rr-05-40.pdf

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Part I

Section 831.--Tax on Insurance Companies other than Life Insurance Companies

(Also § 162; 1.162-1.)

Rev. Rul. 2005-40

ISSUE
Do the arrangements described below constitute insurance for federal income tax
purposes? If so, are amounts paid to the issuer deductible as insurance premiums and
does the issuer qualify as an insurance company?
FACTS
Situation 1
. X, a domestic corporation, operates a courier transport business
covering a large portion of the United States. X
owns and operates a large fleet of
automotive vehicles representing a significant volume of independent, homogeneous
risks. For valid, non-tax business purposes, X
entered into an arrangement with Y, an

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unrelated domestic corporation, whereby in exchange for an agreed amount of
"premiums," Y
“insures” X against the risk of loss arising out of the operation of its fleet
in the conduct of its courier business.
The amount of "premiums" under the arrangement is determined at arm’s length
according to customary insurance industry rating formulas. Y
possesses adequate
capital to fulfill its obligations to X under the agreement, and in all respects operates in
accordance with the applicable requirements of state law. There are no guarantees of
any kind in favor of Y
with respect to the agreement, nor are any of the "premiums" paid
by X to Y in turn loaned back to X. X has no obligation to pay Y additional premiums if
X's actual losses during any period of coverage exceed the "premiums" paid by X. X
will not be entitled to any refund of "premiums" paid if X
's actual losses are lower than
the "premiums" paid during any period. In all respects, the parties conduct themselves
consistent with the standards applicable to an insurance arrangement between
unrelated parties, except that Y
does not “insure” any entity other than X.
Situation 2
. The facts are the same as in Situation 1 except that, in addition to its
arrangement with X
, Y enters into an arrangement with Z, a domestic corporation
unrelated to X
or Y, whereby in exchange for an agreed amount of "premiums," Y also
“insures” Z
against the risk of loss arising out of the operation of its own fleet in
connection with the conduct of a courier business substantially similar to that of X. The
amounts Y
earns from its arrangements with Z constitute 10% of Y's total amounts
earned during the taxable year on both a gross and net basis. The arrangement with Z

accounts for 10% of the total risks borne by Y
.

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Situation 3
. X, a domestic corporation, operates a courier transport business
covering a large portion of the United States. X conducts the courier transport business
through 12 limited liability companies (LLCs) of which it is the single member. The
LLCs are disregarded as entities separate from X
under the provisions of § 301.7701-3
of the Procedure and Administration Regulations. The LLCs own and operate a large
fleet of automotive vehicles, collectively representing a significant volume of
independent, homogeneous risks. For valid, non-tax business purposes, the LLCs
entered into arrangements with Y
, an unrelated domestic corporation, whereby in
exchange for an agreed amount of "premiums," Y “insures” the LLCs against the risk of
loss arising out of the operation of the fleet in the conduct of their courier business.
None of the LLCs account for less than 5%, or more than 15%, of the total risk assumed
by Y
under the agreements.
The amount of "premiums" under the arrangement is determined at arm’s length
according to customary insurance industry rating formulas. Y
possesses adequate
capital to fulfill its obligations to the LLCs under the agreement, and in all respects
operates in accordance with the licensing and other requirements of state law. There
are no guarantees of any kind in favor of Y
with respect to the agreements, nor are any
of the "premiums" paid by the LLCs to Y
in turn loaned back to X or to the LLCs. No
LLC has any obligation to pay Y additional premiums if that LLC's actual losses during
the arrangement exceed the "premiums" paid by that LLC. No LLC will be entitled to a
refund of "premiums" paid if that LLC's actual losses are lower than the "premiums" paid
during any period. Y
retains the risks that it assumes under the agreement. In all

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respects, the parties conduct themselves consistent with the standards applicable to an
insurance arrangement between unrelated parties, except that Y
does not “insure” any
entity other than the LLCs.
Situation 4
. The facts are the same as in Situation 3, except that each of the 12
LLCs elects pursuant to § 301.7701-3(a) to be classified as an association.
LAW
Section 831(a) of the Internal Revenue Code provides that taxes, computed as
provided in § 11, are imposed for each taxable year on the taxable income of each
insurance company other than a life insurance company. Section 831(c) provides that,
for purposes of § 831, the term "insurance company" has the meaning given to such
term by § 816(a). Under § 816(a), 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 162(a) provides, in part, that there shall be allowed as a deduction all the
ordinary and necessary expenses paid or incurred during the taxable year in carrying on
any trade or business. Section 1.162-1(a) of the Income Tax Regulations provides, in
part, that among the items included in business expenses are insurance premiums
against fire, storms, theft, accident, or other similar losses in the case of a business.
Neither the Code nor the regulations define the terms “insurance” or “insurance
contract.” The United States Supreme Court, however, has explained that in order for
an arrangement to constitute insurance for federal income tax purposes, both risk

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shifting and risk distribution must be present. Helvering v. Le Gierse
, 312 U.S. 531
(1941).
The risk transferred must be risk of economic loss. Allied Fidelity Corp. v.
Commissioner, 572 F.2d 1190, 1193 (7
th
Cir.), cert. denied, 439 U.S. 835 (1978). The
risk must contemplate the fortuitous occurrence of a stated contingency, Commissioner
v. Treganowan, 183 F.2d 288, 290-91 (2d Cir.), cert. denied, 340 U.S. 853 (1950), and
must not be merely an investment or business risk. Le Gierse, at 542; Rev. Rul. 89-96,
1989-2 C.B. 114.
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. Risk distribution incorporates the statistical phenomenon
known as the law of large numbers. 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 randomly over time, the insurer smooths out losses to
match more closely its receipt of premiums. Clougherty Packing Co. v. Commissioner
,
811 F.2d 1297, 1300 (9
th
Cir. 1987).
Courts 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.
Humana, Inc. v. Commissioner, 881 F.2d 247, 257 (6
th
Cir. 1989). See also Ocean
Drilling & Exploration Co. v. United States, 988 F.2d 1135, 1153 (Fed. Cir. 1993) (“Risk

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distribution involves spreading the risk of loss among policyholders.”); Beech Aircraft
Corp. v. United States, 797 F.2d 920, 922 (10th Cir. 1986) ("’[R]isk distributing’ means
that the party assuming the risk distributes his potential liability, in part, among others.");
Treganowan
, at 291 (quoting Note, The New York Stock Exchange Gratuity Fund:
Insurance that Isn’t Insurance, 59 Yale L. J. 780, 784 (1950)) (“’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.’”); Crawford Fitting Co. v. United States
, 606 F. Supp. 136, 147 (N.D. Ohio
1985) (“[T]he court finds . . . that various nonaffiliated persons or entities facing risks
similar but independent of those faced by plaintiff were named insureds under the
policy, enabling the distribution of the risk thereunder.”); AMERCO and Subsidiaries v.
Commissioner, 96 T.C. 18, 41 (1991), aff’d, 979 F.2d 162 (9
th
Cir. 1992) (“The concept
of risk-distributing 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
risk between insureds.”).
ANALYSIS
In order to determine the nature of an arrangement for federal income tax
purposes, it is necessary to consider all the facts and circumstances in a particular
case, including not only the terms of the arrangement, but also the entire course of
conduct of the parties. Thus, an arrangement that purports to be an insurance contract
but lacks the requisite risk distribution may instead be characterized as a deposit
arrangement, a loan, a contribution to capital (to the extent of net value, if any), an

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indemnity arrangement that is not an insurance contract, or otherwise, based on the
substance of the arrangement between the parties. The proper characterization of the
arrangement may determine whether the issuer qualifies as an insurance company and
whether amounts paid under the arrangement may be deductible.
In Situation 1, Y enters into an "insurance" arrangement with X. The
arrangement with X represents Y's only such agreement. Although the arrangement
may shift the risks of X to Y, those risks are not, in turn, distributed among other
insureds or policyholders. Therefore, the arrangement between X
and Y does not
constitute insurance for federal income tax purposes.
In Situation 2, the fact that Y also enters into an arrangement with Z does not
change the conclusion that the arrangement between X
and Y lacks the requisite risk
distribution to constitute insurance. Y's contract with Z represents only 10% of the total
amounts earned by Y
, and 10% of total risks assumed, under all its arrangements. This
creates an insufficient pool of other premiums to distribute X’s risk. See Rev. Rul. 2002-
89, 2002-2 C.B. 984 (concluding that risks from unrelated parties representing 10% of
total risks borne by subsidiary are insufficient to qualify arrangement between parent
and subsidiary as insurance).
In Situation 3, Y
contracts only with 12 single member LLCs through which X
conducts a courier transport business. The LLCs are disregarded as entities separate
from X
pursuant to § 301.7701-3. Section 301.7701-2(a) provides that if an entity is
disregarded, its activities are treated in the same manner as a sole proprietorship,
branch or division of the owner. Applying this rule in Situation 3, Y
has entered into an

8
"insurance" arrangement only with X
. Therefore, for the reasons set forth in Situation 1
above, the arrangement between X and Y does not constitute insurance for federal
income tax purposes.
In Situation 4, the 12 LLCs are not disregarded as entities separate from X
, but
instead are classified as associations for federal income tax purposes. The
arrangements between Y
and each LLC thus shift a risk of loss from each LLC to Y.
The risks of the LLCs are distributed among the various other LLCs that are insured
under similar arrangements. Therefore the arrangements between the 12 LLCs and Y

constitute insurance for federal income tax purposes. See Rev. Rul. 2002-90, 2002-2
C.B. 985 (similar arrangements between affiliated entities constituted insurance).
Because the arrangements with the 12 LLCs represent Y
's only business, and those
arrangements are insurance contracts for federal income tax purposes, Y is an
insurance company within the meaning of §§ 831(c) and 816(a). In addition, the 12
LLCs may be entitled to deduct amounts paid under those arrangements as insurance
premiums under § 162 if the requirements for deduction are otherwise satisfied.
HOLDINGS
In Situations 1, 2 and 3, the arrangements do not constitute insurance for federal
income tax purposes.
In Situation 4, the arrangements constitute insurance for federal income tax
purposes and the issuer qualifies as an insurance company. The amounts paid to the
issuer may be deductible as insurance premiums under § 162 if the requirements for
deduction are otherwise satisfied.

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DRAFTING INFORMATION
The principal author of this revenue ruling is John E. Glover of the Office of the
Associate Chief Counsel (Financial Institutions & Products). For further information
regarding this revenue ruling contact Mr. Glover at (202) 622-3970 (not a toll-free call).