 20XX, writes a Stop Loss endorsement on 500+
insurance policies covering more than 150+ insured. 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

Form 886-A (1-1994) Catalog Number 20810W Page 14 of 32 publish. no.irs.gov Department of the Treasury-Internal Revenue Service

Schedule number or exhibit

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

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

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 20XX Quota Share Reinsurance Policy executed with
, the taxpayer was one of 0 companies listed as reinsurer. As Reinsurer #0, the taxpayer
receive 0% of its Quota Share Retained Premiums from in exchange for the
assumption of 0% 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 $0 to 0 Reinsurers. Of this total
premium, the taxpayer received a quota share reinsurance premium of $0, which was based
on 0% of its share of risk assumed. According to the general ledger, the taxpayer reported
receiving a reinsurance premium of $0 from in 20XX . The risk assumed
under the quota share contract accounts for approximately 0% of the total risk assumed by the
taxpayer

Finally, the taxpayer continued to participate in the credit coinsurance reinsurance program
with in 20XX . 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 based insurance company, which served as the
original ceding company. Under the terms of the contract, the taxpayer reinsured a 0% quota
share of the risks from vehicle service contracts reinsured by . The
vehicle service contracts were initially written by in 20XX, assumed by , and
finally assumed by from The taxpayer received a reinsurance premium of $0 from

Under the terms of the contracts reviewed for 20XX , the taxpayer assumed risk exposures as
follows:

Direct Written Premiums $ 0 0%

Quota Share Reinsurance Assumed 0 0

Other Reinsurance Assumed 0 i)
Total $6060 0.00%

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

Form 886-A (1-1994) Catalog Number 20810W Page 15 of 32 publish. no.irs.gov Department of the Treasury-Internal Revenue Service

Schedule number or exhibit

Form 886-A EXPLANATIONS OF ITEMS

(Rev. January 1994)
Name of taxpayer Tax Identification Number Year/Period ended
12/31/20XX
12/31/20XX
12/31/20XX

20XX
Program Revenue Service

Direct Written Premiums $ 0
Quota Share Reinsurance Premiums 0
Credit Coinsurance Reinsurance Premiums _0
Total Premiums 0 0%
Investment Income 0 0
Gain of sale of assets 0 0
Other income __0 0
Gross Receipts $ 0 0.00%
The 20XX bank statements for its checking account with reflected total deposits of $0

for the year. The statements did reflect deposit of direct written premium payments received
by the taxpayer during the year.

Of the total premiums received by the taxpayer in 20XX , 0% of the premiums were generated
from the ten direct written policies with the Affiliated Business Interest, ; 0% of the
premiums are from the Quota Share Reinsurance Risk Pooling Program ; and 0% of the
premiums from the Credit Coinsurance Reinsurance Program.

LAW:

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

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

2. Inthe case of a mutual insurance company, the gross receipts of which for the taxable
   year do not exceed $150,000, and more than 35% of such gross receipts consist of premiums.
   Section 816(a) of the Code 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 the reinsuring of risks underwritten by insurance companies.

Form 886-A (1-1994) Catalog Number 20810W Page 16 of 32 publish. no.irs.gov Department of the Treasury-Internal Revenue Service

Schedule number or exhibit

Form 886-A EXPLANATIONS OF ITEMS

(Rev. January 1994)
Name of taxpayer Tax Identification Number Year/Period ended
12/31/20XX
12/31/20XX
12/31/20XX

Section 1.801-3 of the Income Tax Regulations provides that the term insurance company
mean a company whose primary and predominant business activity during the taxable year is
the issuing of insurance or annuity contracts or the reinsuring of risks underwritten by
insurance companies. Thus, though its name, charter powers, and subjection to State
insurance laws are significant in determining the business, which a company is authorized and
intends to carry on, it is the character of the business actually done in the taxable year, which
determines whether a company is taxable as an insurance company under the Code.

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), aff'g. 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 performance 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 (10 Cir. 1986), historically and
commonly insurance involves risk —shifting and risk distributing. “Risk-shifting” means one
party shifts his risk of loss to another, and “risk-distributing” means that the party assuming the
risk distributes his potential liability, in part, among others. An arrangement without the
elements of risk-shifting and risk-distributing lacks the fundamentals inherent in a true contract
of insurance.

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

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

Form 886-A (1-1994) Catalog Number 20810W Page 17 of 32 publish. no.irs.gov Department of the Treasury-Internal Revenue Service

Schedule number or exhibit

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

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

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
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 —

Form 886-A (1-1994) Catalog Number 20810W Page 18 of 32 publish. no.irs.gov Department of the Treasury-Internal Revenue Service

Schedule number or exhibit

Form 886-A EXPLANATIONS OF ITEMS

(Rev. January 1994)

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

(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

(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,

Form 886-A (1-1994) Catalog Number 20810W Page 19 of 32 publish. no.irs.gov Department of the Treasury-Internal Revenue Service

Schedule number or exhibit

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

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

(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 22, 20XX, seeking retroactive
exemption under IRC 501(c)(15), back to December 6, 20XX, the date of incorporation. The

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

, . The examining agent believes that its counsel advised the taxpayer to withdraw the Form
1024 application because counsel anticipated EO Rulings and Agreements would deny IRC
501(c)(15) tax-exempt status to , 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.

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

Form 886-A (1-1994) Catalog Number 20810W Page 20 of 32 publish. no.irs.gov Department of the Treasury-Internal Revenue Service

Schedule number or exhibit

Form 886-A EXPLANATIONS OF ITEMS

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

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

Neither the Code nor the regulations define the terms “insurance” or “insurance contract.” The
standard for evaluating whether an arrangement constitutes insurance is Helvering v.
LeGierse, 312 U.S. 531 (1941), in which the Court stated that ‘historically and commonly
insurance involves risk-shifting and risk-distributing in a transaction which involve(s) an actual
‘insurance risk’ at the time the transaction was executed.” Insurance has been described as
“involving a contract, whereby, for adequate consideration, one party agrees to indemnity
another against loss arising from certain specified contingencies or perils. Empeir v. United
States, 199 F.2d 508, 509-10 (7th Cir. 1952). Insurance is contractual security against possible
anticipated loss. Id. Cases analyzing “captive insurance” arrangements have distilled the
concept of “insurance” for federal income tax purposes to three elements, applied consistently
with principles of federal income taxation: (1) involvement of an insurance risk; (2) shifting and
distribution of that risk; and (3) insurance in its commonly accepted sense. See e.g.,
AMERCO, Inc. v. Commissioner, 979 F.2d 162, 164-65 (9th Cir. 1992), aff'g. 96 T.C. 18 (1991).
The risk transferred must be risk of economic loss. Allied Fidelity Corp. v. Commissioner, 572
F.2d 1190, 1193 (7th Cir. 1978). The risk must contemplate the fortuitous occurrence of a
stated contingency, Commissioner v. Treganowan, 183 F.2d 288, 290-91 (2d Cir. 1950), and
must not be merely an investment or business risk. LeGierse, 312 U.S. at 542; Rev. Rul. 89-
96.

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

Risk distribution 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

Form 886-A (1-1994) Catalog Number 20810W Page 21 of 32 publish. no.irs.gov Department of the Treasury-Internal Revenue Service

Schedule number or exhibit

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

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

losses to match more closely its receipts of premiums. Clougherty Packing Co. v.
Commissioner, 811 F.2d 1297, 1300 (9th Cir. 1987). Risk distribution necessarily entails a
pooling of premiums, so that a potential insured is not in significant part paying for its own
risks. See Humana, Inc. v. Commissioner, 881 F.2d 247, 257 (6th Cir. 1989).

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

In Rev. Rul. 2002-90, S, a wholly owned insurance subsidiary of P, directly insured the
professional liability risks of 12 operating subsidiaries of its parent. S was adequately
capitalized and there were no related guarantees of any kind in favor of S. Most importantly, S
and the insured operating subsidiaries conducted themselves in a manner consistent with the
standards applicable to an insurance arrangement between unrelated parties. Together, the
12 operating subsidiaries had a significant volume of independent, homogeneous risks. Under
the facts presented, the ruling concludes the arrangement between S and each of the 12
operating subsidiaries of the parent of S constitute insurance for federal income tax purposes.

Situation 1 of Rev. Rul. 2005-40, describes a scenario where a domestic corporation operated
a large fleet of automotive vehicles in its courier transport business covering a large portion of
the United States. This represented a significant volume of independent, homogeneous risks.
For valid non-tax business purposes, the transport company entered into an insurance
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

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

In Situation 4 of Rev. Rul. 2005-40, 12 LLC’s elected classification as associations, each
contributing between 5 and 15% of the insurer's total risks. The Service concluded that this
transaction constituted insurance for federal income tax purposes.

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

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

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 to provide for an adequate premium pooling base.

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

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Name of taxpayer Tax Identification Number Year/Period ended
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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 direct written contracts between the taxpayer and ; ; and , the
Named 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 wholly-owned by beneficial
owners of the taxpayer, and . Of total risk insured by the taxpayer, approximately
0% percent of the risk assumed during the years under audit is that of the affiliated business.
In addition, of the total premiums received during the year, 0% percent of the premiums were
derived from the direct written contracts that cover the risk of the affiliated businesses.
Approximately 0% of all premiums and 0% of the direct written premiums were paid by a single
entity, . The taxpayer did not write, issue or sell separate contracts to each of the
Affiliated Businesses. Nor did the taxpayer receive separate premium payments from each of
the Affiliated Businesses. No written agreement exists between the Affiliated Businesses that
substantiates the portion of the direct written premium attributable to each business. Finally,
the taxpayer did not sell direct written contracts to non-affiliated businesses or the general
public.

During the tax years under audit, the taxpayer was primarily and predominantly supported by
direct written premiums that were received from a single insured party, . The taxpayer
did not receive direct written premiums from an adequate pool of insureds. Thus, the contracts
between the taxpayer and the Affiliated Business Interests, lacks the requisite risk distribution
that is necessary for the contracts to be contracts of insurance, as described in Subchapter L
of the Internal Revenue Code.

The Service concluded that the primary and predominant activity of the taxpayer is to assume
risk from contracts that are too heavily concentrated in a single policyholder, . Because
the risk is too heavily concentrated in an Affiliated Businesses, it is clear that any losses paid
by the taxpayer would be those of the Affiliated Businesses and not from an unrelated third
party. In addition, since paid the all of the direct written premiums received by the
taxpayer during the years under audit, the Service concluded that losses incurred by the
Affiliated Businesses were paid only from the premiums paid to the taxpayer by . In other
words, the arrangement between the taxpayer and the Affiliated Businesses represents a form
of self-insurance, and no court has held that self-insurance is insurance for federal tax
purposes.

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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.

Furthermore, it appears that the various risks insured are not homogeneous, and thus, must be
separated from one another and analyzed separately as to whether there is risk distribution as
to that risk. See. Rev. Rul. 2002-89, supra; also see Rev. Rul. 2005-40.

Assuming that all of the agreements do constitute insurable risks or that a significant majority
of the contracts qualify as insurable risks, over 0% of the total risks assumed by the taxpayer is
with an affiliated entity that is owned and controlled by and , the beneficial
owners of the taxpayer.

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

The Service concluded that the IRC 953(d) election, which was approved by the Service, in
July 20XX, is no longer valid because the taxpayer is not an insurance company within the
meaning of Subchapter L of the Internal Revenue Code.

A Preliminary Report, Form 5701, Notice of Proposed Adjustments, was mailed to the
taxpayer's CPA, , on September 28, 20XX, proposing denial of tax-exempt treatment
under section 501(c)(15) of the Internal Revenue Code, for the tax years ending December 31,
20XX, December 31, 20XX, and December 31, 20XX .

Finally, the Government contends that although the operations and financial records for the tax
year ended December 31, 20XX, were not examined by TEGE, the taxpayer would also fail to
qualify an insurance company for that year, if taxpayer operated in the same manner as that
during the years audited.

TAXPAYER’S POSITION:

A response to the Preliminary Report was received from , CPA, on
November 15, 20XX. In the response, the CPA summarized that the taxpayer disagreed with
the Service’s conclusion that the contracts issued by lack adequate risk distribution,

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

2. The taxpayer indicated that “in analyzing captive insurance arrangements for the
   presence of risk distribution, courts have looked at the level of unrelated risk as a
   metric for the presence of risk distribution.” The Service ignores the Tax Court
   ruling in The Harper Group and Includible Subs. v Commissioner, 96, T.C. 45
   (1991), aff'd, 979 F.2d 1342 (9th Cir. 1992), where 0% unrelated risks was determined
   to be sufficient to meet the risk distribution requirement.

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

4. The taxpayer argues that the 0% outside business principle and the decision in
   Harper are recognized in the Service’s own Foreign Insurance Excise Tax Audit
   Technique Guide.

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

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

7. 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

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policy to the actual risks insured in several revenue rulings. See Rev. Rul. 20XX-26,
Rev. Rul. 92-93, and Rev. Rul. 80-95.

8. Taxpayer argues the Service’s current position is directly contrary to the position it
   has taken in hundreds of prior Section 501(c)(15) tax-exempt determination letters
   that it has issued. These favorable rulings were issued to taxpayer on substantially
   similar, or less favorable, facts to those of . 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).

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

incorrect.
Government’s Response to Taxpayer’s Position:
After reviewing the response to the Preliminary Report received from , CPA, on
November 15, 20XX, the Service’s initial position is unchanged. primary and

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

Taxpayer’s Position:

In the initial paragraph of the November 15, 20XX response to the agent's preliminary report,
the CPA stated that the audit conclusion reached by the Service was solely based on an
unsupported position that insurance operations lacked the requisite risk distribution.

Government’s Response:

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

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single policyholder and payer of direct written premiums. Thus, primary and

predominant activity is not insurance as described in Subchapter L of the Internal Revenue
Code.

Taxpayer’s Position:

On page 2 of the Taxpayer's position, the CPA cites the Harper Group & Subsidiaries v.
Commissioner, 96 T.C. 45 (1991) to support the argument that qualifies as an
insurance company. The CPA sites the court's holding, when a significant percentage (0
percent) of an insurance company’s income is received from a relatively large number of
unrelated insureds, the requirement of risk distribution is satisfied. The source of the
remaining 0 percent is irrelevant on the issue whether sufficient risk distribution is present
because of the significant presence of unrelated risks. The CPA made the following statement
in paragraph 2 on page 2 of the November 15, 20XX response:

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

Government’s Response:

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

Even if the CPA claimed that insurance exists under the rationale in the Harper case, where
approximately 0% of the risk assumed by was from unrelated or unaffiliated insured,
the Service believes that this conclusion would be based on a misunderstanding of the Harper
Case. In the Harper Case, 67% to 71% of the total premiums received for the years at issue
were not related to a single policyholder. Rather, the 67% to 71% were the total percentages
received from all related policyholders, including brother-sister corporations (a total of 13

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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 0 entities making up the nearly two thirds
risk concentration in all the years at issue.

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

Taxpayer’s Position:

On page 3, last paragraph, the CPA stated that in reaching its incorrect conclusion in the
preliminary report, the Service appears to ignore Revenue Ruling 2001-34, 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 before smaller risk-shifting arrangements qualify as insurance for
federal income tax purposes. 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.

However, when the arrangements between the companies do constitute insurance for federal
income tax purposes and assuming these arrangements represented more than 0 percent of
the insuring company's business, the company will be an insurance company within the
meaning of IRC Sections 816 and 831, and the premium payments may be deductible under
Code Sec. 162, assuming the requirements for deduction are otherwise satisfied

Taxpayer’s Position:

On page 4, paragraph 2, of the taxpayer's position, the CPA stated that the Service conducted
no meaningful examination of risk distribution in its audit of . 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:
The proper method for determining the amount of risk being assumed by the company is to
compare the premiums received on the various contracts.

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Schedule number or exhibit

Form 886-A EXPLANATIONS OF ITEMS

(Rev. January 1994)

Name of taxpayer Tax Identification Number Year/Period ended
12/31/20XX
12/31/20XX
12/31/20XX
20XX
Direct Written Premiums $ 0 0%
Other Reinsurance Assumed 0 0%
Pooled Reinsurance Assumed (0) 0%
Total $ 0 0.00%
20XX
Direct Written Premiums $ 0 0%
Other Reinsurance Assumed 0 0
Pooled Reinsurance Assumed 0 0
Total $ 0 0.00%
20XX
Direct Written Premiums $ 0 0%
Other Reinsurance Assumed 0 0
Pooled Reinsurance Assumed 0 0
Total $0 0.00%

Under 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 0 percent of the business
(and premiums) during the three years under audit.

Taxpayer’s Position:

On page 4, paragraph 3, the CPA stated that the Service’s position is directly contrary to the
position it has taken in hundreds of prior Section 501(c)(15) tax-exempt determination letters
that it has issued. These favorable determination letters were issued to taxpayers substantially
similar, or less favorable, facts to those of . 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

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similar captive arrangements in the past, many of the rulings were issued prior to the
publishing of Revenue Ruling 2005-40, and subsequent clarification of the revenue ruling
received from the Office of Chief Counsel.

In addition, the Service is not precluded from proposing denial of IRC 501(c)(15) tax-exempt
status to 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 20XX, because the
taxpayer withdrew the application, in September 20XX, before a final determination could be
made by the Service.

Taxpayer’s Position:

On page 5, paragraph 2, 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 April 21,
20XX.

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

IRC 953(d) allows foreign insurance company to elect to be treated as a domestic company for
tax purposes if it meets certain requirements. One such requirement is that the foreign
company must be a company that would qualify as an insurance company, under part I or II of
subchapter L, for the taxable year if it were a domestic corporation. See IRC 953(d)(1)(B).
Since the Service determined that the taxpayer is not an insurance company within the
meaning of Subchapter L of the Code for the year under audit, it fails to meet the requirements
for the election under IRC 953(d) to be treated as a domestic corporation.

In addition, because the taxpayer does not meet the requirements to make the IRC 953(d)
election, and thus, is not a domestic corporation, the taxpayer should be treated as a

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“controlled foreign corporation,” and the provisions of Subpart F of the Internal Revenue Code
(sections 951-965) should apply.

CONCLUSION:

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

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

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