Tax Treatment of Stock Received on Demutualization of Insurance

In a divided three-judge panel, the 9th Circuit Court has determined that taxpayers have zero basis in stock received on demutualization of insurance. This decision is in conflict with the result in Fisher v US, a Federal Claims Court case which allowed the use of a cost recovery approach so that premiums could be applied to the value of shares received.

Mutual insurance companies are distinct from stock companies in that they are owned by the policyholders and not by stockholders. Mutual companies may convert to stock-based companies and, during this process, normally will issue stock shares to their policyholders. One question raised in this type of transaction is whether the former mutual company owners have any tax basis in their ownership interests.

In the Fisher Case, the Federal Claims Court stated that the premiums paid by policyholders relate to both mutual company ownership rights and to the contract rights under the insurance contracts issued, creating tax basis. It used the “open transaction” to hold that this basis can be recovered entirely against proceeds received on the disposal of either the insurance policy or the ownership interest as such amounts are received. Gain is produced only after the entire basis is recovered.

In the new Dorrance case (in Arizona), the taxpayers received $2,248,806 in shares of the new stock companies upon the demutualization of five companies in which they held policies. They originally reported zero basis on their returns and then filed amended returns claiming tax refunds by applying the premiums paid against the proceeds.

The lower district court did not follow the cost recovery method of the Federal Claims Court but instead calculated basis using a formula based on the IPO value of fixed shares allocated to the taxpayers and 60% of the IPO value of variable shares received. This produced income of only $1,170,678 and permitted a partial refund for the taxpayers.

The 9th Circuit Court majority reversed the decision of the lower court and determined that there should be zero basis in the ownership interests. 

• This is supported, according to the court, by the fact that the insurance policies make no reference to membership rights. Therefore, the premium costs go entirely towards the cost of insurance benefits provided, and there is no charge for membership rights.
• Treating the premiums as payment for membership rights is inconsistent with the Internal Revenue Code’s provisions related to insurance premiums. Gross premiums paid to purchase a policy are allocated as income to the insurance carrier, and no portion is carved out as a capital contribution. Additionally, the policyholder is allowed to deduct the aggregate amount of premiums paid upon receipt of a dividend or cash-surrender value. No amount is allocated to investment in membership rights.
• While the policyholders are provided shares on demutualization based on a value at such time, there is no evidence that this is linked to some premium value paid by the policyholders in the past. By the time of demutualization, most of the surplus supporting the valuation of newly issued stock in the companies could not be traced to payments which were made by current policyholders. Most of the surpluses found in the mutual company related to premiums paid by former policyholders who surrendered such rights when their policies lapsed or were paid on death.

Ultimately, the taxpayers could not meet their burden to demonstrate that any portion of the premiums paid were for membership interests.

It should be noted that, previously, the District Court in California ruled in the Reuben case that mutual company ownership rights had zero basis. In this case, the IRS demonstrated that the value of the membership rights before demutualization was zero. In fact, it was the conversion process itself which created any value. Additionally, the insurance company told the shareholders that the tax basis of the shares would be zero.

This case will probably embolden IRS to take a more aggressive position with respect to this issue. Pending refund claims involving demutualization transactions may be delayed.

You will need to consider this decision in assessing the risks of taking a position that basis applies to mutual company ownership interests.

Certainly, those residing in states where an appeal will go to the 9th Circuit Court of Appeals must recognize that this is the applicable law for them. If they use a more aggressive position which is questioned by the IRS, they may ultimately be required pay the tax and then bring suit in the Court of Claims. The Tax Court will probably defer to this new case where its decision would be appealable to this court.

If you have any questions on this matter, do not hesitate to contact your Marcum professional.