part7-67

IRC 501(c)(15) was amended by the Tax Reform Act
of 1986 (TRA-86). It exempts from income tax “insurance companies
or associations other than life (including interinsurers and reciprocal underwriters)
if the net written premiums (or, if greater, direct written premiums) for
the taxable year do not exceed $350,000.”

IRC 501(c)(15) was amended again by Section 206 of the Pension Funding
Equity Act of 2004 (HR 3108) (the 2004 Act) to provide clarification of exemption
from tax for small property and casualty insurance companies.

Specifically, IRC 501(c)(15) was amended to exempt from income tax insurance
companies (as defined in IRC 816(a)) other than life (including interinsurers
and reciprocal underwriters) if

Section 206(a) of the 2004 Act provides a transition rule for insurance
companies in receivership or liquidation. In the case of a company or association
that, for the taxable year that includes April 1, 2004, meets the requirements
of section 501(c)(15)(a) of the Code, as in effect for the last taxable year
beginning before January 1, 2004, and that is in a receivership, liquidation,
or similar proceeding under the supervision of a State court on April 1, 2004,
the amendments made by section 206 of the 2004 Act apply to taxable years
beginning after the earlier of the date such proceeding ends or December 31,
2007.

The 2004 Act retains the controlled group rule, now requiring aggregation
of gross receipts with those of other members of its controlled group defined
by sections 831 and 1563 of the Code.

Except for companies in receivership or liquidation, discussed in (4)
above, the 2004 Act shall apply to taxable years beginning after December
31, 2003.

In order to qualify for recognition of exemption
under IRC 501(c)(15), an organization:

In addition, an organization must meet one of the following tests:

A mutual company must meet one of the following tests:

Insurance companies in liquidation, or rehabilitation,
are insurance companies for the purpose of IRC 501(c)(15), even though they
do not issue, or reinsure insurance contracts, when their primary activity
involves administering claims.

The Service has taken the position that insurance
companies in liquidation that do not issue insurance contracts, but only administer
claims, may qualify as insurance companies. However, when such companys investment
activity generates more income than necessary to pay its claims, the “excess”
investment activity is non-insurance business. If over
one-half of a company’s business is excess investment activity, the
company is not an insurance company.

“Return premium income”
is
premium income returned by third-party reinsurance companies and is considered
premium income for both the premium income and gross receipts tests under
IRC 501(c)(15). However, when insurance companies in liquidation no longer
receive substantial premiums and their main source of income is investment
income, they may qualify under IRC 501(c)(15), even though they may have millions
of dollars in annual investment income. See Rev. Rul. 67–80, 1967–1
C.B. 143.

IRC 816 states that burial and funeral benefit
insurance companies that provide benefits in the form of supplies and services
are classified as insurance companies other than life, and may qualify for
exemption under IRC 501(c)(15). (See

Thompson v. White River Burial Association, 178 F.2d 954 (8th Cir.
1950). If benefits are paid in cash, the organization is deemed a life insurance
company and exemption is considered under IRC 501(c)(12).

An organization applying for exemption under IRC
501(c)(15) must file its application on Form 1024.

Democratic control by policyholders defined —
Whether democratic control is in the policyholders of a mutual insurance company
depends on the circumstances of each case and is determined by the control
which the policyholders actually exercise, to the exclusion of any group other
than policyholders, and not upon the unexercised power to control which such
other group has by statute or otherwise. Rev. Rul. 55–240, 1955–1
C.B. 406, as clarified by Rev. Rul. 58–616, 1958–2 C.B. 928.

Democratic ownership required — In the absence
of democratic ownership and control by the policy members, an insurance company
may not qualify as a mutual insurance company. Rev. Rul. 55–240, 1955–1
C.B. 406, as clarified by Rev. Rul. 58–616, 1958–2 C.B. 928.

Gross income determination, inclusion of reinsurance
or return premiums — In determining the gross amount (income) received
by a mutual insurance company during the year for purposes of the limitation
provided in IRC 501(c)(15), premiums written or received on insurance contracts
during the taxable year are to be taken into account without deduction for
amounts paid or incurred for reinsurance or for return premiums. Rev. Rul.
67–80, 1967–1 C.B. 143.

Economic Family Theory – In Rev. Rul. 77-316, 1977-2 C.B. 53, the Service
ruled, in three situations, that the contractual arrangement between the domestic
parent and subsidiaries and the insurance subsidiary did not qualify as insurance
for federal income tax purposes. In Situation 1, a parent corporation and
its subsidiaries paid amounts as insurance premiums directly to an insurance
subsidiary. In Situation 2, the premiums were paid to an unrelated insurance
company, and the parties agreed that the unrelated company would immediately
transfer 95 percent of the risks under a reinsurance agreement to the insurance
subsidiary. In Situation 3, the parent and subsidiaries paid premiums to the
insurance subsidiary, with the understanding that it would transfer 90 percent
of the risk through a reinsurance agreement to an unrelated insurance company.
In each situation, the insurance subsidiary insured no other parties and was
wholly owned by the parent. On June 25, 2001, Rev. Rul. 77-316 was revoked
and replaced with Rev. Rul. 2001-31.

Economic Family Theory Revoked – In Rev. Rul. 2001-31, 2001-1 C.B. 1348,
the Service ruled that it would no longer invoke the economic family theory
with respect to captive insurance transactions. The Service may, however,
continue to challenge certain captive insurance transactions based on the
facts and circumstances of each case.

In Rev. Rul. 2002-89; 2002-52 I.R.B. 1, the Service provided guidance
on whether arrangements between a parent and a subsidiary insurance company
qualified as an insurance arrangement and whether premiums paid were deductible
under section 162 of the Code.
(a) Specifically, Situation 1 described
a domestic corporation that entered into an annual arrangement with its wholly-owned
insurance subsidiary. In doing so, the subsidiary either insures or reinsures
the liability risks of the parent corporation. All business is maintained
separately and the parent does not guarantee the subsidiarys risks. Also,
90 percent of the total premiums are received from the parent corporation
on both a gross and net basis. The Service pointed out that when the total
risk and liability coverage is more than 90 percent for the subsidiary, there
is no risk shifting and risk distribution. Accordingly, the Service held that
there was no insurance arrangement and that amounts paid by the parent to
the subsidiary were not deductible under section 162.
(b) Situation 2
has the same fact pattern as Situation 1 except the premiums subsidiary earns
from the arrangement with parent constitute less than 50 percent of subsidiarys
total premiums earned during the taxpayer year on both a gross and net basis.
The liability coverage the subsidiary provides to parent accounts for less
than 50 percent of the total risks borne by subsidiary. The ruling stated
in Situation 2, the arrangement between parent and subsidiary constitutes
insurance for federal income tax purposes, and the amounts paid by parent
to subsidiary pursuant to that arrangement are deductible as premiums under
section 162 of the Code.

In Rev. Rul. 2002-90, 2002-2 I.R.B. 985, describes a holding company
owning stock of 12 subsidiaries. The holding company formed a wholly-owned
insurance subsidiary to directly insure the liability risks of the 12 subsidiaries
of the holding company. The 12 subsidiaries are charged arms-length premiums,
which are established according to customary industry rating formulas. None
of the operating subsidiaries have liability coverage for less than 5 percent,
nor more than 15 percent, of the total risk insured by the wholly-owned insurance
subsidiary. There are no parental (or other related party) guarantees of any
kind, nor does the insurance subsidiary loan any funds to the holding company
or to the 12 operating subsidiaries. The liability risks of the 12 subsidiaries
are pooled such that a loss by one operating subsidiary is borne, in substantial
part, by the premiums paid by others. Therefore, the Service held that the
arrangements between the insurance company and the 12 subsidiaries of the
holding company constitute insurance.

In Rev. Rul. 2002-91, 2002-52 I.R.B. 991, describes a group captive
(GC) formed by a small group of unrelated businesses involved in a highly
concentrated industry to provide insurance coverage is an insurance company
within the meaning of section 831 of the Code. GC was an entity separate from
its owners and adequately capitalized. GC issues insurance contracts, charges
premiums, and pays claims after investigating the validity of the claim. GC
does not engage in any business other than insurance. The Service held that
such arrangement constitutes insurance.

Notice 2003-35 was published to remind taxpayers that an entity must
be an insurance company for federal income tax purposes in order to qualify
as exempt from federal income tax as an organization described in section
501(c)(15) of the Code. For an entity to qualify as an insurance company,
it must issue insurance contracts or reinsure risks underwritten by insurance
companies as its primary and predominant business activity during the taxable
year.

Notice 2002-70 describes many transactions designed to use a reinsurance
arrangement to divert income properly attributable to taxpayer to taxpayers
wholly-owned corporation to reinsure the policies sold by taxpayer. The wholly-owned
company takes the position that it is entitled to exemption under section
501(c)(15) of the Code. Taxpayers wholly-owned reinsurance company then is
subject to little or no federal income tax. The Service stated that it intends
to challenge the purported tax benefits from these transactions on a number
of grounds, specifically, whether the company whose primary and predominant
business activity was that of issuing insurance. Taxpayers using these transactions
that are the same as or similar to the transactions described in this Notice
are required to register or list their transactions and who fail to do so
may be subject to a penalty.

Notice 2004-65 modifies Notice 2002-70 by removing or delisting the
identification of transaction that are the same as, or substantially similar
to, transactions described in Notice 2002-70 as transactions for purposes
of section 1.6011-4(b)(2) of the Regulations and section 301.6111-2(b)(2)
of the Procedure and Administration Regulations. The Service will, however,
continue to scrutinize transactions described in Notice 2002-70 that are being
used to shift income from taxpayers to related companies purported to be insurance
companies that are subject to little or no U.S. federal income tax.

Notice 2004-64 alerts taxpayers to legislative amendments that may affect
the qualification of some insurance companies under section 501(c)(15) for
taxable years beginning after December 31, 2003. For example, an insurance
company with $650,000 of gross receipts in a taxable year would have been
eligible for exemption before the amendments to section 501(c)(15) if the
companys premiums for the year were $350,000 or less. However, for taxable
years beginning after December 31, 2003, an insurance company with $650,000
of gross receipts in a taxable year will not be eligible for exemption from
tax under section 501(c)(15), as amended by the 2004 Act, because the $600,000
gross receipts test will not be met. Conversely, an insurance company with
$500,000 of gross receipts in a taxable year would not have been eligible
to be exempt from federal income tax under former section 501(c)(15) if the
companys premiums were $375,000. However, for taxable years beginning after
December 31, 2003, an insurance company with $500,000 of gross receipts in
a taxable year, including $375,000 from premiums, will be eligible for exemption
under section 501(c)(15). Nonetheless, if the same company is a member of
a controlled group (as defined in section 501(c)(15)(C)), it will not qualify
if other members of the group have gross receipts in the taxable year in excess
of $100,000 because the $600,000 gross receipts test will not be met.

Notice 2005-49 requests comments on additional guidance concerning the
standards for determining whether an arrangement constitutes insurance for
federal income tax purposes.

Rev. Rul. 2005-40, 2005-27 I.R.B. 1, describes certain arrangements
and analyzes whether they constitute insurance for federal income tax purposes
and, if so, whether the amounts paid to the insurer are deductible as insurance
premiums and whether the insurer qualifies as an insurance company.