The U.S. Tax Court Rejects 501(c)(15) Status For Commonwealth Underwriting & Annuity Services, Inc.

Some person unknown, who will be referred to herein as “Owner” created a company in Belize called Commonwealth Underwriting & Annuity Services, Inc., of which he or she was the sole shareholder and the sole officer. Although the company’s name suggests that it is an insurance company, apparently Commonwealth did not acquire an insurance license, but rather operated under Belize corporate law which did not restrict the operations of an investment company.

Nonetheless, Commonwealth sold annuity contracts to various individuals. The premiums paid for these annuity contracts were placed in a segregated trust account, and the segregated trust account had an independent Trustee who had no relation to Owner.

The Trustee took these premiums and placed them into subaccounts that were set up for each investor, and these funds were then invested in various investment funds. Commonwealth apparently did nothing, but rather the Trustee was responsible for paying on the annuity contracts and investing the segregated accounts for each investor. Nonetheless, Commonwealth claimed that the moneys in these investments accounts were owned by it (Commonwealth) rather than each individual purchaser of the annuity contracts.

The payouts under the annuity policies were tied to the amounts in each purchaser’s segregated account within the trust, which also meant that they were subject to investment profits and losses, similar to a variable annuity contract. The annuity contracts did have a charge for a death benefit and for expenses, plus each contract paid for whatever investment advisory expenses were incurred in their particular segregated account. If the purchaser died before the policy annuitized, the designated beneficiary would receive a death benefit equal to the amount in that purchaser’s segregated account as of the time of death, less certain charges.

In 2013, Commonwealth took in a little more than $82.1 million in premiums and was paid about $150,000 in fees, and more than $2.1 million in premiums and about $195,000 in fees for 2014.

In 2014, Commonwealth applied to the IRS for a determination letter that Commonwealth was an insurance company that qualified under Internal Revenue Code § 501(c)(15). That section states that an insurance company is exempt from taxes if basically three conditions are met:

(1) The company is an insurance company, but is not a life insurance company;

(2) The company’s gross receipts for each taxable year is no more than $600,000; and

(3) More than 50% of the company’s gross receipts are premiums received.

Not surprisingly, the IRS determined that exactly none of these three conditions were met, however, and denied Commonwealth’s application. Commonwealth then initiated a lawsuit for declaratory judgment before the U.S. Tax Court, and that resulted in the opinion in Commonwealth Underwriting & Annuity Services, Inc. v. Comm’r, T.C.Memo 2023-27 (Mar. 2, 2023), to which we will now turn our attention.

It is a very short opinion, being only seven paragraphs, which perhaps reflects on just how badly Commonwealth missed on its attempt to qualify as a 501(c)(15) insurance company. For starters, the Tax Court simply assumed, without finding, that Commonwealth was an insurance company for purposes of the Internal Revenue Code. Instead, the Tax Court looked at the premiums that Commonwealth received in 2013 and 2014, both well in excess of the $600,000 limit of 501(c)(15) and determined that Commonwealth simply did not qualify for that exemption.

In response, Commonwealth made an argument to the effect that the moneys paid by purchasers for the annuity contracts “do no comprise premium income”, and that Commonwealth did not retain those moneys since they were instead dumped into the segregated accounts. Thus, in Commonwealth’s view, the only “premiums” that it received were the $150,000 in fees in 2013 and 195,000 in fees for 2014. This argument was just silly and the Tax Court rejected it:

“Petitioner acknowledges that the purchase payments ‘constituted the funds used to make annuity payments.’ This appears to fit squarely within the definition of a premium. See National Association of Insurance Commissioners, Statement of Statutory Accounting No. 51—Life Contracts, para. 5 (explaining that a premium ‘shall be recognized as income on the gross basis (amount charged to the policyholder) when due from policyholders’). Petitioner’s contention that the purchase payments were not ‘retained, controlled or utilized by’ petitioner is contradicted by its own annuity contracts, which provide that the assets held in the segregated trust accounts and subaccounts ‘remain the property of’ petitioner. Moreover, petitioner has not provided any authority suggesting that the premiums were not premium income. Therefore, petitioner has not established that its gross receipts did not exceed $600,000 during either year in issue, thereby failing to satisfy the financial test in section 501(c)(15)(A).”

The Tax Court then went on to observe that even if it bought Commonwealth’s argument that the payments for the annuities were not “premiums”, then Commonwealth still had not offered any proof that its other expense fees were in the nature of premiums. So, Commonwealth lost in that direction as well.

The bottom line is that Commonwealth did not qualify for treatment under 501(c)(15) and the IRS had correctly denied its a determination letter to that effect.

ANALYSIS

In many ways, this Commonwealth deal seems very familiar to the Foster & Dunhill scheme which involved bogus private placement life insurance (PPLI) policies, and which ended in the criminal indictments of the involved promoters. The story in all these deals is basically the same: Purchaser buy “insurance” from an offshore insurance company, their money goes into a segregated account, their money is managed offshore, and they try to avoid the income taxes on the investment income by claiming that the money is no longer theirs. Here, the scheme involved annuities instead of PPLI, but basically to the same effect.

Every few years, we see a deal like this which is designed so badly that it only takes a few milliseconds to conclude that whoever put this together didn’t have the first real clue as to what they were doing. This scheme is a disaster, an offshore planning train wreck of epic proportions. The tax position of Commonwealth here is actually much worse than the Tax Court writes up.

For instance, the Tax Court glossed over whether Commonwealth was not a life insurance company, even assuming that it qualified as any insurance company at all. Insuring annuity contracts is fundamentally a life insurance business; basically, an annuity insures against a person living too long, which is simply the flip-side of life insurance which insures against a person dying too early. Therefore, if the Tax Court had spent even a modicum of time on the subject, it would have concluded that Commonwealth could not qualify under 501(c)(15) because it was a life insurance company, if an insurance company at all.

Was Commonwealth even an insurance company of any kind? No. The Tax Court simply skipped over this too, because it was so easy to reject Commonwealth’s case on the gross receipts issue. But had the Tax Court considered the issue, Commonwealth would have gone down in flames. To be an insurance company, Commonwealth would have had to prove it was engaged in the business of insurance. Whether something constitutes “insurance” typically requires three things:

(1) There is an insurance contract. Commonwealth probably satisfies this prong because it was issuing annuity contracts to purchasers, and annuity contracts are fundamentally insurance contracts. Note that the contrary was Commonwealth’s main argument, so ironicallly Commonwealth was arguing against the one thing that it got right.

(2) There is risk shifting from the insured to the insurer. Here, purchaser simply put money in, and got money back, plus or minus their investment return, and less fees and expenses. Commonwealth was not on the hook for any liability if somebody outlived their life expectancy, and would not have made any additional profit if somebody had died early. In other words, Commonwealth took on no risk at all, and thus there was no risk shifting. Commonwealth thus cannot satisfy this prong of the test.

(3) There is risk distribution between insureds. Insurance companies operate according to the statistical Law of Large Numbers, i.e., over a large number of insureds the profits and losses of their insurance contracts will revert to near the expected mean. Since Commonwealth here was simply taking insured’s money in and giving it back to them, without regard to how long or short they lived, there was no pooling of risk and thus no risk distribution. Thus, Commonwealth cannot satisfy this prong of the test either.

The bottom line is that while Commonwealth facially appeared to be acting as an insurer by issuing annuity contracts, in fact there was no insurance going on at least in the tax sense. Commonwealth tried to claim that its minor expense charges were insurance, but that was just silly to the point of being wholly specious. Because Commonwealth was not engaged in the business of insurance in the tax sense, Commonwealth could not qualify for treatment as an insurance company under any provision of the U.S. Internal Revenue Code.

A discussion of the insurance issue would have required a much more in-depth analysis of what Commonwealth was doing, and the Tax Court obviously did not want to waste any time going through that, nor did it need to. Plainly, Commonwealth had taken in gross receipts far in excess of $600,000 and that was the end of the story. Even if the Tax Court had bought Commonwealth’s argument that its small expenses charges was the real insurance, then the Commonwealth’s case still died stillborn since those charges were not at least 50% of gross receipts. The only mystery here is why anybody not dosing heavily on mescaline thought that Commonwealth could qualify for a determination letter under 501(c)(15).

It is not necessary that a company have an insurance license to be an insurance company for tax purposes, although certainly it is better for optics. It is necessary, however, that the company be acting like an insurance company in terms of shifting and distributing risk, and Commonwealth apparently did none of those things. The Tax Court opinion does not elaborate much on what else Commonwealth was doing or not doing, but the safe guess would be that Commonwealth also fell far short when it came to such functions as underwriting and actuarial determinations considering the nature of how it was conducting its annuity business.

What we do have here appears to be little more than an extremely amateurish attempt at an offshore tax dodge, like something that a 5th grade elementary school class would draw up as a project after spending a couple of hours researching offshore tax shelters on the internet. It is difficult, if not unimaginable, for any minimally learned tax professional to look at this scheme and say, “That might work.” There was no chance of this working as a 501(c)(15) insurance company from the outset. None.

The Tax Court opinion does not give us any indication of who owned Commonwealth, or who the purchasers of the annuities were. Because Commonwealth was seeking treatment under the U.S. Internal Revenue Code, however, we can safely infer that these purchasers were ― directly or indirectly ― U.S. persons. If those, they had all better hope that they had timely filed their Foreign Bank Account Reporting (FBAR) forms, because they all had an interest in a foreign account that required the filing of FBARs, and the penalties for not timely filing FBARs are harsh, to be kind. Similarly, all these folks should have reported the investment income within their segregated accounts on their tax returns, or arguably they committed offshore tax evasion.

But these folks might not even get all of their money back. The reason is that because Commonwealth did not qualify as a 501(c)(15) company (and for that matter, probably cannot qualify as any kind of insurance company for the aforementioned reasons), all of that $82.3 million that it received will be treated as ordinary income to Commonwealth, and Commonwealth will have to pay taxes at the corporate rate on all that ordinary income, presumably at 21% so about $17 million. Unless Commonwealth and its owner have that kind of money ready to send to the IRS, the odds are probably pretty high that will be deducted from the segregated accounts before money is returned to purchasers.

In other words, what remains after this failed 501(c)(15) determination letter application is a huge tax mess, about like what one would expect the class of 5th graders to end up with.

My guess is that the news regarding Commonwealth is just beginning, so stay tuned.