Open Transaction Doctrine Applied to Demutualization


The Court of Federal Claims ruled that gain was not recognized in the sale of stock received in exchange for policy ownership interests in an insurance company’s demutualization.

A mutual insurance company is owned by the policyholders rather than shareholders. When it reorganizes as a traditional stock company, the policyholders become stockholders in the company, in a process known as “demutualization.” It has been a long-standing position of the IRS that this is an exchange of nonrecognition property under IRC § 358(a)(1). Thus, when policyholders receive stock in a demutualization, they take a zero basis, and upon a subsequent sale of the stock, the full amount of the proceeds is taxed to them as capital gain. A retired CPA in Minnesota, Charles Ulrich, had previously challenged this IRS posture (see Associated Press, “Lone Accountant Takes on IRS and Wins”) and advised the plaintiff in this case.

In June 1990, the Seymour P. Nagan Trust purchased a life insurance policy from Sun Life Assurance Co. with a face amount of $500,000. In October 1999, Sun proposed a demutualization plan to its policyholders whereby the policyholders would be given shares of stock in a new holding company that would become Sun’s corporate parent. The policyholders could instead opt for a cash election. The demutualization plan was approved in December 1999.

At the request of the insurance company, the IRS ruled in Private Letter Ruling 200020048 that because their ownership rights could not be purchased separately from an insurance contract, policyholders would not recognize gain or loss on the exchange for stock under section 354(a)(1). The Service also ruled that the basis of the holding company stock received by policyholders would be the same as the basis of the ownership rights surrendered by the policyholders in the exchange, that is, zero. The IRS did not rule on the tax treatment of the cash election option.

As a result of the demutualization, the Nagan trust was offered 3,892 shares of stock but opted for the cash election and accepted $31,759 under a formula. This amount was reported on the federal income tax return of the trust and resulted in a tax liability of $5,725, for which the trust filed a refund claim. When the refund claim was denied, the trust, through trustee Eugene Fisher, filed suit in the Court of Federal Claims.

The court noted that Treas. Reg. § 1.61-6(a) ordinarily would apply. It requires that when a portion of a larger property is sold, the basis of the entire property should be equitably apportioned among the several parts. However, this regulation works only if the component pieces of the larger property can be valued. Because the parties disagreed whether the regulation applied in this case, the court chose to examine the history of the regulation (dating back to the 1920s), which focused on cash equivalency principles.

Under these principles, referred to as the “open transaction” doctrine, the Supreme Court (in Burnet v. Logan, 283 U.S. 404 (1931)) stated that when the value of property is indeterminable, a transaction remains open and the recognition of income is postponed until the value of the property can be established.

The court ruled that the situation was one of the “rare and extraordinary” occasions when the open transaction doctrine should apply. One reason the policyholders’ ownership rights could not be valued was because they were inextricably tied to policies and thus could not be separately purchased, transferred or sold, the court noted, quoting a government expert. But the government’s conclusion that the rights therefore had a value of zero didn’t logically follow, the court said. The court also rejected as determinative the government’s argument that Sun Life had not associated any cost on its books with the policy ownership rights. It found evidence of consideration for some value in the company’s demutualization plan, specifically, for loss of voting control and loss of right to share in any residual value if the company wound up its affairs.

Accordingly, because the trust received less than its cost basis in the Sun policy on the sale of the stock, the court held that income on the sale of stock was not realized and the trust was entitled to the refund.

IRS Chief Counsel Donald Korb said soon afterward in a public forum that the IRS might appeal the decision and that new guidance is needed (Tax Notes, Sept. 5, 2008).

Eugene A. Fisher v. U.S., 102 AFTR2d 2008-5608

By Steven C. Thompson, CPA, Ph.D., McCoy Professor of Business, Texas State University, San Marcos, Texas.


Year-end tax planning and what’s new for 2016

Practitioners need to consider several tax planning opportunities to review with their clients before the end of the year. This report offers strategies for individuals and businesses, as well as recent federal tax law changes affecting this year’s tax returns.


News quiz: Retirement planning, tax practice, and fraud risk

Recent reports focused on a survey that gauges the worries about retirement among CPA financial planners’ clients, a suit that affects tax practitioners, and a guide that offers advice on fraud risk. See how much you know with this short quiz.


Bolster your data defenses

As you weather the dog days of summer, it’s a good time to make sure your cybersecurity structure can stand up to the heat of external and internal threats. Here are six steps to help shore up your systems.