Basis of stock received in insurance demutualization is zero

Husband-and-wife taxpayers had no basis in stock they received as holders of life insurance policies issued by companies that converted from mutual companies to stock corporations, the Ninth Circuit held, overturning a district court holding and creating a circuit split.

Facts: Bennett Dorrance, the grandson of the founder of the Campbell Soup Co., and his wife, Jacquelynn, purchased insurance policies with face values totaling nearly $88 million from five mutual companies. In the early 2000s, each of the companies “demutualized,” converting their surplus into stock, some of which they then distributed to their current policyholders in exchange for their mutual membership rights in the companies. The companies determined the amount of stock to distribute to each policyholder based on a fixed component for the loss of member voting rights and a variable component for the loss of other membership rights, based on each policyholder’s past and projected future contributions to surplus.

The Dorrances received shares whose market value totaled nearly $1.8 million at the time of receipt. They sold the shares in 2003 for more than $2.2 million. On their income tax return for that year, they reported and paid tax on the entire proceeds as capital gain. In 2007, however, the Dorrances filed a refund claim for the taxes paid on the stock sale, which they sought to recharacterize as a return of previously paid premiums. When the IRS did not issue a determination, the Dorrances filed suit in the U.S. District Court for the District of Arizona.

That court held that the Dorrances had basis in the stock they received through the demutualization of the insurance companies (Dorrance, CV-09-1284-PHX-GMS (D. Ariz. 4/19/13); see earlier coverage, “Tax Matters: Courts Diverge on Basis in Shares Received in Demutualization,” JofA, June 2013, page 77). The IRS had argued its long-standing position that stock received in a demutualization necessarily carries a zero basis. The court rejected this argument, concluding that the Dorrances had basis in their membership rights because they had paid premiums for policies that included policy rights and mutual rights, and that they had basis in the stock because they exchanged those membership rights for the stock. The Dorrances had argued that the basis in the stock could not be accurately determined and, therefore, under the open-transaction doctrine, they could characterize all proceeds from the stock sale as a return of premiums paid. The court also rejected this argument, determining that the basis in the stock was (1) the initial public offering (IPO) value of the fixed shares allocated to the Dorrances in 2003, plus (2) 60% of the IPO value of the variable shares, making the total basis of the stock received $1,078,128. Both parties appealed.

Issues: The Dorrances again argued before the Ninth Circuit that they were due a full refund of taxes paid on the stock sale, either because the proceeds were a return of previously paid premiums or because their mutual rights were incapable of valuation and, under the open-transaction doctrine, their entire cost of premiums should be applied toward their basis in the stock. The IRS again pressed the argument that the Dorrances had paid nothing for their membership rights in the insurance companies and therefore had no basis in them. Consequently, they had no basis in the stock that they received for the membership rights when the insurance companies demutualized.

Holding: The Ninth Circuit held that the stock had a zero basis. The court noted that the Dorrances’ premiums were not reduced after the demutualization, suggesting that no portion of them had been paid for membership rights. The court also noted that the demutualization process was a tax-free reorganization, so that the membership rights were directly exchanged for stock with no gain or loss. In keeping with IRS rulings, the companies had advised policyholders that the stock they received would have no tax basis. The district court erroneously focused on the value of the membership rights without determining what, if anything, the Dorrances paid for them, the Ninth Circuit said. The Ninth Circuit did not address the applicability of the open-transaction doctrine.

A few weeks later, the Ninth Circuit issued an unpublished ruling in Reuben, an appeal on similar facts by a taxpayer of a holding by the District Court for the Central District of California that stock he received from an insurance demutualization had a zero basis and the open-transaction doctrine did not apply. The Ninth Circuit cited its holding in Dorrance in affirming Reuben.

The decisions create a split with the Federal Circuit, which, without discussion, affirmed a Court of Federal Claims holding that under the open-transaction doctrine, while the value of the policyholder’s ownership rights could not be completely determined, he did have a cost basis in his policy that exceeded his income from the sale of the stock he received in a demutualization of an insurance company (Fisher, 333 Fed. Appx. 572 (2009)).

• Dorrance, 807 F.3d 1210 (9th Cir. 2015)
• Reuben, No. 13-55240 (9th Cir. 1/5/16)

—By Paul Bonner, a JofA senior editor.