Courts diverge on basis in shares received in demutualization

Two district courts reached opposite conclusions on whether stock received by policyholders in connection with demutualization of insurance companies had a cost basis greater than zero. They agreed, however, that the “open transaction doctrine” did not apply.

The first case is Dorrance, in the District of Arizona. The second is Reuben, in the Central District of California. In each situation the plaintiffs had purchased a life insurance policy or policies from mutual companies. Along with the insurance benefits, the policies granted the plaintiffs mutual ownership rights in the companies. The companies subsequently demutualized and converted into stock-based companies. As a result, the plaintiffs lost their mutual rights, which included the right to share in company profits, the right to vote, and the right to a preferred position in the event of liquidation. The plaintiffs were compensated for the loss of their mutual rights with shares of stock in the new companies. Upon subsequent sale of these shares, the plaintiffs reported a zero cost basis in the stock and a gain equal to the amount of proceeds, consistent with the IRS’s long-standing position on basis of stock received in a demutualization.

However, in Fisher, 82 Fed. Cl. 780 (2008), aff’d without opinion, 33 Fed. Appx. 572 (2009), the Court of Federal Claims held that surrendered insurance demutualization rights could have a discernible value and compensation for them a corresponding basis. The plaintiffs in Dorrance and Reuben later filed claims for refund, contending they did not owe tax on the proceeds. The plaintiffs in both cases argued that the demutualization should be covered by the open transaction doctrine, which was applied in Fisher. The open transaction doctrine may be applied when property is split and it is impossible or impracticable to allocate the cost of that property to the resulting assets. In such case, a taxpayer does not recognize any capital gain until the entire cost basis of the original property has been recovered.

Both district courts held that the open transaction doctrine did not apply because the mutual rights were not “elements of value so speculative in character as to prohibit any reasonably based projection of worth” (both quoting Campbell, 661 F.2d 209, 215 (1981)). That is, it was not impossible to determine an equitable division and allocation of the original basis in the mutual companies. As a result, the issue remaining for the courts was to determine if there actually was a basis in the stock and, if so, an appropriate method to calculate that basis and thus determine any taxable gain on the sale of that stock.

In Dorrance, the insurance companies determined the number of shares of stock to give policyholders upon demutualization by calculating both a fixed component for the loss of voting rights and a variable component for loss of other rights, based on each policyholder’s past and projected future premium contributions to the company’s surplus (book value). Sixty percent of this variable component reflected the past contributions to surplus, and the remaining 40% was an estimate of future contributions. The insurance companies determined that the fair market value of the shares issued to the policyholders was equivalent to the value of the mutual rights they gave up. As a result, the valuation of the mutual rights was the initial public offering price of the shares of stock they received as a result of the demutualization.

The court ruled for the husband and wife plaintiffs, stating that the basis should be calculated from the fixed component plus the 60% of the variable component that related to past contributions to surplus.

In Reuben, the court ruled the opposite, determining that the plaintiff had a zero basis in the stock, based on several arguments. First, regardless of the difficulty, it is the taxpayers’ burden to establish that they have a basis in property. Plaintiff Timothy Reuben argued that some portion of the premiums paid on the life insurance policy was for membership rights, but he failed to provide any evidence in support of that position.

The IRS provided substantial evidence that none of the premiums paid were for the membership interests rather than the underlying life insurance policy. For example, at the time of demutualization, the insurance company informed its policyholders that “the cost of common shares acquired in exchange for ownership rights will be nil,” and that the tax basis in these shares would be zero. Policyholders were further informed that they would not recognize any taxable gain or loss when they received the common shares, but when the shares were subsequently disposed of, a taxable gain would be reported equal to the proceeds from that sale. Likewise, an independent actuary stated that the “demutualization benefits are a windfall to the eligible policyholders” and the administrator of the trust in which the policies were held indicated that the cost basis of the stock on the date of acquisition would be zero.

Furthermore, the value of the membership rights before demutualization was zero, and it was the process of demutualization that gave those rights a monetary value, an expert for the IRS stated. Lastly, the premiums paid for the life insurance policies did not change after the demutualization, which would indicate that all the premiums paid prior to the demutualization were for the underlying life insurance policy and not for membership rights.

In light of these arguments and the fact that the taxpayer did not provide any evidence as to what was paid for the mutual rights separately from the policy as a whole, the court found that Reuben had failed to satisfy his burden to establish that the basis was other than zero and thus ruled in favor of the IRS.

Dorrance, No. CV-09-1284-PHX-GMS (D. Ariz. 3/19/13); earlier proceedings at 877 F. Supp. 2d 827 (D. Ariz. 2012)

Reuben, No. CV-11-09448 SJO (C.D. Cal. 1/15/13)

By Karen M. Cooley, CPA, MBA, instructor of accounting, and Darlene Pulliam, CPA, Ph.D., Regents Professor and McCray Professor of Business, both of the College of Business, West Texas A&M University, Canyon, Texas.