In two separate private letter rulings (PLRs), the IRS concluded that a corporation formed to pool casualty risk (PLR 202445009) and a trust formed to self-insure workers compensation claims (PLR 202445010) of school districts could exclude their income from gross income under IRC Section 115(1).

Facts

In PLR 20245009, certain school districts formed a corporation under a state statute that specifically authorized public agencies to work together to perform any lawful activity. Specifically, the school districts formed the corporation to create a program to self-insure school property with property and casualty insurance coverage. The corporation has a board of directors consisting of an administrator and at least five members (all representatives of a participating school district) that appoints officers and oversees the corporation's operations.

The agreement between the school districts prohibits any earnings or profits from the corporation to accrue to private interests, except as reasonable compensation for providing services to the corporation. The agreement states that the corporation was formed to protect against casualty and property risks. Upon dissolution, any of the corporation's remaining assets must be distributed to the state, a political subdivision of the state or to another entity whose income is excludable from gross income under IRC Section 115(1).

In PLR 202445010, a trust (Trust) was formed to provide self-insured workers compensation coverage to all school districts within the state and similar public entities, all of which are members of Association, an IRC Section 501(c)(4) tax-exempt corporation. Trust's declaration requires each group member to be a political subdivision of the state, an integral part thereof, or an entity whose income is excluded from gross income under IRC Section 115(1).

Trust is governed by a 10-member board of trustees, half of which are current or former Association members and half of which are appointed by the participating school boards at large. Trust's governing documents expressly prohibit any individual or entity connected with Trust from receiving any of its net earnings or pecuniary profit. Upon dissolution, any of Trust's remaining assets must be distributed to the state, a political subdivision or an entity whose income is excluded from gross income under IRC Section 115(1).

Law and analysis

Under IRC Section 115(1), gross income does not include "income derived from any public utility or the exercise of any essential governmental function and accruing to a State or any political subdivision thereof." In Revenue Ruling 77-261, the IRS interpreted IRC Section 115(1) to allow income from the temporary investment of cash balances of a state and its participating political subdivisions in a state-established investment fund to be excluded from gross income. While the investment fund was a separate entity from the state and its political subdivisions, the income resulted from an essential government service; because the participants had an unrestricted right to their proportionate share of the fund's income, that income accrued to them.

In Revenue Ruling 90-74, the IRS ruled that income of an organization formed, operated, and funded by a state's political subdivisions to pool their casualty risks was excluded from gross income under IRC Section 115(1). While noting that facts and circumstances determine whether a function is an essential government function, the IRS found that the significant involvement of the political subdivision in the formation and management of the pool and the overall absence of a benefit to private interests evinced an essential government function.

According to the IRS, both the corporation and the trust in question derive their income from the exercise of an essential government function; because that income accrues to a state or its political subdivision, that income is excluded from gross income under IRC Section 115(1).

Implications

Any entity that performs essential government functions should evaluate IRC Section 115(1), and the relevant revenue rulings and the PLRs described above, to determine if it may exclude any income from total gross income for federal income tax purposes. Entities hoping to qualify for this income exclusion must serve an essential government function, evidenced by having a board of directors comprised of representatives of a state or political subdivision thereof. Those entities should also have explicit provisions in their governing documents that (1) prohibit any net earnings or profits from benefiting private interests, (2) demonstrate that their income accrues to the state or political subdivisions, and (3) provide that upon dissolution, any remaining assets be distributed to the state or a political subdivision thereof. Maintaining thorough documentation to demonstrate that an entity meets the above criteria can support a position that its income is excludible from gross income for federal tax purposes.

A state institution whose income is excluded from gross income pursuant to IRC Section 115(1) is not required to file a Form 990-series return or e-Postcard. Such organizations should continue to maintain records reflecting federal tax compliance and must make their IRS exemption determination letters publicly available but can save time and expense by not having to file an annual information return with the IRS.