The IRS on March 24, 2017, publicly released two written determination letters* concluding that the taxpayer did not qualify as an exempt section 501(c)(15) insurance company because its primary activity is not insurance and the purported insurance or reinsurance transactions lack economic substance.
*Written determination letters are documents the IRS is required to make open to public inspection pursuant to the provisions of I.R.C. Sec. 6110. They do not contain proprietary information; however, it is important to note that, pursuant to section 6110(k)(3), such items cannot be used or cited as precedent. Nonetheless, such determination letters can provide useful information about how the IRS may view certain issues.
The facts are similar in both rulings. The taxpayer was formed as a foreign captive insurance company to provide certain property and casualty insurance type services. Created as a controlled foreign corporation, 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 (“IRC”). The taxpayer wrote several direct-written contracts of which the IRS concluded that all but one of the contracts represented a business or investment risk rather than a true insurance risk.
The issues analyzed were as follows:
Whether the contracts executed constitute contracts of insurance
The IRS analyzed the risk of the contracts to determine whether the contracts qualify as contracts of insurance, annuity contracts, or reinsurance contracts rather than those dealing with a business or investment risk. Cases analyzing captive insurance arrangements have described the concept of insurance for federal income tax purposes as containing three elements: (1) involvement of an insurance risk; (2) shifting and distributing of that risk; and (3) insurance in its commonly accepted sense1. The test, however, is not rigid and there is also no single definition of insurance for non-tax purposes.
With regard to whether a business or investment risk was present within the contracts elements such as the following were considered: the ordinary activities of a business enterprise, the typical activities and obligations of running a business, whether an action that might be covered by a policy is in the control of the insured, whether the economic risk involved is a market risk that is part of a business environment and whether the insured is required by law or regulation to pay for the covered claim, etc.
The following policies were reviewed by the IRS:
1. Special Risk – Collection Rate Insurance Policy
The policy indemnifies for a portion of the differential between the Net Collection Percentage (NCP) for cash collections relating to billed invoices during the covered period and the NCP during a baseline period. The NCP is calculated by dividing the actual collections amount during a specified period into the gross billings amount for that same period. The IRS concluded that the policy is not insurance because there is no insurance risk but only investment or business risk.
2. Excess Directors & Officers Liability Insurance Policy
The policy covers wrongful acts of directors and officers and the IRS concluded that this is insurance in the commonly accepted sense.
3. Excess Employment Practices Liability Insurance Policy
This covers 11 categories of wrongful acts including wrongful termination, refusal to hire or promote, retaliatory treatment, etc. The IRS concluded that this policy was not insurance since there is no insurance risk but only investment or business risk.
4. Special Risk – Expense Reimbursement Insurance Policy
This coverage deals with (a) crisis management public relations expenses to mitigate the insured’s adverse publicity generated from an actual or imminent liability incident and also (b) uninsured defense for actual or alleged civil liability where there is no insurer to provide such coverage. The IRS concluded that the crisis management coverall deals with investment or business risks (not insurance risk) and that the terms of the uninsured deference coverage were vague and more information was needed.
5. Special Risk – Loss of Major Business to Business (“B-2-B”)
This policy covers any business interruption suffered as a result of losing services of a major B-2-B relationship. Because it includes losses such as revenue and extra expenses involved in replacement relationships, the IRS concluded that this coverage involved only business risk, not insurance risk.
6. Special Risk – Loss of Services Insurance Policy
This policy covers the involuntary loss of services for key employees because of sickness, disability, death, loss of license, etc. The IRS concluded this was not insurance because the policy covered many non-insurance risks that were only investment or business risks.
7. Special Risk – Payee Audit This policy covers the amount of unexpected audit liability insured as a result from an audit by the State Workers Compensation Commission as well as expenses incurred in preparation for the audit. Because it is questionable whether an audit from the State was even a possibility, the IRS concluded there was no insurance risk in the commonly accepted sense, but only an investment or business risk.
8. Excess Pollution Liability Insurance Policy
This policy covers clean-up costs and diminution in value costs resulting from pre-existing or new on-site pollution conditions and provides for third party claims for on-site or off-site clean-up. Again the IRS concluded that there was only an investment or business risk.
9. Special Risk – Punitive Wrap Liability Insurance Policy
This policy covers claims for punitive or exemplary damages upon the failure of the insurer under policies listed that are issued to the insured to cover punitive or exemplary damages, judgments, or awards solely due to the enforcement of any law or judicial ruling that precludes the insuring of punitive or similar damages and that but for such law or ruling would otherwise be covered. The IRS concluded that this policy was not for insurance but only investment or business risk.
10. Regulatory Changes Insurance Policy
This policy covers actual compliance expenses and any business interruption loss as a result of any regulatory change that has an adverse impact on normal on-going business operations. The IRS concluded that this policy did not involve insurance but only an investment or business risk.
11. Special Risk – Representation and Warranties Insurance Policy
The IRS concluded that this contract was too vague to assess whether or not this could be insurance in the commonly accepted sense.
12. Special Risk – Breach of Medical Standards Insurance Policy
This policy covers all fines, penalties, defense expense, and costs to bring operations in compliance resulting from an investigation or hearing brought by a public regulatory agency. The IRS concluded that more information was needed to determine what the policy actually covered.
13. Special Risk – Tax Liability Insurance Policy
This policy covers additional tax liability and defense expenses incurred in determining the final tax liability amount. The IRS concluded that the policy is not insurance in the commonly accepted sense because it only involved investment or business risk.
Whether the arrangements involved the requisite elements of risk distribution
Risk distribution incorporates the statistical concept known as the law of large numbers. It emphasizes that it is the pooling aspect of insurance, i.e., the nature of an insurance contract to be part of a larger collection of coverages and that the risks are distributed among the insureds.
The IRS concluded that the facts preclude a sufficient pooling (and distribution) of risks to constitute insurance. In reaching this conclusion, the IRS noted that most of the risk insured by the taxpayer is under the direct written contracts with affiliated businesses, which are partially-owned by a beneficial owner of the taxpayer.
Does the taxpayer qualify for treatment as a tax-exempt entity under section 501(c)(15) of the Internal Revenue Code (“IRC”)?
Section 501(c)(15) provides exemptions for insurance companies if the gross receipts for the taxable year do not exceed $600,000 and more than 50% of those gross receipts consist of premiums.
Based on the IRS’s analysis only one of the contracts was deemed to be insurance. Therefore, the amounts received by the taxpayer for the remaining contracts are not considered insurance premiums and, therefore, more than 50% of the business could not be the issuing of insurance or annuity contracts.
Because the taxpayers did not qualify as an insurance company for federal income tax purposes, they fail to meet the requirements of section 501(c)(15) of the Code. Thus, the taxpayers did not qualify for recognition of exemption under section 501(a) of the Code as an organization described in section 501(c)(15).
Since the IRC 953(d) election has not been approved by the IRS, the taxpayers must be treated as a controlled foreign corporation, and the subpart F provisions must apply.
Organizations that are not exempt under section 501 generally are required to file federal income tax returns (Form 1120, Form 1041 or Form 1120-F for foreign corporations) and pay tax, where applicable.
The written determination letters are responses to tax exemption requests under section 501(c)(15), which were written by the IRS Exempt Organizations division rather than the Insurance Branch. The recent Rent-A-Center (RAC)2 and Securities3 decisions don’t appear to be taken into consideration into the IRS’s analysis. For example, in Securitas the court held that the risk distribution requirement was met based on the hundreds of thousands of employees and vehicles insured under the captive arrangement. The idea that risk distribution relies on insurable units instead of entities with economic risk of loss was present throughout the case. Similarly, in RAC, the court held that the subsidiaries had a sufficient number of statistically independent risks and therefore adequate risk distribution was present to constitute insurance. It is unclear why these recent cases were not considered.
The written determination letters also disregard the recent R.V.I.4 decision which held that “residual value insurance”—a contract that insures against the risk that the residual value of an asset, when returned at the end of a lease, will be significantly lower than the expected value—as sold by the taxpayer constituted contracts of “insurance” for federal income tax purposes. The insureds in R.V.I. purchased insurance to protect against the risk that unexpected events would wreak havoc with lease-pricing formulas and generate an ordinary business loss instead of a profit. The court held that is not an investment risk or a business risk; it is a risk at the very heart of the lessor’s business model. The court was not persuaded by the government’s argument that it was a given (and thus not a fortuity) that market forces would affect the value of the assets covered under the R.V.I. policies. The R.V.I. decision seriously undercuts the determination letters’ position that most of the described policies were not insurance because they covered business or investment risks.
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 See AMERCO, Inc. v. Commissioner, 979 F.2d 162, 164-65 (9th Cir. 1992).
 Rent-A-Center, 142 T.C. No. 1 (January 14, 2014)
 Securitas Holdings Inc. and Subsidiaries v. Commissioner, T.C. Memo
2014-225 (October 29, 2014)
 R.V.I. Guaranty Co. Ltd. et al. v. Commissioner, 145 T.C. No. 9 (Sep. 21, 2015).
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