Insurance Company Loses Exemption

Person to Contact/ID Number: * * *

In a determination letter dated in 20XX, you were held to be exempt from Federal income tax under section 501(c)(15) of the Internal Revenue Code (the Code).

Based on recent information received, we have determined you have not operated in accordance with the provisions of section 501(c)(15) of the Code. Accordingly, your exemption from Federal income tax is revoked effective January 1, 20XX. This is a final adverse determination letter with regard to your status under section 501(c)(15) of the Code.

We previously provided you a report of examination explaining why we believe revocation of your exempt status is necessary. At that time, we informed you of your right to contact the Taxpayer Advocate, as well as your appeal rights. On February 6, 20XX, you signed Form 6018-A, Consent to Proposed Action, agreeing to the revocation of your exempt status under section 501 (c)(15) of the Code.

You have filed taxable returns on Form 1120, U.S. Corporation Income Tax Return, for the year ended December 31, 20XX with us. For future periods, you are required to file Form 1120 with the appropriate service center indicated in the instructions for the return.

You have the right to contact the Office of the Taxpayer Advocate. Taxpayer Advocate assistance is not a substitute for established IRS procedures, such as the formal Appeals process. The Taxpayer Advocate cannot reverse a legally correct tax determination, or extend the time fixed by law that you have to file a petition in a United States court. The Taxpayer Advocate can, however, see that a tax matter that may not have been resolved through normal channels 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:

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

We have also enclosed Publication 892, Exempt Organization Appeal Procedures for Unagreed Issues, and Publication 3498, The Examination Process. These publications include information on your rights as a taxpayer, including administrative appeal procedures within the Internal Revenue Service.

If you request a conference with Appeals, we will forward your written statement of protest to the Appeals Office, and they will contact you. For your convenience, an envelope is enclosed. If you and Appeals do not agree on some or all of the issues after your Appeals conference, the Appeals Office will advise you of its final decision

If you elect not to request Appeals consideration but instead accept our findings, please sign and return the enclosed Form 6018-A, Consent to Proposed Adverse Action. We will then send you a final letter modifying or revoking your exempt status under I.R.C. § 501(c)(15). If we do not hear from you within 30 days from the date of this letter, we will process your case on the basis of the recommendations shown in the report of examination and send a final letter advising of our determination.

In either situation outlined in the paragraph above (execution of Form 6018-A or failure to respond within 30 days), you are required to file federal income tax returns for the tax period(s) shown above, for all years still open under the statute of limitations, and for all later years. File the federal tax return for the tax period(s) shown above with this agent within 60 days from the date of this letter, unless a request for an extension of time is granted. File returns for later tax years with the appropriate service center indicated in the instructions for those returns.

You have the right to contact the office of the Taxpayer Advocate. Taxpayer Advocate assistance is not a substitute for established IRS procedures, such as the formal appeals process. The Taxpayer Advocate cannot reverse a legally correct tax determination, or extend the time fixed by law that you have to file a petition in a United States court. The Taxpayer Advocate can, however, see that a tax matter that may not have been resolved through normal channels gets prompt and proper handling. You may call toll-free 1-877-777-4778 and ask for Taxpayer Advocate Assistance.

If you 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.

* * * * *

 

 

 

 

ISSUES

 

• Definitions and explanations of the structure, operations procedure and powers of the Pool.

• Definitions of the role and responsibilities of all parties involved: Board of Directors, Administering Carrier and Participating Carrier.

• Definitions of the interpretation of terminology found in the legislation,

• Documentation of the rules of reinsurance operations and procedures.

• Promoting the availability of accident and health insurance coverage to small employers

• To provide reinsurance as a mechanism to fairly share the risk.

• To improve the efficiency and fairness of the small group accident and health insurance marketplace

A copy of the Application Form 1024, Application for Recognition of Exemption Under Section 501(a), and the determination letter was not provided by the organization. Agent requested a copy of the application form from the EO Determination Records Unit in * * * and from the * * *. Neither location was able to provide a copy. According to the information in the Service's database, * * * received tax exempt status under IRC 501(c)15) in 20XX.

* * * had no shareholders. There were * * * board members. All were selected from members. At least one director shall represent a domestic insurance company licensed to transact accident and health insurance. At least * * * shall represent Small Employer Carriers. At least * * * shall represent an HMO. At least * * * shall represent a nonprofit hospital.

During the year under examination, * * * did not have any insurance or reinsurance policies in force. No premiums were received. Only income received by the organization was investment income. * * * assessed its members * * * to help cover expenses, including a loan that was outstanding with a bank.

During the year there were no claims filed or paid. There were no policies for claims to be filed. Only expenses incurred during the year included administrative expenses, interest expense, and some professional fees.

At the beginning of the year, * * * reported $* * * as Loss Reserves on its Form 990. In Part II, Statement of Functional Expenses, of Form 990 for 20XX, * * * reported a reduction in expenses by the same amount and labeled it, "Health Benefits Recovered". At the end of 20XX, there were no Loss Reserves reported on Form 990.

Form 990 was filed for the 20XX tax year. The following is a breakdown of the Gross Receipts received by * * * for the year ending December 31, 20XX, and the percentage of Written Premiums to Gross Receipts for the same years.

 

 

An election under IRC 831(b) has never been filed. As of the writing of this report, there has never been a filing of the election, either with the filing of the Forms 990 or separately.

Neither I.R.C. 501(c)(15) nor its corresponding regulations define an "insurance company." Subchapter L of the Code (I.R.C, sections 801-848), however, addresses the taxation of insurance companies. The term "insurance company" has the same meaning under section 501(c)(15) as it does in Subchapter L. See H. Conf. Rep. No. 99-841, 99^th Cong., 2^nd Sess. (Vol. II) 370-71, reprinted in 1986-3 (Vol. 4) C.B. 370-71.

I.R.C. section 816 (formally I.R.C. section 801) defines a life insurance company. As part of this definition, I.R.C, section 816 provides, "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."

Treas. Reg. section 1.801-3(a)(1) defines an insurance company as;

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 Internal Revenue Code.

In this case, * * * primary and predominant business activity was not the issuing of insurance or annuity contracts or the reinsuring of risks underwritten by insurance companies. * * * was not involved in either of these two activities. Its sole purpose was to collect investment income from the investment accounts.

Another aspect to consider in this case is that there are no insurance contracts that provides both risk shifting and risk distribution. In AMERCO & Subsidiaries, 96 T.C. 18 (1991), a case affirmed by the 9^th Circuit, the Tax Court adopted a three-part test The three parts consist of; (1) Is the risk an insurance risk?; (2) Is there risk shifting and risk distribution?; and (3) Is there insurance in its generally accepted sense?

Neither the Internal Revenue Code nor the Regulations specifically define the term "insurance contract." The courts have generally required that a transaction involve both risk shifting (from the insured's perspective) and risk distribution (from the insurer's perspective) in order to be characterized as insurance. Helvering v. Le Gierse, 312 U.S. 531, 539 (1941); Gulf Oil Corp. v. Commissioner, 914 F.2d 396, 411 (3^rd Cir. 1990).

Risk shifting occurs when a person facing the possibility of a loss transfers some or all of the financial consequences of the loss to the insurer. Rev. Rul. 88-72, 1988-2 C.B. 31, clarified by Rev. Rul. 89-61, 1989-1 C.B. 75. The risk transferred pursuant to an insurance contract must be a risk of economic loss. Allied Fidelity Corp. v. Commissioner, 66 T.C. 1068 (1976), aff'd., 572 F.2d 1190 (7^th Cir. 1978), cert. denied, 439 U.S. 835(1978).

It is exam's position that risk distribution requires both a distribution of exposure units and a distribution of a pool of premiums. In addressing distribution courts have focused on one or the other, but no case has address both.

Risk distribution of exposure units refers to the operation of the statistical phenomenon known as the "the law of large numbers." When additional statistically independent risk exposure units are insured, although the potential total losses increase, there is also an increase in the predictability of average loss. This increase in the predictability of the average loss decreases the amount of the capital that an insurance company needs per risk unit to remain at a given solvency level. See Rev. Rul. 89-61, 1989-1 C.B. 75.

The Courts have not spent a great deal of time explaining what they mean by risk distribution. No court has squarely held that there can be no risk distribution if there is only one, or a few, insureds. A fair reading of the court opinions addressing the issue, however, supports the IRS's position. See Barnes v. United States, 801 F.2d 984, 985 (7^th Cir. 1986) ("Risk distributing is the spreading of the risk of loss among the participants in an insurance program."). See also, Commissioner v. Treganowan, 183 F.2d 288 , 291 (2^nd Cir. 1950). Such spreading is effectuated by pooling among unrelated insureds. "[R]isk distribution means that the party assuming the risk distributes his potential liability, in part, among others." Beech Aircraft Corp. v. United States, 797 F.2d 920, 922 (10^th Cir. 1986). Risk distribution is accomplished where the risk is distributed among insureds other than the entity that incurred the loss. See Ross v. Odem, 401 F.2d 464 (5^th Cir. 1968).

The Sixth Circuit touched on the issue of risk distribution in Humana, Inc. v. Commissioner, 881 F.2d 247, 257 (6^th Cir. 1989), noting that there was adequate risk distribution, "where the captive insures several separate corporations within an affiliated group and losses can be spread among the several distinct corporate entities." The Ninth Circuit has also measured risk distribution by explaining, "[i]nsuring many independent risks in return for numerous premiums serves to distribute risk. By assuming numerous relatively small, independent risks that occur randomly over time, the insurer smoothes out losses to match more closely its receipt of premiums." Clougherty Packing Co. v. Commissioner, 811 F.2d 1297, 1300 (9^th Cir. 1987)

* * * did not issue or reinsure any policies. Its only activity was collecting investment income from their investment accounts and assessing its members to help cover administrative costs. There was no risk shifting and risk distribution with because * * * had no insurance policies.

Also, to show that * * * was not an insurance company was the lack of reserves to pay claims, and the payment of claims themselves. * * * started the year with reserves but during the year they decreased the reserve amount to zero and reported the amount as a reduction in expenses labeled, "Health Benefits Recovered". The reserves were not needed because there were no claims or potential claims.

Therefore, it is of the Service's position that * * * did not qualify as an insurance company under IRC 501(c)(15). To qualify for tax exempt status under IRC 501(c)(15), an organization must be operating as an insurance company.

The Commissioner may revoke a favorable determination letter for good cause. Regulations 1.501(a)-1(a)(2). A favorable determination letter may be revoked by written notice to the organization to whom the determination originally was issued. Regulations 601.201 (m) (cross-referencing Reg. 601.201(1)); Rev. Proc. 90-27, 14, 1990-1 C.B. 514, 518.

If the Commissioner revokes the tax exempt status of an organization, the remaining question is whether the revocation should be applied prospectively or retroactively. Generally, revocation of a determination letter is prospective. Rev. Proc. 2008-4, 14.02 (cross-referencing 13.01 et seq.). Revocation of a determination letter may, however, be retroactive if the organization omitted or misstated a material fact or operated in a manner materially different from that originally represented. Regulations 601.201(n)(6)(i); Rev. Proc. 90-27, 14.01; Rev. Proc. 2008-4 14.02 (cross-referencing 13.01 et seq.).

In cases where the organization omitted or misstated a material fact, revocation may be retroactive to all open years under the statute. Regulations 601.201(l)(1). In cases where revocation is due to a material change, inconsistent with exempt status, in the character, the purpose, or the method of operation, revocation will ordinarily take effect as of the date of the material change. Regulations 601.201(n)(6)(i); Rev. Proc. 90-27. In any event, revocation will ordinarily take effect no later than the time at which the organization received written notice that its exemption ruling or determination letter might be revoked. Regulations 601.201(n)(6)(i).

Under certain circumstances, however, the Commissioner may, in his discretion grant relief from retroactive revocation under I.R.C. 7805(b) of the Code. Section 7805(b)(8) of the Internal Revenue Code provides:

The Supreme Court has held that the Commissioner has broad discretion under I.R.C. 7805(b) (and its predecessor) in deciding whether to revoke a ruling retroactively. Automobile Club of Michigan v. Commissioner. 353 U.S. 180, 184 (1957). See also Dixon v. United States, 381 U.S. 68, 74-75 (1965). The Commissioner's determination is reviewable by the courts only for abuse of that discretion. Virginia Education Fund v. Commissioner, 85 T.C. 743, 752 (1985).

It is the Service's position that the activities of the organization have changed dramatically compared to the organizing documents above. If the organization would seek exemption now, based on its current activities, there is a very high probability it would not receive a determination letter from the Service granting tax exempt status under IRC 501(c)(15). The insurance activities that were conducted when the organization applied for exemption are no longer being conducted.

Therefore, it is appropriate for the Commissioner to NOT grant relief from retroactive revocation of * * * determination letter.

IRC 831 discusses tax on insurance companies other than life insurance companies.

IRC 831(a) states as a general rule, "Taxes computed as provided in section 11 shall be imposed for each taxable year on the taxable income of every insurance company other than a life insurance company."

IRC 831(b) provides an alternative tax for certain small companies. It states in IRC 831(b)(1) that, in general, "In lieu of the tax otherwise applicable under subsection (a), there is hereby imposed for each taxable year on the income of every insurance company to which this subsection applies a tax computed by multiplying the taxable investment income of such company for such taxable year by the rates provided in section 11(b)."

IRC 831(b)(2) discusses the companies to which this subsection applies.

Regs. 301.9100-8(a)(3) describes the manner of making elections. It states," Except otherwise provided in this section, the elections described in paragraph (a)(1) of this section must be made by attaching a statement to the tax return for the first taxable year for which the election is to be effective."

Based on the Code and Regulation sections above, * * * is not entitled to the relief under IRC 831(b), for 2006, because it did not meet the requirements of Regs 301.9100-8(a)(2), and therefore would be required to report all income and expenses on Form 1120 for each year. As of this writing, the election has never been filed, either with the filing of the Form * * * or separately. When an election is filed, it would only allow the organization to receive relief under IRC 831(b) in the year it is filed and all future years. The election would not be retroactive to any prior years.

Therefore, * * * would be responsible for filing Form 1120 for years beginning January 1, 20XX and the election under IRC 831(b) would not be applicable until the election is made and for only the year it was made and subsequent years. The election can not be made retroactively.