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B. Life Insurance Companies

1. Special life insurance company deduction (sec. 1011 of the Act and former sec. 806(a) of the Code)6

Prior Law

Under present and prior law, a life insurance company is taxed at corporate rates on its life insurance company taxable income (LICTI) and certain other income. Under prior law, a life insurance company was allowed a special deduction in computing LICTI equal to 20 percent of the income from insurance businesses that otherwise would be subject to taxation (sec. 806(a)).

Reasons for Change

The 20-percent special life insurance company deduction was enacted in 1984 because it was believed necessary to ameliorate the sudden, substantial increase in the tax liability of life insurance companies. This increase occurred as a result of the change from the three-phase taxable income computation that was in effect previously to a single-phase system consistent with generally applicable corporate tax law. The provision was not intended to tax life insurance companies at generally lower tax rates than other corporations.

In light of the overall reduction of corporate tax rates contained in other provisions of the Act, Congress concluded that the 20-percent special life insurance company deduction was no longer necessary. Despite the elimination of this special deduction, the maximum marginal tax rate applicable to life insurance companies will decline under the Act.

Explanation of Provision

Under the Act, the special life insurance company deduction is repealed. In addition, a special rule is provided in the case of a life insurance company owning the stock of another corporation through a partnership, which stock was acquired on January 14, 1981.

Effective Date

This provision is effective for taxable years beginning after December 31, 1986.

6 For legislative background of the provision, see: H.R. 3838, as reported by the House Committee on Ways and Means on December 7, 1985, sec. 1011; H. Rep. 99-426, p. 662; H.R. 3838, as reported by Senate Committee on Finance on May 29, 1986, sec. 1011; S. Rep. 99-313, pp. 491-492; and H. Rep. 99-841, Volume II (September 18, 1986), p. 344 (Conference Report).

2. Tax-exempt organizations engaged in insurance activities (sec. 1012 of the Act and sec. 501(m) of the Code)?

In general

Prior Law

Prior and present law (sec. 501(c)) specifies various standards that an organization must meet in order to qualify for exemption from Federal income taxation. These standards vary depending on the basis on which the entity is seeking exemption. Certain insurance activities performed by an organization may make it ineligible for tax exemption.

In addition, an organization that is otherwise exempt from Federal income tax generally is taxed on any income from a trade or business that is unrelated to the organization's exempt purposes. Specific exclusions from unrelated trade or business taxable income are provided for certain types of income, including rents, royalties, dividends, and interest, and certain other income, other than income derived from "debt-financed property."

Charitable organizations

An organization is exempt from Federal income tax if it is a corporation, community chest, fund, or foundation organized and operated exclusively for religious, charitable, scientific, literary, educational, or certain other purposes (sec. 501(c)(3)). An organization is not considered organized or operated exclusively for one or more of the exempt purposes unless it serves a public rather than a private interest.8

Under prior law, the providing of insurance benefits by an organization otherwise described in sec. 501(c)(3) generally was considered a commercial activity that did not meet the requirements for tax-exempt status. For example, if two or more unrelated taxexempt organizations pooled funds for the purpose of accumulating and holding funds to be used to satisfy malpractice claims against the organizations, the organization holding the pooled funds was not entitled to tax exemption because the activity (i.e., the provision of insurance) was inherently commercial in nature.9

Nevertheless, at least one major organization, which provides life insurance and annuities to employees of tax-exempt educational institutions, was recognized as a charitable organization by the IRS.

? For legislative background of the provision, see: H.R. 3838, as reported by the House Committee on Ways and Means on December 7, 1985, sec. 1012; H. Rep. 99-426, pp. 662-666; and H. Rep. 99-841, Volume II (September 18, 1986), pp. 344-351 (Conference Report).

Treas. Reg. sec. 1.501(c)(3)-1(dX1).

See, e.g., GCM 39122, CC:EE-36-82 (January 25, 1984); GCM 39003, CC:EE-37-82 (June 24, 1983).

Social welfare organizations

Under prior and present law, an organization is entitled to tax exemption if it is operated exclusively for the promotion of social welfare.10 At least one major health insurance provider was treated as a tax-exempt social welfare organization under prior law. Other organizations providing insurance were denied tax-exempt status as social welfare organizations. For example, an insurance trust set up to provide group life insurance for members was held not to be tax-exempt because the trust was organized only for the benefit of its members, which was a limited class.11 Further, if the benefit from an organization is limited to that organization's members, except for some minor and incidental benefit to the community as a whole, then, under prior and present law, the organization is not operated exclusively for the promotion of social welfare.12 Fraternal beneficiary societies

Under prior and present law, a fraternal beneficiary society, order, or association (sec. 501(c)(8)) is entitled to tax exemption if it operates under the lodge system or for the exclusive benefit of the members of a fraternity itself operating under the lodge system, and provides for the payment of life, sick, accident, or other benefits to the members of such society, order, or association or their dependents.

Reasons for Change

Congress was concerned that exempt charitable and social welfare organizations that engage in insurance activities are engaged in an activity whose nature and scope is inherently commercial rather than charitable; hence, tax-exempt status is inappropriate. Congress believed that the tax-exempt status of organizations engaged in insurance activities provided an unfair competitive advantage to these organizations. Congress further believed that the provision of insurance at a price sufficient to cover the costs of insurance generally constitutes an activity that is commercial.

In addition, the availability of tax-exempt status under prior law allowed some large insurance entities to compete directly with commercial insurance companies. For example, Blue Cross/Blue Shield organizations historically had been treated as tax-exempt organizations described in sections 501(c)(3) or (4). Other tax-exempt charitable and social welfare organizations engaged in insurance activities also had a competitive advantage over commercial insurers who do not have tax-exempt status.

Congress was also concerned that some tax-exempt fraternal beneficiary societies described in section 501(c)(8) of the Code engage in large-scale insurance activities which may be inherently commercial in nature, and that such organizations may derive a competitive advantage from their tax-exempt status.

10 Sec. 501(c)(4).

11 N. Y. State Association of Real Estate Boards Insurance Fund v. Comm'r, 54 TC 1325 (1970). 12 Rev. Rul. 75-199, 1975-1 CB 160.

Explanation of Provision

Under the Act, an organization described in sections 501(c)(3) and (4) of the Code is exempt from tax only if no substantial part of its activities consists of providing commercial-type insurance. For this purpose, no substantial part has the meaning given to it under present law applicable to such organizations. See, e.g., Haswell v. U.S., 500 F.2d 1133 (Ct. Cl. 1974); Seasongood v. Comm'r, 1227 F.2d 907 (6th Cir. 1955); see also sec. 501(h).

In the case of such a tax-exempt organization, the activity of providing commercial-type insurance is treated as an unrelated trade or business (sec. 513) but, in lieu of the usual tax on unrelated trade or business taxable income, the unrelated trade or business activity is taxed under the rules relating to insurance companies (Subchapter L).

For this purpose, commercial-type insurance generally is any insurance of a type provided by commercial insurance companies. The Act provides that the issuance of annuity contracts is treated as providing insurance. The activity of providing insurance or annuities under a qualified pension plan (described in sec. 401(a)) is an activity of providing commercial-type insurance, but is not affected by section 501(m) because such plans are not charitable or social welfare organizations to which the provision applies.

Several exceptions are provided to the definition of commercialtype insurance. Commercial-type insurance does not include insurance provided at substantially below cost to a class of charitable recipients. See, e.g., Rev. Rul. 71-529, 1971-2 C.B. 234 (relating to the meaning of substantially below cost). A class of charitable recipients refers to a group of recipients that would constitute a charitable class under present law. Commercial-type insurance also does not include health insurance provided by a health maintenance organization that is of a kind customarily provided by such organizations and is incidental to the organization's principal activity of providing health care.

The Act is not intended to alter the tax-exempt status of an ordinary health maintenance organization that provides health care to its members predominantly at its own facility through the use of health care professionals and other workers employed by the organization. HMOs provide physician services in a variety of practice settings primarily through physicians who are either employees or partners of the HMO or through contracts with individual physicians or one or more groups of physicians (organized on a group practice or individual practice basis). Similarly, organizations that provide supplemental health maintenance organization-type services (such as dental services) would not be affected if they operate in the same manner as a health maintenance organization.

Similarly, commercial-type insurance does not include arrangements that are not treated as insurance (i.e., in the absence of sufficient risk shifting and risk distribution for the arrangement to constitute insurance). 13 For example, if a hospital that is exempt

13 See Helvering v. LeGierse, 312 U.S. 531 (1941). The Internal Revenue Service has ruled that risk shifting and risk distribution are necessary to a valid insurance transaction. See Rev. Rul. 77-316, 1977-2 C.B. 53, and Rev. Rul. 78-338, 1978-2 C.B. 107.

from income tax under section 501(c)(3) establishes a trust to accumulate and hold funds for use in satisfying malpractice claims against the hospital, the arrangement does not constitute insurance and accordingly is not treated as providing commercial-type insurance.

Under the Act, commercial-type insurance does not include property or casualty insurance provided directly or through an organization described in section 414(e)(3)(B)(ii) by a church or convention or association of churches for the church, convention or association. It also does not apply to the provision of retirement or welfare benefits by such organizations directly or indirectly through an organization described in section 414(e)(3)(A) or 414(e)(3)(B)(ii) for the employees of such organizations, or for employees' beneficiaries. This exception is not intended to apply if insurance is provided to persons other than the church or convention or association of churches and their employees.

With respect to fraternal beneficiary societies engaged in insurance activities, Congress reemphasizes the requirement of present and prior law that such tax-exempt organizations maintain an active lodge system. The Act also requires that the Treasury Department audit and study fraternal beneficiary organizations (described in sec. 501(c)(8)) that received gross insurance premiums in excess of $25,000,000 in taxable year 1984. Congress intends that the use of revenues from the insurance activities of such organizations be studied. The Treasury has authority under the Act to require the furnishing of information necessary to conduct the audit and study. The results of the study, together with recommendations, are to be submitted to the Committee on Ways and Means of the House of Representatives, the Committee on Finance of the Senate, and the Joint Committee on Taxation no later than January 1, 1988, so that Congress may consider the recommendations and take such action regarding the tax treatment of fraternal beneficiary societies engaged in insurance activities as is appropriate. Certain health insurance providers

The Act provides the following treatment of existing Blue Cross or Blue Shield organizations and other organizations that meet certain requirements and substantially all of whose activities are providing health insurance. Health insurance includes insurance that provides coverage of medical expenses.

The Act provides that such existing Blue Cross and Blue Shield organizations and other organizations eligible for this treatment are subject to tax as stock property and casualty insurance companies under Part II of Subchapter L of the Code, as amended under the Act. Thus, such organizations are generally subject to the provisions applicable to property and casualty insurance companies in the Act, except as otherwise provided.

Certain treatment (described in more detail below) applies to Blue Cross and Blue Shield organizations providing health insurance that (1) were in existence on August 16, 1986; (2) are determined at any time to be tax exempt under a determination that

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