Determination Letter 201712013 Released March 24, 2017 Denied Transcribed from scan

Captive insurer denied exemption for insufficient insurance risk and distribution

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This page covers one taxpayer's ruling from 2017, which can't be cited as precedent. Ezel answers your situation under the current Code and IRS guidance, with citations.

Not precedent. Under 26 U.S.C. § 6110(k)(3), this written determination may not be used or cited as precedent. It resolved one taxpayer's situation on its specific facts, and identifying details were redacted by the IRS before release. The official IRS release (linked on this page as a PDF) is the authoritative source.

About this page: The plain-English summary and ruling snapshot below were written by Ezel based on the official IRS release. The full text is the IRS's own document.

Transcribed from a scanned original: the IRS released this determination as an image-only PDF. The full text below is a machine transcription, proofread against the scan. Check the original PDF before quoting exact language.

View official IRS release (PDF)

Plain-English summary

A foreign captive company claimed exemption as a small property and casualty insurer under section 501(c)(15). The IRS found that only one of the direct-written contracts it reviewed covered an insurance risk, while the other contracts covered business or investment risks, lacked fortuity, or were too vague to qualify as insurance. It also concluded that most premiums and risks came from a small group of affiliated businesses, so the arrangement lacked adequate risk distribution and functioned largely as self-insurance. The company's quota-share and credit-coinsurance arrangements did not cure that problem, and the IRS determined that qualifying premium income did not exceed 50 percent of gross receipts. Because the company was not an insurance company under subchapter L, it did not qualify for section 501(c)(15) exemption. The IRS also concluded that its section 953(d) election was ineffective and that it should be treated as a controlled foreign corporation subject to the subpart F rules.

Ruling snapshot

Question: Did the captive's related-party contracts and reinsurance arrangements make it an insurance company eligible for exemption under IRC § 501(c)(15)?
Outcome: denied
Key authorities: IRC §§ 501(c)(15), 816, 831, and 953(d); Rev. Rul. 2002-89; Rev. Rul. 2005-40

Full text (IRS public release)

Internal Revenue Service Department of the Treasury

Appeals Office
Employer Identification Number:

Release Number: 201712013 Person to Contact:
Release Date: 3/24/2017
Date: September 26, 2016

Employee ID Number:
ORG , Tel:
ADDRESS Fax:

Tax Period(s) Ended:
December 31, 20XX
December 31, 20XX
December 31, 20XX
Certified Mail December 31, 20XX

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 (Form 1120, Form 1041 or Form 1120-F for foreign corporations) 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

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: September 3, 2013
Taxpayer Identification Number:
ORG
ADDRESS Form:
990-EZ / 990
Tax Period(s) Ended:
12/31/20XX; 12/31/20XX;
12/31/20XX; 12/31/20XX
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 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. 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

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.

Enclosures:
Publication 892
Publication 3498
Form 6018-A

Report of Examination
Envelope

Sincerely,

Director, EO Examinations

ISSUES:

Whether the contracts executed by constitute contracts of insurance?
Whether the arrangement entered into by involves the requisite element of risk
distribution?
Whether more than half of the business of during each of the taxable years under

consideration is the issuing of insurance or annuity contracts or the reinsuring of risks
underwritten by insurance companies?

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?
Is the IRC 953(d) election valid if the taxpayer is not an insurance company, and the
election was never approved by the Service?

FACTS:

(“Taxpayer”) was formed and incorporated in on December 28, 20XX, under
the provisions of Section 9 of the Companies Act, 2000. The taxpayer was formed to provide
certain property and casualty insurance type services. The taxpayer is formed as a foreign
captive insurance taxpayer. The taxpayer is authorized to issue 0 common shares with a $0
par value. The taxpayer actually issued 0 shares in consideration of $0 capital contribution.

The taxpayer is wholly owned by , a State limited liability company, located at

; , as the sole shareholder, purchased 0 shares of the taxpayer's stock for $0, on
December 29, 20XX. is owned by (0%) and (0%), 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
the taxpayer. Other documents were received from CPA, 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 of the taxpayer.

is also a significant owner of — __, and owns and/or is associated with various other
business interests called “Affiliated Business Interests.”

The Affiliated Business Interests desired to insure certain of their property
and casualty exposures, and are unwilling, or in some cases, unable to do
so through the conventional insurance marketplace. The Affiliated
Business Interests looked at alternative methods of arranging such
insurance coverage and have found that providing such coverage through
a captive insurance company offers the best method for satisfying its
needs. will be operated primarily to accomplish this objective.

The taxpayer was created as a controlled foreign corporation. The taxpayer is not a member

of a controlled group of corporations. As a controlled foreign corporation, , President,
signed an IRC 953(d) election statement on February 23, 20XX. It appears that the election
statement was filed with the IRS ; office on the same day.

On October 14, 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
full tax year of the taxpayer. Prior to filing the Form 1024 application, the taxpayer had filed
Form 990 for the tax year ended December 31, 20XX, with the Ogden Service Center. ,
President, signed the application on September 29, 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.

Around November 20XX, the Form 1024 application was referred to Rulings and Agreements
in Washington, D.C., for consideration and ruling. The application was assigned to a Tax Law
Specialist for review. No action was taken on the application until January 20XX. On January
7, 20XX, the Tax Law Specialist mailed a letter to the taxpayer's domestic address ,

A copy of the letter was mailed to the taxpayer's attorney, Indv-3. The letter requested
additional information about the taxpayer’s operations. The taxpayer’s response to the letter
was due by February 7, 20XX. submitted the response to the request for additional
information on February 19, 20XX.

The Form 1024 application administrative file does not reflect any more action taken on the
organization’s application by the Tax Law Specialist between late February 20XX, and mid-

September 20XX. The taxpayer’s President, , submitted a letter dated September 16,
20XX, requesting that the Form 1024 application be withdrawn from further 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. In addition to not completing the exemption application process, there is no
evidence that its IRC 953(d) election statement was approved by the Internal Revenue
Service. On March 31, 20XX, the TEGE examining agent requested the effective date of the
IRC 953(d) election from the IRS ; office. On April 1, 20XX, the IRS ; office
informed the examining agent that the Service does not have record that the IRC 953(d)
election was ever approved.

The taxpayer's initial tax year consisted of the period, December 28, 20XX (the date of
incorporation), through December 31, 20XX. The taxpayer did not file a return for its initial
short tax year. The initial return filed by taxpayer was a Form 990 return for 20XX. Taxpayer
also filed Form 990 returns for the 20XX, 20XX and 20XX tax years.

The Financial Services Commission, , issued a Class ‘B: General Insurance License to
the taxpayer effective December 28, 20XX. The taxpayer did not conduct any business during
the period of December 28, 20XX, through December 31, 20XX. During the years under audit,
the taxpayer operated primarily to provide property and casualty “insurance” coverage to

, which is partially owned by an officer and beneficial owner of

In 20XX, the taxpayer wrote thirteen (13) direct-written contracts to as follows: (1)
Special Risk —Collection Rate, (2) Excess Directors & Officers Liability, (3) Excess
Employment Practices Liability, (4) Special Risk - Expenses Reimbursement, (5) Special Risk
— Loss of Major B2B Relationships; (6) Special Risk — Loss of Services, (7) Special Risk —
Payee Audit Liability; (8) Special Risk — Representations and Warranties; (9) Special Risk —
Breach of Medical Standards, (10) Excess Pollution Liability, (11) Special Risk — Regulatory
Changes, (12) Special Risk — Punitive Wrap Liability, and (13) Special Risk ~— Tax Liability,
Under the terms of each policy, was listed as the Lead Insurer (0%). The taxpayer was
listed as one of three Joint Insurers. Each Joint Insurer, ; ; and , assumed
0% of the risk. as Stop Loss Insurer, assumed the remaining 0% of the risk.

Each policy listed (“"); .( ”), and the (“ ”), located atAddress, ~~,
, as the Named Insureds.

Supplemental information submitted by taxpayer with the Form 1024 application revealed that
each of the Named insureds is owned as follows:

0%
0%
0%
and are not related to or
20XX Tax Year

Special Risk-Collection Rate Insurance Policy
(Policy Number: )

With the office practice currently billing several million dollars annually, a drop in its collection
rate of only percentage points, where attributable to factors largely outside of

control, such as levels of reimbursements by health insurers, pricing of services by third party
payers including Medicare, etc) would result in a six-figure decrease in revenue.

Excess Directors & Officers Liability Insurance Policy

(Policy Number: )
Actions against the directors and officers may follow from patients, referring physicians,
leased facilities, hospitals, managed care providers, or other third parties if billing

procedures are alleged to be inappropriate.

Excess Employment Practices Liability Insurance Policy
(Policy Number: )

is at risk for employment practices liability for discrimination, harassment, wrongful
termination, or similar wrongful act. Further, in some jurisdictions, these civil rights allegations
can come from third parties such as patients.

Special Risk — Expense Reimbursement Insurance Policy
(Policy Number: )
may confront unanticipated allegation, suspension of professional licenses, or other
adverse events, significant amounts of monies could be required for public relations crisis
management to avert and offset negative publicity which could ultimately lead to a loss of
business.
Special Risk — Loss of Major Business to Business Relationship

(Policy Number: )
is a participant in virtually all of the major managed care insurance plans in the
geographical area. of State, Medicare, and the Workers

Compensation Commission of State represents business relationships where a significant
exposure may exist.

Special Risk —- Loss of Services Insurance Policy
(Policy Number: )
As a professional practice, the practice is highly dependent on the services of ;
and The business is at risk of significant income loss upon the incapacitation or loss of
services from one or more of the insureds who are large or significant billers.
Special Risk-Payee Audit Liability Insurance Policy
(Policy Number: )

is at risk for potential unexpected costs or liability resulting from an audit, by the State
Workers Compensation Commission, of its billed medical services provided for patient
treatment of a worker's compensation related injury

Excess Pollution Liability Insurance Policy

(Policy Number: )

has a significant waste exposure which is excluded from its commercial general liability

insurance coverage. It deals with “sharps” (used needles, etc.), bodily fluids, and chemical
wastes on a daily basis. Handling procedures are in place; however, historical claims,
occurring industry-wide, illustrate that improper handling is possible and represents a
significant exposure. Further, contracts out its waste disposal and cannot guarantee
the proper disposal of its waste once it leaves facilities. If these wastes are mishandled,
a pollution incident could occur resulting in significant damage, injuries, cleanup costs, and
fines.

Special Risk-Punitive Wrap Liability Insurance Policy

(Policy Number: )
The Company is at risk if a jurisdiction rules that its conventional liability coverage cannot
provide coverage for punitive or exemplary damages. The damage awards are often
significant multiples of the actual damages sought by a plaintiff.

Special Risk-Regulatory Changes Insurance Policy
(Policy Number: )
is at risk of external factors such as regulatory changes in the field
specifically or in its industry as a whole, or even regulatory changes within the facilities at
which operates. could incur significant costs to come into compliance with rules

and regulations regarding or . There is also the possibility that
compliance may not be cost effective, thereby eliminating a revenue stream from the office
practice and also resulting in a potential loss of patients.

Special Risk-Representation and Warranties Insurance Policy

(Policy Number:
Under the terms of the May 20XX Reacquisition of assets of ; assigned to rights
to , to received certain amounts from other third parties under the Closing Documents or
other agreements associated with the sale. is at risk for any amounts that are
subsequently deemed uncollectible.

Special Risk-Breach of Medical Standards Insurance Policy
(Policy Number: )
is entrusted with and manages a large volume of sensitive personal information on
patients. The volume of “incidents” and related lawsuits from the mishandling/security breach
of sensitive personal information is on the rise — especially given the increasing reliance on
electronic data processing and the growing threat of identity theft from underground and
organized information thieves. These risks represent a potential and substantial exposure to

13.Special Risk - Tax Liability Insurance Policy
(Policy Number:
is also at risk if it were to suffer an adverse decision from an unexpected tax audit with
regard to its organizational structure, cash basis accounting, captive planning, billing
methodology, or any other federal tax related issue.

Each of the above contracts appeared to have written and sold by another captive company
called . In each contract, is reflected as the Lead Insurer. In addition, the policy
number reflected on each contract has the designation “ ” and then lists the type of
contract and the contract number. , as Lead Insurer, assumed 0% of the stated
Limits of Insurance. is reflected as one of three Joint Insurers, each of which assumed
0% of the stated Limited of Insurance. Together, the Lead and Joint Insurers assumed 0% of
the stated Limits of Insurance. The remaining 0% of the stated Limited of Insurance was

assumed by , as the Stop Loss Insurer. During 20XX, did not write, sale or
issue any direct written contracts to any related or unrelated parties for which it was the Lead
insurer.

Each direct written contract listed the Named Insured as ; and the , located
at . The policy period for each contract was from January 1, 20XX to January 1,
20XX.

The contracts also listed the aggregate limit of insurance and the premium paid by the total
Combined Premium paid by the Named Insured as follows:

Aggregate Combined
Contract Limit Premium
Special Risk-Collection Rate $ $ 0
Excess D&O Liability
Excess Employment Practices
Special Risk-Expense Reimb.
Special Risk-Loss of Major B2B
Special Risk-Loss of Services
Special Risk-Payee Audit
Excess Pollution Liability
Special Risk-Punitive Wrap
Special Risk-Regulatory Changes
Special Risk-Rep. and Warranties
Special Risk-Breach of Medical
Special Risk-Tax Liability
Totals $

[illegible]
[illegible]

The taxpayer relied on the services of and to establish the premium rating
methodology for the direct written contracts and the Quota Share Reinsurance Agreement.

Joint Underwriting Stop Loss Endorsement
With respect of each of the 13 above referenced property and casualty contracts, the taxpayer
and (“ ”) entered into an agreement titled, “Joint Underwriting Stop Loss
Endorsement.” The taxpayer and appear to be separate independent companies.
However, it is not known whether the companies are owned and controlled by related parties.
Under the terms of the agreement, the taxpayer is listed as the Lead Insurer, and is
responsible for payment of claims incurred by the Named Insureds under the direct written
contracts, up to certain specified thresholds. If the specified thresholds are met, then ,
as the Stop Loss Insurer, becomes liable for payment of claims up to certain secondary
specified limits. If the specified limits for payment of claims are exceeded, then the
taxpayer again becomes liable. For 20XX, the Named Insureds paid a total Combined
Premium of $0 for the 13 direct written contracts. Of the total Combined Premium paid by the
Named insureds $0 (or 0%) was paid to the taxpayer. 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.

For the 13 direct written contracts and the Joint Underwriting Stop Loss Endorsement
agreement, the Named Insureds was required to pay of total premiums of $0. Of the total
premium, $0 (or 0%) was paid to , as Stop Loss Insurer, and the balance of $0 (or 0%)
was paid directly to the taxpayer, as Lead Insurer.

Quota Share Reinsurance Agreement
The taxpayer also entered into two types of reinsurance arrangements. The first arrangement

is referred to as a “reinsurance risk pooling program.” executed a Quota Share
Reinsurance Policy (# ) with .The agreement indicates that is located at
is identified as the “Reinsurer” and is the “Reinsured.”

The policy runs from January 1, 20XX, to January 1, 20XX.

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+
insureds. 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 44 reinsurers participating in the Quota Share Reinsurance Program in 20XX. As Reinsurer

, the taxpayer received a Quota Share 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 a total combined reinsurance premium of $0 to the 44 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.

Credit Coinsurance Reinsurance Agreement
Under the terms of the second arrangement, which is referred to as the Credit Coinsurance
Reinsurance Program, 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%

For the tax year ended December 31, 20XX, the taxpayer reported total revenue of $0.
Revenue was derived primarily from premiums received from the direct written, reinsurance
risk pooling program, and the credit coinsurance reinsurance programs. The taxpayer
reported revenue from the following sources:

Per Return 20XX
Program Revenue Service
Direct Written Premiums $ 0
Quota Share Reinsurance Premiums 0
Credit Coinsurance Reinsurance Premiums 0
Total Premiums 0
investment Income 0
Proceeds from sale of assets’ (0
Other income -0
Gross Receipts $ 0

However, based on the audit, the gross receipts were adjusted as follows to comply with the
guidelines for the IRC 501(c){15) gross receipt tests described in Notice 20XX-42:

Per Audit 20XX
Program Revenue Service
Direct Written Premiums $
Quota Share Reinsurance Premiums
Credit Coinsurance Reinsurance Premiums
Total Premiums

[illegible]

' Proceeds of $0 less cost basis of $0, the incurred a net loss of $0. Only the net loss was reported on the return.

Investment Income
Gains from sale of assets
Other income
Gross Receipts, per audit $

The primary difference between gross receipts reported on the return and the gross receipts as
adjusted during the audit is, only gains from the sale of assets were included in adjusted gross
receipts based on the guidelines described in Notice 2006-42.

In 20XX, the taxpayer deposited the direct written premiums received from the Named
Insureds into its investment account.

Of the total premiums received by the taxpayer in 20XX, 0% of the premiums were generated
from the thirteen direct written policies with the Named Insureds, ; ; and the

; 0% of the premiums are from the Quota Share Reinsurance Risk Pooling Program; and 0% of
the premiums from the Credit Coinsurance Reinsurance Program.

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

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 participated in the same three
programs that it engaged in during the 20XX tax year: (1) direct written contracts with affiliated
business interests; (2) quota share risk pool reinsurance; (3) credit coinsurance reinsurance.
The taxpayer wrote fourteen (14) direct contracts to insure certain property and casualty of
Affiliated Business Interests. The taxpayer wrote many of the same direct contracts as was
written in 20XX, with a couple of exceptions. The taxpayer dropped the Special Risk-Loss of
Services and the Special Risk-Representation and Warranties contracts in 20XX. However,
the taxpayer added the Special Risk-Legal Expense Reimbursement and the Excess Cyber
Risk contracts in 20XX. The contracts appear to have been written by , as Lead Insurer.
The fourteen contracts were written for the policy period of January 1, 20XX, to January 1,
20XX. None of the fourteen direct contracts identified the names of the Insurers. The
contracts either never included this information, or the contracts were sanitized of this
information before the documents were submitted to the examining agent for review.
However, the Joint Underwriting Endorsement did reveal that the taxpayer was one of four
Insurers that assumed risk under the direct written contracts. The taxpayer assumed 0% of
the stated Limits of Insurance in exchange for 0% of the Combined Premium paid the Named

Insureds. Based on the information revealed during the review of the 20XX contracts, the
other Insurers involved in the direct written contracts were , and

appears to be the Lead Insurer, and ; and appear to be Joint Insurers.
The four captive companies assumed 0% of the stated Limits of Insurance in exchange for 0%
of the Combined Premium paid the Named Insureds. The remaining 0% of the Combined
Premium was paid to , as the Stop Loss insurer.

In 20XX, the direct written contracts listed the same three Named Insureds: ; ; and
. However, General Endorsement Changes were made removing the as one of the
three Named Insureds, and transferring its risk to another captive company. Effective October
1, 20XX, through January 1, 20XX, the insurance coverages for the was transferred
from to another unknown captive company. In the response to IDR #1 for the 20XX and
20XX tax years, the taxpayer’s , CPA, provided two sets of direct written contracts in
effective during 20XX. The CPA provided the fourteen contracts written by , in which
the taxpayer is a Joint Insurer. The CPA also provided a copy of the 14 fourteens written by
an unknown Lead Insurer. The designation of the Lead Insurer is . In his September
27, 20XX cover letter that accompanied the response to IDR #1 for 20XX and 20XX, the CPA
stated the confidential information of third was removed.

Taxpayer participated as a Joint Insurer in the following direct contracts written by with
the ; and

Aggregate

Contract Name Policy Number Limit Premium
Special Risk — Collection Rate $ 0 $ 0
Excess Directors & Officers Liability
Excess Employment Practices Liability
Special Risk ~ Expense Reimbursement
Expense Reimbursement — Legal Expenses
Excess Pollution Liability
Special Risk — Punitive Wrap
Special Risk ~ Regulatory Changes
. Special Risk — Tax Liability

Expense Reimbursement ~ Breach of Medical
Payer Audit Liability
Special Risk ~ Loss of Major B2B
Special Risk — Commercial Medical Malprac.
Excess Cyber Risk

Totals

[illegible]

[illegible]
[illegible]

The 20XX direct written premiums charged by the Lead Insurer were lower than the 20XX
premiums because coverages were transferred to another captive. Taxpayer did not
write, sale or issue direct written contracts to the general public or unrelated third parties.

Effective October 1, 20XX, the coverages for were transferred to another unknown
captive company. insured the same property and casualty coverages with as
with , With the exception that the Excess Cyber Risk contract was replaced by a Special
Risk- Loss of Service contract. is listed as the only Named Insured under the fourteen

direct contracts written by

Under the terms of the Joint Underwriting Endorsement with, the taxpayer is listed as one of
five Insurers. The taxpayer appears to be a Joint Insurer that agreed to assume 0% of the
stated Limits of Insurance in exchange for 0% of the Combined Written Premium by
The other four Insurers assumed the remaining 0% of the stated Limits of Insurance in
exchange for 0% of the Combined Premium paid by . Together, the five Insurers
assumed 0% of the stated Limited of Insurance in exchange for 0% of the Combined Premium
paid by . The remaining 0% of the Combine Premium was paid to as a Stop Loss
Insurer under the Joint Underwriting Endorsement. Page 1 of the Joint Underwriting
Endorsement includes the following language:
(" ”), as the Stop Loss Insurer, is not
Subject to Quota Share Participation, and is instead subject to the
Joint Underwriting Stop Loss Endorsement to the Policy.

In 20XX, the taxpayer participated as a Joint Insurer under the following direct contracts written
by :

Aggregate

Contract Name Policy Number Limit Premium
Special Risk — Collection Rate
Excess Directors and Officers
Excess Employment Practices
Special Risk — Expense Reimbursement
Legal Expense Reimbursement
Excess Pollution Liability
Special Risk — Punitive Wrap
Special Risk — Regulatory Changes
. Special Risk — Tax Liability

Breach of Medical Standards
Payer Audit Liability
Special Risk ~ Commercial Medical Mal.
13, Special Risk ~ Loss of Major B2B
Special Risk ~ Loss of Service

Totals $

[illegible]

[illegible]
[illegible]

According to the business plan, the taxpayer purchased the direct written contracts because of
the following exposures:

Special Risk-Collection Rate Insurance Policy

With the office practice currently billing several million dollars annually, a drop in its collection
rate of only percentage points, where attributable to factors largely outside of

control, such as levels of reimbursements by health insurers, pricing of services by third party
payers including Medicare, etc) would result in a six-figure decrease in revenue.

Excess Directors & Officers Liability Insurance Policy

Actions against the directors and officers may follow from patients, referring physicians,
leased facilities, hospitals, managed care providers, or other third parties billing
procedures are alleged to be inappropriate.

Excess Employment Practices Liability Insurance Policy

Special Risk — Expense Reimbursement Insurance Policy
may confront unanticipated allegation, suspension of professional licenses, or other

adverse events, significant amounts of monies could be required for public relations crisis
management to avert and offset negative publicity which could ultimately lead to a loss of
business.

Special Risk — Legal Expense Reimbursement
The contract covers all litigation expenses incurred by the Company resulting from actual or
alleged civil liability.
Excess Pollution Liability Insurance Policy

has a significant waste exposure which is excluded from its commercial general liability
insurance coverage. It deals with “sharps” (used needles, etc.), bodily fluids, and chemical
wastes on a daily basis. Handling procedures are in place; however, historical claims,
occurring industry-wide, illustrate that improper handling is possible and represents a
significant exposure. Further, contracts out its waste disposal and cannot guarantee
the proper disposal of its waste once it leaves facilities. If these wastes are mishandled,
a pollution incident could occur resulting in significant damage, injuries, cleanup costs, and
fines.

Special Risk-Punitive Wrap Liability Insurance Policy

The Company is at risk if a jurisdiction rules that its conventional liability coverage cannot
provide coverage for punitive or exemplary damages. The damage awards are often
significant multiples of the actual damages sought by a plaintiff.

Special Risk-Regulatory Changes Insurance Policy

is at risk of external factors such as regulatory changes in the field
specifically or in its industry as a whole, or even regulatory changes within the facilities at
which operates. could incur significant costs to come into compliance with rules
and regulations regarding or . There is also the possibility that
compliance may not be cost effective, thereby eliminating a revenue stream from the office
practice and also resulting in a potential loss of patients.

Special Risk - Tax Liability Insurance Policy

is also at risk if it were to suffer an adverse decision from an unexpected tax audit with
regard to its organizational structure, cash basis accounting, captive planning, billing
methodology, or any other federal tax related issue.

Special Risk-Breach of Medical Standards Insurance Policy

is entrusted with and manages a large volume of sensitive personal information on
patients. The volume of “incidents” and related lawsuits from the mishandling/security breach
of sensitive personal information is on the rise — especially given the increasing reliance on
electronic data processing and the growing threat of identity theft from underground and
organized information thieves. These risks represent a potential and substantial exposure to

Special Risk - Payee Audit Liability Insurance Policy

Special Risk — Loss of Major Business to Business Relationship

is a participant in virtually all of the major managed care insurance plans in the
geographical area. of State, Medicare, and the Workers
Compensation Commission of State represents business relationships where a significant
exposure may exist.

Special Risk — Loss of Services Insurance Policy

As a professional practice, the practice is highly dependent on the services of ,

and The business is at risk of significant income loss upon the incapacitation or loss of
services from one or more of the insureds who are large or significant billers.

14a. Special Risk — Commercial Medical Malpractice
The contract provides commercial malpractice coverage for the insured during the 20XX
calendar year. The contract reimburses the Named Insured for any loss sustained for which a

Claim against the underlying insurance policy specified above is denied solely and exclusively
to the exclusion, endorsement, or limitation specified above.

14b. Excess Cyber Risk

The contract protects the Named Insured from losses resulting from cyber-attacks such as
computer viruses, unauthorized access through cyber presence; and degradation or loss to its
system due to cyber presence.

JOINT UNDERWRITING ENDORSEMENT
In addition to the direct property and casualty insurance contracts, the taxpayer also executed
separate Joint Underwriting Stop Loss Endorsements, with , for the
and contracts, whereby both parties agreed to underwrite the insurance
coverages described in the 14 policies with the Affiliated Business Interests.

Under the Joint Underwriting Endorsement, the taxpayer is identified as one of four
Insurers. The other three Lead Insurers were sanitized from the contract. However, the
examining agent believes the parties are ; , and . The taxpayer assumed
0% of the stated Limits of Insurance in exchange for 0% of the Combined Premium paid the
Named Insureds.

Under the , the taxpayer is identified as one of five Insurers. The names of the other
four Insurers were sanitized from the agreement by the taxpayer's CPA. However, the
agreement reveals that taxpayer assumed 0% of the stated Limits of Insurance in exchange for
0% of the Combined Premium paid by , as the sole Named Insured. The terms of the
endorsements included the following language:

The Limits of Insurance shall be borne proportionately by all Quota Share
participants listed herein to a combined maximum of 0% of the Limits of
Liability stated in the Declarations.

, as the Stop Loss Insurer, is not subject to Quota Share Participation,
and is instead subject to the Joint Underwriting Stop Loss Endorsement to
the Policy.

Under the and , the Insurers assumed 0% of the stated Limits of Insurance in
exchange for 0% of the Combined Premium by the Named Insureds. The remaining 0% of the
Combined Premium was paid by the Named Insureds directly to

Therefore, in 20XX, the Combined Premium paid by the Named [nsureds under the fourteen
and contracts was allocated to the taxpayer as follows:

(Rev. January 1994}

14 Direct Written Contracts

Total combined premium $ 0 @ 0% $0
14 Direct Written Contracts

Total combined premium $ 0 @ 0% _0
Total Direct Written Premiums Rec’d by Taxpayer in 20XX $0

QUOTA SHARE REINSURANCE POLICY
Taxpayer continued to participate in the reinsurance risk pooling program by executing a
Quota Share Reinsurance Policy # ) with . The agreement indicates that
is located at , ; . Taxpayer is identified as the “Reinsurer” and
is the “Reinsured.”

According to the terms , as reinsurer, received a Quota Share 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. The policy period runs from January 1, 20XX, through January 1, 20XX.

The contract reflects a total of 58 reinsurers participating in the Quota Share Reinsurance
Program. paid total reinsurance premiums of $0 to the 58 reinsurers. is not
identified by number. However, there are three reinsurers listed on page 2 of Schedule 1 of
the contract that assumed 0% of the quota share risk pool. could either be Reinsurer

,Reinsurer# ,orReinsurer# . It is not pertinent to determine which of the three

reinsurers represents For purposes of the case write up, the examining agent
identified as Reinsurer #

As Reinsurer# , received a quota share reinsurance policy premium of $0, which was
equal to 0% of the total premium of $0. Of the $0 quota share premium received from ;
$0 is the portion of the premium retained by (as a quota share retained premium) until
the final accounting and settlement of the Risk Pool is completed. The final accounting and
settlement generally occurs 180 days following the expiration date shown in the Policy
declaration. The quota share retained premium is calculated at 0% of the quota share
reinsurance policy premium of $0.

CREDIT INSURANCE COINSURANCE CONTRACT
Taxpayer continued to participate in the Credit Coinsurance Contract with ,a in
which the taxpayer agreed to reinsure a prorate share (0%) of “all net retained policies in force
on the effective date assumed by from a corporation
under a treaty dated June 1, 20XX, with yan corporation that was merged into
, on January 1, 20XX.

The risks reinsured are the 20XX insurance exposures on all policies of vehicle service

contracts direct written by in force on January 1, 20XX, and subsequently issued, and
assumed by , from , under its treaty dated January 1, 20XX.
The reinsurance premiums to be paid by to the Taxpayer shall be

taxpayer's pro rata share (0%) of the earned premiums during the accounting period under
each reinsured policy. Earned premiums are the gross premiums charged the insureds plus
the unearned premiums at the beginning of the Accounting Period less the unearned
premiums at the end of the Accounting Period. Taxpayer received $0 in reinsurance premiums
under this contract 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%

For the tax year ended December 31, 20XX, the taxpayer reported gross receipts of $0 and
total revenue 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:

Program Revenue Service

Direct Written Premiums $ 0

Quota Share Reinsurance Premiums 0

Credit Coinsurance Reinsurance Premiums Q

Total Premiums 0 0%

Investment Income 0 0
Proceeds from sale of assets” 0 0
Other income -Q- 0.00

Gross Receipts 0 0.00%

• After offsetting cost basis of $0, the incurred a net gain of $0, Only the net gain was reported on the return.

The 20XX direct written premiums were deposited to the taxpayer's Investment
Account. The investment account statements revealed that the taxpayer received the direct
written premiums from the following payers:

$ 0 0%
0 0
Q Q
Total $ 0 0.00%

A list of the deposits is shown in Exhibit A that is attached to the end of this report.

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

Taxpayer's primary business continued to be that of providing property and casualty coverages

for the Named Insureds, ; , and . Taxpayer continued to operate as a Joint
Insurer for property and casualty coverages written for the Named Insureds by and
continued to provide property and casualty coverages to and , and

continued to provide coverages to

During 20XX, the taxpayer continued to operate as a Joint Insurer under the same 14 property
and casualty contracts written by , and the , as in the 20XX tax year. As in
20XX, taxpayer was one of four Insurers providing coverage to the Named Insureds. Although
the contracts were sanitized by taxpayer’s CPA, it appears that continued to serve as
the Lead Insurer, while ; and were Joint Insurers. The Lead Insurer
assumed 0% of the stated Limits of Insurance in exchange for 0% of the Combined Premium
paid by the Named Insureds. While each of the Joint Insurers assumed 0% of the stated
Limits of Insurance in exchange for 0% of the Combined Premium.

Together, the Insurers assumed 0% of the stated Limits of Insurance in exchange for 0% of the
Combined Premium paid by the Named Insureds. The remaining 0% of the Combined
Premium was paid by the Named Insureds to , as Stop Loss Insurer under the Joint
Underwriting Endorsement.

The 14 contracts written by , in 20XX, continued to list the Named Insureds as: ;

; and , even though coverages were transferred to effective October
1, 20XX. do not remove as a Named Insureds from its 14 property and casualty
contracts even though it was suppose to provide coverage only to and . However,
the 14 contracts written by did reflect as the sole Named Insured. The policy

period for each contract is January 1, 20XX, through January 1, 20XX.

During 20XX, the taxpayer did not insure direct contracts with unrelated and unaffiliated
parties, or the general public. Nor did the taxpayer write any direct contracts, during the years
under audit, with related or unrelated parties where it served as Lead Insurer.

Taxpayer served as a Joint Insurer under the following contracts written by in 20XX.
Aggregate

Contract Name Policy Number Limit Premium
Special Risk — Collection Rate $ 0 $
Excess Directors & Officers Liability
Excess Employment Practices Liability
Special Risk — Expense Reimbursement
Expense Reimbursement ~— Legal Expenses
Excess Pollution Liability
Special Risk — Punitive Wrap’
Special Risk — Regulatory Changes
. Special Risk — Tax Liability

Expense Reimbursement — Breach of Medical
Payer Audit Liability
Special Risk — Loss of Major B2B
Special Risk — Commercial Medical Mal.
Excess Cyber Risk

Totals

[illegible]
[illegible]

With respect to the contracts, the taxpayer was one of five Insurers that provided
property and casualty coverage to , as the sole Named Insured. Under the terms of the
contracts, the taxpayer is listed as one of five Insurers. The names of the Lead Insurer and
other Joint Insurers were sanitized by the CPA. The contracts continue to list as the
sole Named Insured.

Taxpayer agreed to assume 0% of the stated Limits of Insurance in exchange for 0% of the
Combined Premium paid by the Named Insured. Together, the five insurers agreed to insure

(Rev. January 1994}

100% of the stated Limits of Insurance in exchange for 0% of the Combined Premium paid by
, as the sole Named Insured. The remaining 0% of the Combined Premium was paid by
to , as the Stop Loss Insurer under the Joint Underwriting Endorsement.

Taxpayer served as a Joint Insurer under the following contracts written by in 20XX.

Aggregate
Contract Name Policy Number Limit Premium

Special Risk — Collection Rate $ 0 $ 0

Excess Directors & Officers Liability

Excess Employment Practices Liability

Special Risk ~ Expenses Reimbursement

Expense Reimbursement — Legal Expenses

Excess Pollution Liability

Special Risk — Punitive Wrap

Special Risk — Regulatory Changes

. Special Risk — Tax Liability

Expense Reimbursement — Breach of Med.
Payer Audit Liability
Special Risk — Loss of Major B2B
Special Risk - Commercial Medical Mal.
Special Risk - Loss of Service

Totals

[illegible]

[illegible]
[illegible]

According to the business plan, the taxpayer purchased the direct written contracts because of
the following exposures:

Special Risk-Collection Rate Insurance Policy

With the office practice currently billing dollars annually, a drop in its collection
rate of only percentage points, where attributable to factors largely outside of

control, such as levels of reimbursements by health insurers, pricing of services by third party
payers including Medicare, etc) would result in a six-figure decrease in revenue.

Excess Directors & Officers Liability Insurance Policy

Actions against the directors and officers may follow from patients, referring physicians,
leased facilities, hospitals, managed care providers, or other third parties if billing
procedures are alleged to be inappropriate.

Excess Employment Practices Liability Insurance Policy

Special Risk — Expense Reimbursement Insurance Policy

may confront unanticipated allegation, suspension of professional licenses, or other
adverse events, significant amounts of monies could be required for public relations crisis
management to avert and offset negative publicity which could ultimately lead to a loss of
business.

Special Risk — Legal Expense Reimbursement
The contract covers all litigation expenses incurred by the Company resulting from actual or
alleged civil liability.
Excess Pollution Liability Insurance Policy

has a significant waste exposure which is excluded from its commercial general
liability insurance coverage. It deals with “sharps” (used needles, etc.), bodily fluids, and
chemical wastes on a daily basis. Handling procedures are in place; however, historical
claims, occurring industry-wide, illustrate that improper handling is possible and represents a
significant exposure. Further, contracts out its waste disposal and cannot guarantee
the proper disposal of its waste once it leaves facilities. If these wastes are mishandled,
a pollution incident could occur resulting in significant damage, injuries, cleanup costs, and
fines.

Special Risk-Punitive Wrap Liability Insurance Policy

Special Risk-Regulatory Changes Insurance Policy

Special Risk - Tax Liability Insurance Policy

Special Risk-Breach of Medical Standards Insurance Policy
is entrusted with and manages a large volume of sensitive personal information on
patients. The volume of “incidents” and related lawsuits from the mishandling/security breach

of sensitive personal information is on the rise — especially given the increasing reliance on
electronic data processing and the growing threat of identity theft from underground and
organized information thieves. These risks represent a potential and substantial exposure to

Special Risk - Payee Audit Liability Insurance Policy

Special Risk — Loss of Major Business to Business Relationship

Special Risk — Loss of Services Insurance Policy

As a professional practice, the practice is highly dependent on the services of ,

and The business is at risk of significant income loss upon the incapacitation or loss of
services from one or more of the insureds who are large or significant billers.

14a. Special Risk — Commercial Medical Malpractice

The contract provides commercial malpractice coverage for the insured during the 20XX
calendar year. The contract reimburses the Named Insured for any loss sustained for which a
Claim against the underlying insurance policy specified above is denied solely and exclusively
to the exclusion, endorsement, or limitation specified above.

14b. Excess Cyber Risk

JOINT UNDERWRITING ENDORSEMENT
in addition to the direct property and casualty insurance contracts, the taxpayer also executed
separate Joint Underwriting Stop Loss Endorsements, with , for and
contracts, whereby both parties agreed to underwrite the insurance coverages described in the
14 policies with the Affiliated Business Interests.

Under the Joint Underwriting Endorsement, the taxpayer is identified as one of four
Insurers. The other three Lead Insurers were sanitized from the contract. However, the

examining agent believes the parties are , , and The taxpayer assumed
0% of the stated Limits of Insurance in exchange for 0% of the Combined Premium paid the
Named Insureds.

Under the Joint Underwriting Endorsement, the taxpayer is identified as one of five
Insurers. The names of the other four Insurers were also sanitized from the agreement by the
taxpayer's CPA. However, the agreement reveals that taxpayer assumed 0% of the stated
Limits of Insurance in exchange for 0% of the Combined Premium paid by , as the sole
Named Insured.

The terms of the endorsements included the following language:

The Limits of Insurance shall be borne proportionately by all Quota Share
participants listed herein to a combined maximum of 0% of the Limits of
Liability stated in the Declarations.

, as the Stop Loss Insurer, is not subject to Quota Share Participation,
and is instead subject to the Joint Underwriting Stop Loss Endorsement to
the Policy.

Under the and Joint Underwriting Endorsements, the Insurers assumed 0% of
the stated Limits of Insurance in exchange for 0% of the Combined Premium by the Named
Insureds. The remaining 0% of the Combined Premium was paid by the Named Insureds
directly to

Therefore, in 20XX, the Combined Premium paid by the Named Insureds under the fourteen

and contracts was allocated to the taxpayer as follows:
14 Direct Written Contracts
Total combined premium $ 0 @ 0% $ 60
14 Direct Written Contracts
Total combined premium $ 0 @ 0% 0
Total Direct Written Premiums Rec'd by Taxpayer in 20XX $ 0

QUOTA SHARE REINSURANCE POLICY
Taxpayer continued to participate in the reinsurance risk pooling program by executing a
Quota Share Reinsurance Policy (# ) with . The agreement indicates that is

(Rev. January 1994}

located at , , . Taxpayer is identified as the “Reinsurer” and is the
“Reinsured.”

According to the terms , as reinsurer, received a Quota Share 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. The

policy period runs from January 1, 20XX, through January 1, 20XX.

The policy reflects a total of 53 reinsurers participating in the Quota Share Reinsurance
Program. Taxpayer is identified as Reinsurer# in Schedule 1A attached to the policy. In
20XX, paid premiums of $0 to the 53 reinsurers.

As Reinsurer# , Taxpayer received a quota share reinsurance policy premium of $0, which
was equal to 0% of the total premium of $0 paid by to the reinsurers.

CREDIT INSURANCE COINSURANCE CONTRACT

Taxpayer continued to participate in the Credit Coinsurance Contract with ,a in
which the taxpayer agreed to reinsure a prorate share (0%) of “all net retained policies in force
on the effective date assumed by from an corporation under a treaty
dated June 1, 20XX, with ,a corporation that was merged into , on January
1, 20XX.

The risks reinsured are the 20XX insurance exposures on all policies of vehicle service
contracts direct written by in force on January 1, 20XX, and subsequently issued, and
assumed by , from , under its treaty dated January 1, 20XX.

The reinsurance premiums to be paid by to the Taxpayer shall be taxpayer's pro rata

share (0%) of the earned premiums during the accounting period under each reinsured policy.
Earned premiums are the gross premiums charged the insureds plus the unearned premiums
at the beginning of the Accounting Period less the unearned premiums at the end of the
Accounting Period. Taxpayer received $0 in reinsurance premiums under this contract in
20XX.

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

Direct Written Premiums $ O 0%

Quota Share Reinsurance Assumed 0 0

Other Reinsurance Assumed 0 0
Total $ 0 0.00%

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
Proceeds from sale of assets® 0 0
Other income 0 Q
Gross Receipts 0 0.00%
The 20XX direct written premiums were deposited to the taxpayer’s investment

Account. The investment account statements revealed that the taxpayer received the direct
written premiums from the following payers:

$ 0 0%
0 0
0 0
Total $ 0 0.00%

A list of the deposits is shown in Exhibit B that is attached to the end of this report.

20XX Tax Year
Taxpayer filed Form 990 for the tax year ended December 31, 20XX. The insurance contracts
and books and records for 20XX were not reviewed during the audit. Although, the taxpayer
reported income and expenses similar to that reported on the returns examined. Thus, it is
safe to assume that the taxpayer operated in the same manner as it did during the years
actually examined. In addition, it is safe to assume that the taxpayer executed the same or
similar direct written insurance and reinsurance contracts in 20XX.

SA fier offsetting cost basis of $0, the incurred a net gain of $0. Only the net gain was reported on the return.

On the Form 990 for 20XX, taxpayer reported the following sources of income:

Program Revenue Service

Direct Written Premiums $ 0

Quota Share Reinsurance Premiums 0

Credit Coinsurance Reinsurance Premiums Q

Total Premiums 0 0%

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

Total Revenue $ 0 0.00%

During 20XX, the taxpayer reported total premiums and assumed risk as follows:

Direct Written Premiums $ 0 0%
Quota Share Reinsurance Assumed 0 0
Other Reinsurance Assumed ie) 0

Total $ 0 0.00%

During the tax years under audit, total assets ranged from a low of $0 as of December 31,
20XX, to $0, as of December 31, 20XX. The assets included loans to the affiliated businesses.
of $0. The initial loan was made by taxpayer to the affiliated business in 20XX, in the amount
of $0. The outstanding loan balance increased to $0 in 20XX. The loan was repaid by the
affiliated business during the 20XX tax year. As of December 31, 20XX, the outstanding loan
receivable balance was zero.

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:

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

Section 831(c) defines the term “insurance company” for purposes of section 831, as having
the same meaning as the terms is given under section 816(a). Section 816(a) provides that
the term “insurance company” means any company more than half of the business of which
during the taxable year is the issuing of insurance or annuity contracts or reinsuring of risks

underwritten by insurance companies. .

Pursuant to:

Helvering v. LeGierse, 312 U.S. 531 (1941), the United States Supreme Court in defining the
term “insurance contract” held that in order for a contract to amount to an insurance contract, it
must shift and distribute a risk of loss and that risk must be an “insurance” risk.

AMERCO, Inc. v. Commissioner, 979 F.2d 162, 164-65 (9th Cir. 1992), 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 (10th Cir. 1986), historically and
commonly insurance involves risk —shifting and risk distributing. “Risk-shifting” means one
party shifts his risk of loss to another, and “risk-distributing” means that the party assuming the
risk distributes his potential liability, in part, among others. An arrangement without the
elements of risk-shifting and risk-distributing lacks the fundamentals inherent in a true contract
of insurance.

Ocean Drilling & Exploration Co. v. United States, 988 F.2d 1135, 1153 (Fed. Cir. 1993), for
insurance purposes, “risk-shifting” means one party shifts his risk of loss to another, and “risk-

distributing” means that the party assuming the risk distributes his potential liability, in part,
among others.

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

Humana, Inc. v. Commissioner, 881 F.2d 247, 257 (6th Cir. 1989), risk distribution involves
shifting to a group of individuals the identified risk of the insured. The focus is broader and
looks more to the insurer as to whether the risk insured against can be distributed over a larger
group rather than the relationship between the insurer and any single insured.

Revenue Ruling 89-96, 1989-2 C.B. 114, an insurance agreement or contract must involve the
requisite risk shifting necessary for insurance.

Revenue Ruling 2002-89, 2002-2 C.B. 984, it is not insurance where a parent company formed
a subsidiary insurance company and 90% of the subsidiary’s earned premium was paid by the
parent company. The Rev. Rul. further held that such arrangement between a parent and a
subsidiary would constitute insurance if less than 50% of the premium earned by the
subsidiary is from the parent company.

Revenue Ruling 60-275, 1960-2 C.B. 43, risk shifting not present where subscribers, all
subject to the same flood risk, agreed to coverage under a reciprocal flood insurance
exchange.

Revenue Ruling 2002-90, 2002 C.B. 985, a wholly owned subsidiary that insured 12
subsidiaries of its parent constitute insurance for federal income tax purposes.

Revenue Ruling 2005-40, 2005-40 1.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 —

(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 | or Il of subchapter L for the
taxable year if it were a domestic corporation,

(C) such foreign corporation meets such requirements as the Secretary shall
prescribe to ensure that the taxes imposed by this chapter on such foreign corporation are
paid, and

(D) such foreign corporation makes an election to have this paragraph apply and
waives all benefits to such corporation granted by the United States under any treaty, for
purposes of this title, such corporation shall be treated as a domestic corporation.

GOVERNMENT’S POSITION:
Form 1024 Application

The taxpayer filed a Form 1024 application on October 14, 20XX, seeking retroactive
exemption under IRC 501(c)(15), back to December 28, 20XX, the date of incorporation. The
application was ultimately withdrawn by , President, on September 16, 20XX. The
examining agent believes that the application was withdrawn by the company on the advice on
its counsel, : , and Indv-3, 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

Neither the Internal Revenue Code nor the Income Tax Regulations define the terms
“insurance” or “insurance contract.” The standard for evaluating whether an arrangement
constitutes insurance for federal tax purposes has evolved over the years and is, at best, a
nonexclusive facts and circumstances analysis. Sears, Roebuck and Co. v. Commissioner,
972 F.2d 858, 861-64 (7th Cir. 1992). The most frequently cited opinion on the definition of
insurance is Helvering v. LeGierse, 312 U.S. 531 (1941), in which the Court describes
“insurance” as an arrangement involving risk-shifting and risk-distributing of an actual
“insurance risk” at the time the transaction was executed. Cases analyzing “captive insurance”
arrangements have described the concept of “insurance” for federal income tax purposes as
containing three elements: (1) involvement of an insurance risk; (2) shifting and distributing of
that risk; and (3) insurance in its commonly accepted sense. See e.g., AMERCO, Inc. v.
Commissioner, 979 F.2d 162, 164-65 (9th Cir. 1992), aff'g. 96 T.C. 18 (1991). The test,
however, is not a rigid three-prong test.

There is also no single definition of insurance for non-tax purposes. “[T]he subject has no
useful, or fixed definition. There is neither a universally accepted definition or concept of
‘insurance’ nor a [sic] exclusive concept or definition that can be persuasively applied in
insurance lawyering.” 1 APPLEMAN ON INSURANCE 2d, § 1.3 (2005). While “it seems
appropriate that any concept and meaning of insurance be sufficiently broad and flexible to
meet the varying and innovative transactions which humankind perpetually produces,” care
must be used to describe insurance because “overbroad definitions are not useful and may
cause many commercial relationships erroneously to constitute insurance.” Id. Moreover, a
state’s determination of whether a product is insurance for state law purposes does not control
whether the product is insurance for federal tax law. See AMERCO, 96 T.C. 18, 41 (1991).
There is no need for parity between a state law definition and federal definition as the objective
for state purposes is company solvency. Solvency is not a concern for determining whether an
arrangement qualifies as insurance for federal income tax purposes.

Not all contracts that transfer risk are insurance policies even where the primary purpose of the
contract is to transfer risk. For example, a contract that protects against the failure to achieve

a desired investment return protects against investment risk, not insurance risk. LeGierse, 312
U.S. at 542 (the risk must not be merely an investment risk); Securities and Exchange
Commission v. United Benefit Life Insurance Co., 387 U.S. 202, 211 (1967) (the transfer of an
investment risk cannot by itself create insurance). See also, Rev. Rul. 89-96, 1989-2 C.B. 114
(risks transferred were in the nature of investment risk, not insurance risk); Rev. Rul. 68-27,
1968-1 C.B. 315 (although an element of risk existed, it was predominantly a normal business
risk of an organization engaged in furnishing medical services on a fixed price basis rather
than an insurance risk) and Rev. Rul. 2007-47, 2007-2 C.B. 127 (the arrangement lacked the
requisite insurance risk to constitute insurance because the arrangement lacked fortuity and
the risk at issue was akin to the timing and investment risks of Rev. Rul. 89-96).

The line between investment risk and insurance risk, however, is pliable.

[t]he finance and insurance industries have much in common. The different tools these
industries provide their customers for managing financial insurable risks rely on the same two
fundamental concepts: risk pooling and risk transfer. Further, the valuation techniques in both
financial and insurance markets are formally the same: the fair values of a security and an
insurance policy are the discounted expected values of the cash flows they provide their
owners. Scholars and practitioners recognize these commonalities. Not surprisingly the
markets have converged recently; for example, some insurance companies offer mutual funds
and life insurance tied to stock portfolios, and some banks sell annuities.

FINANCIAL ECONOMICS WITH APPLICATIONS TO INVESTMENTS, INSURANCE AND
PENSIONS 1 (Harry H. Panier, ed., 2001).

Insurance risk requires a fortuitous event or hazard and not a mere timing or investment risk.
A fortuitous event* (such as a fire or accident) is at the heart of any contract of insurance. See
Commissioner v. Treganowan, 183 F.2d 288, 290-91 (2d Cir. 1950) (the risk must contemplate
the fortuitous occurrence of a stated contingency not an expected event).

Lack of Insurance Risk
The Service analyzed the risk of the contracts to determine whether the contracts qualify as
contracts of insurance, annuity contracts or reinsurance contracts: In deciding whether the
contracts qualify as insurance contracts for federal tax purposes, we have considered all of the
facts and circumstances associated with the parties in the context of the captive arrangement.

4 A happening that, because it occurs only by chance or accident, the parties could not reasonably have foreseen. Black's
Law Dictionary, 725 (9th ed. 2009). See also, First Restatement of Contracts § 291, cmt. a (1932); American Law

institute, Restatement (Second) Contracts § 379, cmt. a (1981). See Generally, Jeffery W. Stempel, Stempel on
Insurance Contracts, § 1.06A[4] (2007 Supp.) ("[I]n the past 20 years, a “modern" view of fortuity as a matter of law has
emerged in United States courts, one that largely embraces the notions of fortuity held by the American Law Institute
when it adopted the Restatement of Contracts, first in 1932 and again in the Second Restatement published in 1981.”

When deciding that a specific contract is not insurance because it does not have an insurance
risk but deals with a business or investment risk, we have considered such things as the
ordinary activities of a business enterprise, the typical activities and obligations of running of a
business, whether an action that might be covered by a policy is in the control of the insured
within a business context, whether the economic risk involved is a market risk that is part of the
business environment, whether the insured is required by a law or regulation to pay for the
covered claim, and whether the action is question is willful or inevitable.

Special Risk — Collection Rate Insurance Policy

Policy indemnifies for a portion of the differential between the Net Collection Percentage (NCP)
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.

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

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

Insurance.

Excess Employment Practices Liability Insurance Policy.

Covers 11 categories of wrongful acts including wrongful termination, refusal to hire or
promote, sexual harassment, unlawful discrimination based on age, gender, etc., invasion of
privacy, failure to create employment policies or procedures, retaliatory treatment, violation of
civil rights, violation of Family and Medical Leave Act, breach of employment contract, failure
to provide safe work environment, violations listed herein against a non-employee. There is
excluded from coverage claims related to employee's entitlements under various listed non-
specific laws, rules or regulations. Also excluded are claims under various listed laws such as
the Occupational Safety and Health Act. These exclusions shall not apply to claim for any
actual or alleged retaliatory, discriminatory, or other employment practices-related treatment.

Not insurance.

Schedute number or exhibit

Policy is not insurance in its commonly accepted sense. There is no insurance risk but only
investment or business risk.

Special Risk —- Expense Reimbursement Insurance Policy.

Coverage Form A deals with crisis management public relations expenses. This covers all
public relations expenses to mitigate the insured's adverse publicity generated from an actual
or imminent: liability incident that could exceed $0; product recall; employee layoff or labor
dispute; government litigation; financial crisis; loss of intellectual property rights; unsolicited
takeover bid; security incident; or any incident expected to reduce annual gross revenue by at
least 0%.

Coverage Form B deals with uninsured defense. This covers all defense expense for actual
or alleged civil liability where there is no insurer to provide such coverage or where such
coverage has been exhausted under an existing insurance contract.

Not insurance. Coverage Form A is not insurance in the commonly accepted sense. There is
no insurance risk but only investment or business risk. The description of Coverage B is
vague as to what liability/contract underlies the need for defense expenses. Consider
obtaining more information.

Special Risk - Loss of Major Business to Business

Covers any business interruption loss of up to = months suffered as a result of losing the
services of a Major Business-to-Business Relationship (any business relationship that
contributes 0% or more to revenue). Business interruption losses include the impact of lost
revenue and the extra expenses involved in finding a replacement Business-to-Business
Relationship. The policy will not cover the voluntary loss of a Major Business-to-Business
Relationship where the insured initiates the termination of the agreement; the loss of a Major
Business-to-Business Relationship that insured did not attempt or intent to replace; or the loss
of a Major Business-to-Business Relationship due to insured’s substantial non-compliance with
the terms and conditions of its contractual agreement with the customer.

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

Special Risk — Loss of Services Insurance Policy.

Covers the involuntary loss of services for key employees. The covered cause of loss must be
involuntary and includes sickness, disability, death, loss of license, resignation or retirement
after days. Coverage does not include any loss of services if the insured terminated the
employment of the employee. Also excluded is any claim if the insured does not attempt to
replace the employee timely. Claim costs can include costs incurred by existing employees,
costs of temporary employees, training costs, and lost net revenue.

Not insurance. The policy is not insurance in the commonly accepted sense. Although a
policy only covering death or disability of a key employee is insurance, the policy here covers
many non-insurance risks, that is investment or business risks.

Special Risk — Payee Audit

Covers amount of unexpected audit liability insured incurs as a result from audit by the State
Workers Compensation Commission (SWCC) of insured’s billed medical services provided for
patient treatment of a workers compensation-related injury. Also covers defense expenses
insured incurs in preparing for, or participating in any SWCC audit.

Not insurance. Insureds are located in State. It is very questionable whether an audit from
the State Workers Compensation Commission is even a possibility; therefore, there would be
no risk to insure. If insureds do provide medical care in State, then the policy is still probably
not insurance in the commonly accepted sense because there is no insurance risk but only
investment or business risk.

Excess Pollution Liability Insurance Policy.

Insuring Agreement 1 and 2 cover clean-up costs and diminution in value costs resulting from
pre-existing or new on-site pollution conditions. Coverage is conditioned on an affirmative
obligation to report on site pollution conditions to a governmental agency so as to be in
compliance with environmental laws. Various laws covering solid waste disposal, super funds,
clean air, clean water, and toxic substances are listed in a non-exclusive list provided the
insured has or may have a legal obligation to incur clean up costs for pollution conditions or
pollution release. Clean up costs cover the expenses of investigation or removal of, or
rendering non-hazardous pollution conditions to the extent required by environmental laws.
Diminution in value means the difference in the fair market value of the property when the
remedial action plan is approved and the fair market value of the property had there been no
on site pollution conditions.

Schedute number or exhibit

Insuring Agreements 3 to 12 provide for third party claims for on site or off site clean up and
diminution in value costs for pre-existing or new on site or off site pollution conditions, as well
as bodily and property damage, as well as non-owned locations.

Insuring Agreement 13 covers pollution release from transported cargo carried by covered
autos. No covered auto is identified in the declarations.

insuring Agreement 14 covers third party claims from transporting of a product or waste.
Insuring Agreement 15 covers actual loss resulting from the interruption of the business
operations caused solely and directly by on site pollution conditions. Actual loss means the
net income the insured would have earned had there been no interruption. Coverage also
includes loss of rental value, which generally means the anticipated rental income from tenant
occupancy of insured property.

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

Special Risk — Punitive Wrap Liability Insurance Policy.

Covers claims for punitive or exemplary damages upon the failure of the insurer under policies
listed that are issued to the insured to cover punitive or exemplary damages, judgments, or
awards solely due 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,
and for which an insured is legally obligated to pay.

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

Special Risk — Regulatory Changes Insurance Policy.

Covers actual compliance expenses and any business interruption loss of up to. months as
a result of any regulatory change that has an adverse impact on insured's normal on-going
business operations. Regulatory changes include governmental, administrative agency, or
legislative changes, changes to environmental, zoning, transportation, or safety laws or
regulations, changes to import/export laws, regulatory changes due to foreign political risk
including the collapse of a foreign economy, and any regulatory change due to the insured's
reorganization, such as changing from a corporation to a limited partnership. The policy
excludes any claim for an adverse regulatory change due to the insured's substantial non-
compliance with regulations or other guidelines.

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

Special Risk-Representation and Warranties Insurance Policy

Not insurance. The contract is vague as to what it covers. The documents provided do not
provide enough information for us to be able to conclude that this contract is insurance in the
commonly accepted sense.

Special Risk — Breach of Medical Standards Insurance Policy.

Covers all fines, penalties, defense expense and costs to bring operations in compliance
resulting from an investigation or hearing of type brought by a public regulatory agency or
private medical standards board. Types of investigations covered include but are not limited to
allegations of HIPAA violations and medical standards reviews. Criminal acts not covered.
Liability coverage is exciuded.

Not insurance. We cannot conclude that this contract is insurance in its commonly accepted
sense. We need a better explanation of what the policy covers. For example, does the
excluded liability coverage include negligence?

Special Risk — Tax Liability Insurance Policy.

Covers any additional tax liability up to $0 subject to a deductible equal to 0% of the actual
filed IRS tax liability provided return prepared and signed by CPA. Policy also covers defense
expenses incurred in determining the final tax liability. Several IRS penalties are excluded
from coverage.

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

During 20XX, the taxpayer provided coverages under 15 direct contracts written by and
. Of the 15 contracts, the taxpayer participated in 12 of 13 contracts written in 20XX.

Taxpayer eliminated the Special Risk — Representations and Warranties contract. However,

during 20XX, the taxpayer added the Special Risk — Legal Expense Reimbursement contract,

the Special Risk —- Commercial Medical Malpractice contract, and the Excess Cyber Risk
contract.

{. Special Risk Legal Expense Reimbursement Insurance Policy

Covers all litigation expenses incurred by the insured resulting for insured’s actual or alleged
civil liability.

Not Insurance. We cannot conclude that this contract is insurance in its commonly accepted
sense. The policy is too vague as to what liability/contract underlies the need for defense
expenses. Resembles Coverage Form B from Special Risk — Expense Reimbursement
Insurance Policy (20XX).

Special Risk — Commercial Medical Malpractice Insurance Policy

Covers claims that have been denied by the listed insurance company, which issued the
underlying medical malpractice insurance policy, due to a breach of warranty, failure to notify
the insurer of medical operations or procedures, sales or distribution of excluded products, or
the exhaustion of the primary limits.

Not Insurance. We cannot conclude that this contract is insurance in its commonly accepted
sense. It is vague as to what it covers.

Excess Cyber Risk Insurance Policy

Insuring Agreement 1 — Cyber Risk Liability covers all damages that insured becomes legally
obligated to pay and defense expenses as a result of any claim made against insured for a
Wrongful Act. Wrongful Acts may include, but are not limited to the following: defamation;
infringement of intellectual property; and failure to prevent unauthorized access to, use of,
tampering with, or introduction of malicious code into data or systems.

Insuring Agreement 2 — 1° Party Property Loss & Business Interruption covers loss of or
damages to insured’s covered property caused by, but not limited to the following: a computer
virus; a cyber attack, theft of computer system resources; and computer crimes. Insuring
Agreement 2 also covers business interruption expenses, monies surrendered or costs
incurred as a result of Cyber-Extortion, and reward money for information leading to the arrest
and conviction of individuals committing or attempting to commit illegal acts related to
coverage under the policy.

Insuring Agreement 3 — Post-Loss Systems Crisis Management covers the cost of public
relations services required to protect insured’s image and reputation following a covered loss.
Insuring Agreement 3 also covers service fees of consultants hired to identify and/or
implement ways to prevent or decrease the possibility of a further or future loss similar to the
covered loss.

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

The taxpayer participated in, and provided coverage under the same 15 and direct
written contracts as in 20XX.

The contracts for the 20XX tax year were not reviewed during the audit.

Our review of the direct written contracts executed during the tax years under consideration is
summarized as follows:

Deemed Deemed Not
Contract Insurance Insurance

Excess Directors & Officers Yes

Special Risk-Expense Reimbursement No
Loss of Major Business to Business No
Special Risk-Loss of Services No
Special Risk-Punitive Wrap No
Special Risk-Regulatory Changes No
Special Risk-Tax Liability No
Legal Expense Reimbursement No
Special Risk- Excess Pollution No
Special Risk — Loss of Major Customer No
Excess Employment Practices No
Excess Cyber Risk No
Breach of Medical Standards No
Special Risk-Collection Rate No
Commercial Medical Malpractice No
Special Risk-Payee Audit No
Representations and Warranties No

We were able to definitively deem only one of the direct written contracts as insurance
contracts because they included an insurance risk. Fourteen of the fifteen direct written

and contracts were deemed not to include an insurance risk and was either a
business or investment risk, or we were unable to clearly identify an insurance risk.

Other Insurance Policies

Quota Share Reinsurance Program.

participated in over 0 insurance policies with more than 0 insureds. blended

together is direct written insurance and then reinsured the entire book on a quota share basis
with each of the pool participants. As Reinsurer No. , in the 20XX reinsurance program,
Taxpayer received a Quota Share reinsurance premium from in exchange for the
assumption of 0% of the risk pool comprised of the stop loss coverages issued to all the stop
loss endorsement policyholders (see also the Joint Underwriting Stop Loss Endorsement). In
20XX, taxpayer was identified as Reinsurer No. , and received a reinsurance premium from
in exchange for the assumption of 0% of the risk pool. In 20XX, taxpayer was Reinsurer No.

. Again, taxpayer received a reinsurance premium from in exchange for the
assuming 0% of the risk pool.

We do not have any understanding of the risks insured by Taxpayer. We do not know whether
the policies "reinsured” are similar to the several policies that we have concluded above are
not insurance. However, the direct written contracts insured by do include the 15
contracts written by . Therefore, it is highly likely that the entire pool, which is insured
by and reinsured on a quota share basis with each of the pool participants, is primarily
comprised of direct written contracts that the Service would deem not be insurance in the
commonly accepted sense. Thus, all or a portion of the premiums received by taxpayer,
during the taxable years under consideration, would not be for reinsuring insurance risks.

Credit Coinsurance Reinsurance Program.

The policy reinsures risks on vehicle service contracts. Again, we do not know what risks are
being insured and reinsured.

insurance In Its Commonly Accepted Sense

Staff

As a foreign corporation, taxpayer contracted with in , to serve as its
Residential Insurance Manager. Taxpayer did not hire or employ staff to conduct an insurance
business. During the tax years under consideration, taxpayer did not incur salaries and wages
expenses or any other payroll costs.

Pricing of Contracts
The Service also has concern about whether the premiums charged for the contracts were

reasonable. A premium for an insurance contract is based on actuarial calculations and
factors. Even if an insurance contract is deemed to be “insurance” for federal tax purposes, the
premium paid pursuant to that contract must be determined based on actuarial factors and
principles. In Item #2 of the September 28, 20XX response to IDR #2, the CPA provided a
copy of letters from ; - and , which was propose to address the method used
for pricing the direct written and reinsurance contracts for the taxable years under
consideration. However, the Service concluded that the letters did not address the method of
pricing the specific direct written and reinsurance contracts that was a party to during
20XX, 20XX, and 20XX. Thus, the Service concluded that the premiums received by taxpayer
were not reasonable because they were not based on actuarial calculations and factors.

Use of Assets

Taxpayer engaged in investment activities that are typical of insurance companies. Based on
the review of the Form 990 returns, taxpayer made loans to the Affiliated Businesses to
whom it executed the direct written contracts. Loans were made during the 20XX and 20XX
tax years. The amount of the outstanding loan receivable balances represented the total
percentage of assets as follows:

12/31/20XX 12/31/20XX = 12/31/20XX = 12/3 1/20XX

Loan balance -0- $ 0 $ 0 -0-
Total Assets $ 0 $ 0 $ 0 $ 0
Percentage 0% 0% 0% 0%

The Affiliated Businesses repaid the outstanding notes receivable balance to taxpayer during
20XX.

Risk Shifting

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

Risk Distribution
Risk distribution incorporates the statistical phenomenon known as the law of large numbers.
The concept of risk distribution “emphasizes the pooling aspect of insurance: that it is the
nature of an insurance contract to be part of a larger collection of coverages, combined to
distribute risks between insureds.” AMERCO and Subsidiaries v. Commissioner, 96 T.C. 18,
41 (1991), aff'd, 979 F.2d 162 (9th Cir. 1992). In Treganowan, 183 F.2d at 291, the court
quoting Note, The New York Stock Exchange Gratuity Fund: Insurance That Isn’t Insurance,
59 Yale L.J. 780, 784 (1950), explained that “by diffusing the risks through a mass of separate
risk shifting contracts, the insurer casts his lot with the law of averages. The process of risk
distribution, therefore, is the very essence of insurance.” Also see Beech Aircraft Corp. v
United States, 797, F.2d 920, 922 (10" Cir. 1986), (risk distribution “means that the party
assuming the risk distributes his potential liability, in part, among others”); Ocean Drilling &
Exploration Co. v. United States, 988 F.2d 1135, 1135 (Fed. Cir. 1993) (“risk distribution
involves spreading the risk of loss among policyholders”).

Distributing risk allows the insurer to reduce the possibility that a single costly claim will exceed
the amount taken in as premiums and set aside for the payment of such a claim. By assuming
numerous relatively small, independent risks that occur over time, the insurer smoothes out
losses to match more closely its receipts of premiums. Clougherty Packing Co. v.
Commissioner, 811 F.2d 1297, 1300 (9th Cir. 1987). Risk distribution necessarily entails a
pooling of premiums, so that a potential insured is not in significant part paying for its own
risks. See Humana, Inc. v. Commissioner, 881 F.2d 247, 257 (6th Cir. 1989).

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

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

Situation 1 of Rev. Rul. 2005-40, describes a scenario where a domestic corporation operated
a large fleet of automotive vehicles in its courier transport business covering a large portion of
the United States. This represented a significant volume of independent, homogeneous risks.
For valid non-tax business purposes, the transport company entered into an insurance
arrangement with an unrelated domestic corporation, whereby in exchange for an agreed
amount of “premiums,” the domestic carrier “insured” the transport company against the risk of
loss arising out of the operation of its fleet in the conduct of its courier business. The unrelated
carrier received arm’s length premiums, was adequately capitalized, received no guarantees
from the courier transport company and was not involved in any loans of funds back to the
transport company. The transport company was the carrier’s only “insured.” While the
requisite risk-shifting was seemingly present, the risks assumed by the carrier were not
distributed among other insured’s or policyholders. Therefore, the arrangement between the
carrier and the transport company did not constitute insurance for federal income tax
purposes.

The facts in Situation 2 of Rev. Ruling 2005-40 mirror the facts of Situation 1 except that in
addition to its arrangement with the transport company, the carrier entered into a second
arrangement with another unrelated domestic company. In the second arrangement, the
carrier agreed that in exchange for “premiums,” it would “insure” the second company against
its risk of loss associated with the operation of its own transport fleet. The amount that the
carrier received from the second agreement constituted 0% of the total amounts it received
during the tax year on a gross and net basis. Thus, 0% 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

(Rev. January 7994)

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 Situation 1 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 Situation 1. The Service concluded in both of
the above scenarios that insurance did not exist because there lacked a sufficient number of
insureds. The small number of insureds produced an insufficient pool of premiums to
distribute any insurance risk.

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

With respect to the contracts reviewed during the tax years under audit, the Service concluded
that the contracts between the taxpayer and the Named insureds: ; and ;
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 partially-owned by a beneficial owner of
the taxpayer, . Of total risk insured by the taxpayer, approximately 0% percent of the

risk assumed during the years under audit is that of the affiliated businesses. In addition, of
the total premiums received during the year, 0% percent of the premiums were derived from
the direct written contracts that insure the risk of the affiliated businesses. Approximately 0% of
all premiums and 0% of the direct written premiums were paid by three related entities,

and . The taxpayer did not write, issue or sell direct written contracts as a Lead
Insurer. Nor did the taxpayer write, issue or sell direct written contracts to non-affiliated
business interests or to the general public. Rev. Rul. 2005-40 cited several court decisions
that have recognized that risk distribution necessarily entails a pooling of premiums, so that a
potential insured is not in significant part paying for its own risks. In this case, the large
concentration of insurance risks of three insureds does not constitute risk distribution because
of the very high likelihood of the insured paying for any of its claims with its own premiums.
Such an arrangement is not insurance but a form of self-insurance.

During the tax years under audit, the taxpayer was primarily and predominantly supported by
direct written premiums that were received from three Affiliated Businesses. 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, ; ; and ;
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 solely concentrated in a limited number of policyholders, the
affiliated businesses. Because the risk is too heavily concentrated in the 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 the Affiliated Businesses
paid the majority of premiums received by the taxpayer during the years under audit, the
Service concluded that losses incurred by the businesses were paid primarily from the
premiums paid to the taxpayer by the businesses. 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.

Also, an arrangement that provides for the reimbursement of believed-to-be inevitable future
costs does not involve the requisite insurance risk for purposes of determining whether the
assuming entity may account for the arrangement as an “insurance contract" for purposes of
Subchapter L of the Internal Revenue Code.

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

Gross Receipts Test

Section 501(c)(15) of the Internal Revenue Code provides exemptions for insurance
companies, other than life insurance companies (including inter-insurers and reciprocal
underwriters), if the gross receipts for the taxable year do not exceed $600,000, and more than
50% of such gross receipts consist of premiums.

Based the Service’s analysis of the contracts for 20XX, twelve of the thirteen direct written
contracts were deemed not to be insurance (or we could definitively determine whether the
contract included an insurance risk). Therefore, the amounts received by for those
twelve direct written contracts are not considered insurance premiums. The amount received
by taxpayer for one of the thirteen direct written contracts was deemed to be a premium
because only for this single contract included an insurance risk. For 20XX and 20XX, only one
of the fifteen direct written contracts was deemed to include an insurance risk. The rest of the
contracts were not insurance contracts because they did not cover an insurance risk. The
contracts covered either a business or investment risk. During the taxable years under
consideration, received amounts that the Service deemed to be direct written and
reinsurance premiums as follows:

Contract Premium
Excess Directors & Officers Liability
$ 0 Xx 0% $ 0
Amount Deemed Premiums from Direct Written Contracts $ 0
Quota Share Premiums 0
Credit Coinsurance Reinsurance 0
Total Premiums for 20XX $ 0
Gross Receipts for 20XX 0
Percentage of Premiums to Gross Receipts 0%
Contract Premium
Excess Directors & Officers Liability
$ 0 X 0% $ 0
$ 0 Xx 0% 0
Amount Deemed Premiums from Direct Written Contracts 0
Quota Share Premiums 0
Credit Coinsurance Reinsurance 0
Total Premiums for 20XX $ O

Gross Receipts for 20XX $ 0
Percentage of Premiums to Gross Receipts 0%
Contract Premium
Excess Directors & Officers Liability
$0 X 0% $ 0
$ 0 x 0% 0

Amount Deemed Premiums from Direct Written Contracts $ 0
Quota Share Premiums 0
Credit Coinsurance Reinsurance _ 0
Total Premiums for 20XX $ 0
Gross Receipts for 20XX $ 0
Percentage of Premiums to Gross Receipts 0%

Premiums received by taxpayer for each contract in 20XX was not requested during the
examination.

The amounts received by under the remaining contracts were not for insurance in the
commonly accepted sense. The terms of the contracts did not include insurance risk but
covered investment or business risks. The remaining contracts lacked the requisite insurance
risk to constitute insurance because the contracts lacked fortuity, and the risk at issue is akin
to the timing and investment risks of Rev. Rul. 89-96.

An arrangement that provides for the reimbursement of believed-to-be inevitable future costs
does not involve the requisite insurance risk for purposes of determining whether the assuming
entity may account for the arrangement as an “insurance contract” for purposes of Subchapter
L of the Internal Revenue Code. For the contracts that are deemed not to qualify as insurable
risks, the amount paid for each contract, by : - and to the TP, do not
qualify as an insurance premium.

In addition, although we question whether the Quota Share contracts are actually valid
reinsurance contracts, and whether the amounts received by taxpayer under the contracts are
valid reinsurance premiums, the amounts received by taxpayer from

were included as “premium income” for purposes of the gross receipts computation
shown above. Even after given the taxpayer the benefit of the doubt, the taxpayer still failed
the gross receipts for the years under audit.

During the tax years under consideration, the premium income received by taxpayer did not
exceed 50% of its gross receipts. Gross receipts were computed under Notice 2006-42.°
Although gross receipts are less than the $600,000 limitation, the amount deemed to be
premiums, for each taxable year, is not more than 50% of gross receipts. Therefore, we are
revising our position on the gross receipts test as stated in our Preliminary Report issued to
taxpayer on March 13, 20XX. Based on further analysis of the contracts, we concluded that
the taxpayer did not meet the 50% gross receipts test described in IRC 501(c)(15) and Notice
2006-42 for any tax year under audit.

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 the Affiliated Businesses lack the requisite risk distribution. Therefore, the taxpayer does
not qualify as an insurance company.

Application of Foreign Corporation Tax Provisions

The administrative file for the original Form 1024 application filed by included a copy of
the IRC 953(d) election filed by the Company on February 23, 20XX. However, the IRS has
no record that the election was approved. As of the date of this examination, it appears that
the Service still has not approved the IRC 953(d) election filed years ago. withdrew the
initial Form 1024 application on September 16, 20XX.

IRC 953(a)(1) defines insurance income to mean income which is attributable to the issuing or
reinsuring of an insurance or annuity contract, and would be taxed under subchapter L if such
income were the income of a domestic insurance company. Therefore, any premium income
received by a CFC could qualify

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 company does not meet the requirements to make the IRC 953(d)
election, and thus, is not a domestic corporation, the company should be treated as a
“controlled foreign corporation,” and the provisions of Subpart F of the Internal Revenue Code
(sections 951-965) should apply. However, the Company did not generate any passive

5 Under Notice 2006-42, only gains from the sale of capital assets are included in gross receipts.

sources of income such as dividends, interest, royalties, rents or annuities, during the tax year
under audit.

The subpart F provisions apply to foreign corporations that qualify as controlled foreign
corporations (“CFCs”). IRC 957 defines a CFC as a foreign corporation with regard to which
more than 50% of the total combined voting power of all classes of stock entitled to vote or the
total value of the stock is owned by U.S. shareholders. A U.S. shareholder, in turn, is defined
under IRC 951(d) as a U.S. person who owns 10% or more of the total combined voting power
of all classes of stock entitled to vote of the foreign corporation. Therefore, a corporation with
regard to which more than 50% of the vote or value is owned by U.S. persons who individually
own 10% or more or the vote will qualify as a CFC under IRC 957.

IRC 953(a)(2) of the Code excepts “exempt insurance income (as defined in subsection (e)”
from the definition of insurance income. However, to qualify as exempt insurance income,
such income must be derived by a qualifying insurance company. A qualifying insurance
company is defined as a company that “is engaged in an insurance business and would be
subject to tax under subchapter L if it were a domestic corporation.

IRC 953(e)(3)(C) states that income derived from U.S. sources does not qualify for exemption.

If a CFC does not qualify as an insurance company under subchapter L, it will not meet the
definition of a qualifying insurance company for purposes of IRC 953(e). Thus, none of its
insurance income will be exempt insurance income.

A Preliminary Report, Form 5701, Notice of Proposed Adjustments, was mailed to the
taxpayer's CPA, ,on March 13, 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 May 17, 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, 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:

The Service’s incorrect conclusion is based solely upon its unsupported and

unsupportable 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.

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), affd979 F.2d 1342 (9th Cir. 1992), where 30% unrelated risks was
determined to be sufficient to meet the risk distribution requirement.
The taxpayer stated that the Service conducted no meaningful examination of risk
distribution in its audit of . Rather, the Service simply claims that the direct
written contracts lack the requisite risk distribution. The nature of insurance is the
number of underlying risk exposures present, not an artificial entity count or an
artificial count of the number of policies written. The Taxpayer cites AMERCO, Inc.
v. Commissioner, No. 91-70732, slip op. 13187 (9th Cir. Nov. 5, 1992).
The taxpayer argues that the 30% outside business principle and the decision in
Harper are recognized in the Service’s own Foreign insurance Excise Tax Audit
Technique Guide.
The Service appears to ignore Revenue Ruling 2001-31, in which the Service
conceded that it would no longer assert the economic family theory due to its
rejection by the courts.
The taxpayer argues the Service’s analysis of risk distribution is incomplete. The
Service ignores the numerous unrelated risks that insures. Courts have
recognized that risk distribution can occur even with a single insured. The taxpayer
cited, Malone & Hyde v. Commissioner.
Taxpayer argues that the Service merely asserts that risk distribution is lacking,
instead of engaging in a meaningful analysis of the number of independent risk
exposures insured by
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).

Government’s Response to Taxpayer’s Position:
After reviewing the response to the Preliminary Report received from CPA, CPA, on May 17,
20XX, the Service's initial position is unchanged. primary and predominant business in
tax years 20XX, 20XX, 20XX, and 20XX, was not insurance because the contracts issued by
the company lacked the requisite risk distribution.

Taxpayer’s Position:

In the second paragraph of the May 17, 20XX response to the agent's preliminary report, the
CPA stated that the audit conclusion reached by the Service was solely based upon its
unsupported and unsupportable 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 direct written 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 of large numbers to operate. The
pool consisted of a 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 his argument that qualifies as an insurance
company. The CPA cited the court’s holding, when a significant percentage (29 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 71 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 1 on page 2
of the May 17, 20XX response:

In its preliminary report, the Service merely states, that due to 0 percent of
premiums being direct written premiums for coverages written to four
insureds, which in fact owned no interest in , there is a lack of
adequate risk distribution. The Service’s position 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. The Service also ignores
achieving distribution by issuing 28 policies to these four 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 insureds, _
the Service believes that this conclusion would be based on a misunderstanding of the Harper
Case. In the Harper Case, 67% to 71% of the total premiums received for the years at issue
were not related to a single policyholder. Rather, the 67% to 71% were the total percentages
received from all related policyholders, including brother-sister corporations (a total of 13
entities). The court’s analysis in Harper Group must be read in its entirety and all the facts and
circumstances must be considered, i.e. that there are 13 entities making up the nearly two
thirds risk concentration in all the years at issue.

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

Taxpayer’s Position:

On page 2, paragraph 5, 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. Using the amounts reported on the
Form 990 returns, the taxpayer assumed risks as follows:

Direct Written Premiums $ 0 0%
Other Reinsurance Assumed 0 0%
Pooled Reinsurance Assumed 0 0%
Total $ 0 0.00%
Direct Written Premiums $ 0 0%
Other Reinsurance Assumed 0 0
Pooled Reinsurance Assumed 0 Q
Total $ 0 0.00%
Direct Written Premiums $ 0 0%

Other Reinsurance Assumed 0 0

Pooled Reinsurance Assumed 0 0
Total $ 0 0.00%

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 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:

In paragraph 7, page 3, the CPA stated that in reaching its incorrect conclusion in the
preliminary report, the Service appears to ignore Revenue Ruling 2001-31, in which the
Service conceded that it would no longer assert the economic family theory due to its rejection
by the courts.

Government’s Response:
The current Service position is expressed in Revenue Ruling 2005-40, I.R.B. 2005-27 (June

17, 2005), which provides IRS issued guidance emphasizing that the requirement of risk
distribution must be met. The ruling demonstrated that this risk distribution requirement cannot
be satisfied if the issuer of the contract enters into such a contract with only one policyholder. If
the contract fails to constitute insurance, then the premiums paid are not deductible business
expenses under Code Sec. 162 and the issuing company is not an insurance company for
federal tax purposes. Rev. Rul. 2005-40 cited several court decisions that have recognized
that risk distribution necessarily entails a pooling of premiums, so that a potential insured is not
in significant part paying for its own risks. In this case, the large concentration of insurance
risks in one or two insureds does not constitute risk distribution because of the very high
likelihood of the insured paying for any of its claims with its own premiums. Such an
arrangement is not insurance but a form of self-insurance.

However, when the arrangements between the companies do constitute insurance for federal
income tax purposes and assuming these arrangements represented more than 50 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:

In the first paragraph on page 4 of the May 17, 20XX response, the CPA indicated that the
Service did not engage in a meaningful analysis of the number of independent risk exposures
insured by

Government’s Response:

was incorporated on December 28, 20XX. The 20XX tax year was the taxpayer's first
full year. In Item #5 of the January 3, 20XX response to IDR #2 for 20XX, the CPA indicated
that paid out reinsurance losses of $0 for the year. In Item #18 of the September 28,
20XX response to IDR #1, for the 20XX and 20XX tax years, the CPA indicated the taxpayer
paid reinsurance losses of $0 for 20XX, and $0 for the 20XX tax year. In addition, the
taxpayer set up reserves for claims received under the direct written contracts executed in
20XX and 20XX. One claim was received by taxpayer in 20XX, and six claims were received
in 20XX. Four of the seven claims were filed jointly by all three of the Named insureds. Three
claims were filed by only one of the Named Insureds ( ). Under the direct written
contracts, the taxpayer is one of four insurers responsible for providing the various coverages.

Under the terms of the direct written contracts, the insurers did not insure the risks of any
unrelated third parties or the general public. Thus, if the Named Insureds filed claims, such
claims would have been paid by premiums paid by only the Named Insureds. The taxpayer
did not receive direct written premiums from any other sources during the tax years under
audit.

Under the Quota Share reinsurance contract, the taxpayer was responsible for reinsuring
minimum risks (less than 0% of total risks during the years under audit) incurred by

. At least 50 other companies shared reinsuring the risks of under
the pooling arrangement.

Taxpayer’s Position:

In paragraph 2, on page 4, the CPA stated that 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 determination letters were issued to taxpayers 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.

Government's Position:

Each taxpayer stands alone. The audit of the activities and books and records of and
the outcome of such audit stands alone. The issues raised by the Service with respect to the
audit of are based on available facts.

Taxpayer's Position:

In the last page of the May 17, 20XX response, the CPA stated that qualified for tax-
exempt status as an insurance company described in IRC Section 501(c)(15) during all of the
years under review. As made a valid election under IRC Section 953(d) to be treated
as a domestic corporation, the Service’s conclusion that is a controlled foreign
corporation is incorrect.

Government’s Response:

According to the Form 1024, Application for Recognition of Tax-Exempt Status, administrative
file, the taxpayer filed its IRC 953(d) election with the ; office of the Service on
February 23, 20XX.

IRS records reveal that the IRC 953(d) election was not approved by the Service because the
taxpayer did not submit proof of IRC 501(c)(15) tax-exempt status. The taxpayer could not
provide proof of IRC 501(c)(15) tax-exempt status because it did not complete the Form 1024
application process. The taxpayer withdrew its Form 1024 application on September 16,
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 | or II of
subchapter L, for the taxable year if it were a domestic corporation. See IRC 953(d)(1)(B).
Since the Service determined that the taxpayer is not an insurance company within the
meaning of Subchapter L of the Code for the year under audit, it fails to meet the requirements
for the election under IRC 953(d) to be treated as a domestic corporation.

In addition, because the taxpayer does not meet the requirements to make the IRC 953(d)
election, and thus, is not a domestic corporation, the taxpayer should be treated as a
“controlled foreign corporation,” and the provisions of Subpart F of the Internal Revenue Code
(sections 957-965) should apply.

CONCLUSION:

Because you do not qualify as an insurance company for federal income tax purposes, you fail
to meet the requirements of section 501(c)(15) of the Code. Thus, you do 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 tax years ended December 31, 20XX,
December 31, 20XX, December 31, 20XX, and December 31, 20XX.

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

Exhibit A
Deposit of Direct Written Premiums
20XX

Date of Deposit | Total Deposit | Total
3/3/20XX | 0 | 0 | 0
4/1/20XX | 0 | 0 | 0
4/15/20XX | 0
5/5/20XX | 0 | 0 | 0
6/2/20XX | 0 | 0 | 0 | 0 | 0
7/2/20XX | 0 | 0 | 0 | 0
7/24/20XX | 0 | 0 | 0
8/4/20XX | 0 | 0 | 0 | 0 | 0
8/26/20XX | 0 | 0 | 0
8/28/20XX | 0 | 0 | 0
8/31/20XX | (0) | (0) | (0)
9/10/20XX | (0) | (0) | (0)
9/14/20XX | 0
10/19/20XX | 0 | 0 | 0
12/28/20XX | 0 | 0 | 0
12/31/20XX | (0) | (0)

Totals | 0 | 0 | 0 | 0 | 0

Exhibit B
Deposit of Direct Written Premiums
20XX

Date of Deposit | Total Deposit | Total
1/6/20XX | 0 | -
1/11/20XX | 0 | - | - | - | -
2/2/20XX | 0 | -
3/2/20XX | 0 | -
3/15/20XX | 0 | 0 | 0 | 0
3/16/20XX | 0 | 0 | 0
3/29/20XX | 0 | 0 | 0
3/30/20XX | 0 | - | - | - | -
4/5/20XX | 0 | 0 | 0
4/19/20XX | 0 | 0 | 0
4/26/20XX | 0 | 0 | 0 | 0 | 0
5/4/20XX | 0
5/10/20XX | 0 | 0 | 0
5/14/20XX | 0 | 0 | 0 | 0
6/3/20XX | 0 | 0 | 0 | 0 | 0
6/3/20XX | 0
6/28/20XX | 0 | 0 | 0
7/6/20XX | 0 | -
7/13/20XX | 0 | 0 | 0 | 0
7/14/20XX | 0 | 0 | 0
8/3/20XX | 0 | 0 | 0 | 0
8/23/20XX | 0 | 0 | 0
9/8/20XX | 0 | 0 | 0 | 0
9/15/20XX | 0 | - | - | - | -
9/13/20XX | 0 | 0 | 0
10/4/20XX | 0 | 0 | 0 | 0
10/31/20XX | 0 | 0 | 0
11/2/20XX | 0 | -
11/2/20XX | 0 | - | - | -
12/6/20XX | 0 | -

Totals | 0 | 0 | 0 | 0 | 0

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This page covers one taxpayer's ruling from 2017, which can't be cited as precedent. Ezel answers your situation under the current Code and IRS guidance, with citations.

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Document type

Determination Letter

IRS subject

Insurance Companies or Associations With Net Written Premiums of $350,000 Or Less

Topics

Tax-exempt organizations

Code sections

§ 162, § 501, § 816, § 831, § 951, § 953, § 955, § 957, § 958, § 965, § 7428

Ruling dated

September 26, 2016

Publicly released

March 24, 2017

View Official PDF