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Courts Split on Tax Treatment of Gain on the Sale of Demutualized Stock
(Parker's Federal Tax Bulletin: May 10, 2013)

So far this year, two district courts have expressed differing views on the tax treatment of gain on the sale of stock acquired as a result of the demutualization of insurance companies. And those two opinions are at odds with a 2008 Court of Federal Claims decision that was upheld by an appellate court. In Fisher v. U.S., 2008 PTC 2 (Fed. Cl. 2008), aff'd, 333 Fed. App'x 572 (2009), the Court of Federal Claims concluded that the open transaction doctrine applied to the sale of the taxpayer's stock acquired as a result of a demutualization. Under the open transaction doctrine, until the taxpayer recovered his stock basis, no gain was recognized on the sale of the stock. This is, of course, the best result a taxpayer could hope for. Unfortunately, other courts did not agree with that analysis.

In Reuben v. U.S., 2013 PTC 74 (C.D. Calif. 2013) and Dorrance v. U.S., 2013 PTC 34 (D. Ariz. 2013), the taxpayers tried to apply the open transaction doctrine to the sale of stock acquired as a result of a demutualization, citing the opinion in Fisher. However, the Arizona district court, as well as the California district court, criticized the Fisher court's analysis and concluded that the open transaction doctrine did not apply.


A mutual insurance company has no shareholders, but instead is owned by its participating policyholders, who possess both ownership rights, such as voting and distribution rights, as well as the typical contractual insurance rights. The policyholders' voting rights differ from those possessed by traditional shareholders in that each policyholder has but a single vote, regardless of how many policies it owns or the amounts thereof. Once the mutual company pays its claims and operating expenses, the profits belong to the policyholders. Typically, some of those profits are returned to the policyholders as dividends, which reduce premium payments, while the remainder is retained as surplus, often accumulating from year to year. Payment of such policy dividends is largely at the discretion of the board elected by the participating policyholders. The ultimate goal of this arrangement is to provide insurance at the lowest possible cost.

A mutual insurance company may decide to convert to a publicly traded stock company. This happens through a process called demutualization. The policyholders continue to own their insurance policies and receive stock in the company in exchange for their voting and liquidation rights. Upon the subsequent sale of the stock, the calculation of gain has been problematic from a tax point of view.

Gross income includes gains derived from dealings in property, and such gains generally equal the amount realized less the seller's cost basis in the property sold. Though clear in principle, these rules are not always easily applied particularly where the property sold was first acquired, for a lump sum, as part of a larger assemblage, and especially where the values of the individual components of that grouping are not readily ascertainable. In this situation, there are several possible outcomes. The property can be treated as having little or no cost basis, so that most or all of the sale proceeds are taxable. Alternatively, the property can be treated as sharing the cost basis of the entire bundle, so that no gain is realized until all the capital represented by that basis is recovered. Or finally, a valuation can be assigned to the rights given up and some sort of allocation can be made to come up with a policyholder's stock basis. These are among the possible outcomes involving insurance policy rights acquired as an indivisible package, but then separated and sold as part of a demutualization of the insurance provider.

The Best Possible Outcome - the Fisher Decision

In 1990, the Seymour P. Nagan Irrevocable Trust bought a life insurance policy from Sun Life Assurance Company on the lives of Seymour Nagan and Gloria Hagan. Eugene Fisher was the trust's trustee. Before 2000, Sun Life Assurance Company was a Canadian mutual life insurance and financial services company that conducted business in Canada, the United States, and other countries. The policy purchased by the trust was for $500,000, with annual premiums at $19,764 per year. Under this "participating policy," the policyholder's ownership rights included the ability to vote on matters submitted to participating policyholders, participate in the distribution of profits of Sun Life from all its businesses, participate in any distribution of demutualization benefits, and if Sun Life were ever to become insolvent, participate in the distribution of any remaining surplus after satisfaction of all obligations.

The trust's right to receive distribution of profits took the form of an annual dividend representing the amount, if any, of profits not retained in surplus. These ownership rights could not be sold separate from the policy and were terminated when the policy ended.

In 1999, Sun Life proposed to its policyholders a plan to demutualize. Under the plan, the policyholders would retain their insurance coverage at premiums that would be unaffected by the demutualization, but would receive shares of stock in a new holding company, Sun Life of Canada Holding Corp. (Financial Services), which would become the corporate parent of Sun Life. Those shares were to be exchanged for the ownership rights possessed by the participating policyholders, with approximately 20 percent of the shares being allocated to compensate for the loss of voting control and the remaining 80 percent of the shares being allocated to compensate for the loss of other ownership rights, including the right to receive a liquidating distribution. Under the plan, eligible policyholders did not have to take stock in exchange for their shares. Instead, they could take a cash amount determined by multiplying the number of Financial Services Shares sold . . . by the Initial Share Price at which the number of Financial Services Shares are sold in connection with the initial public offering."

With the plan for demutualization, Sun Life provided to its policyholders an actuarial study that focused on whether the stock to be provided in the demutualization adequately compensated the policyholders for the ownership rights they were relinquishing. It recognized that the stock allocation "should fairly compensate for what policyholders lose in the demutualization; namely, voting control of the insurance company and the right to share in the insurance company's residual value if it is wound up."

The trust received 3,892 shares of Financial Services stock in exchange for its voting and liquidation rights. Opting for the "cash election," the trust permitted Sun Life to sell those shares on the open market for $31,759. The trust reported this amount, unreduced by any basis adjustment, on its federal income tax return for 2000 and paid the resulting tax of $5,725. In 2004, the trust filed a refund claim, which the IRS denied. After the district court found that the proceeds from the sale of the Financial Services stock could not be deemed a distribution by Sun Life of a policy dividend, or the equivalent thereof, so as to be excluded from gross income as a return of capital under the annuity rules of Code Sec. 72, the case proceeded to trial.

At trial, the parties' expert witnesses assigned dramatically different values to the basis of the ownership rights. The trust's expert testified that he could not form an opinion as to the fair market value of the ownership rights because he found the ownership rights to be inextricably tied to the policy; in his view, the ownership rights added value to the policy but never had a separate value. The IRS's expert determined that the fair market value of the ownership rights was zero. He emphasized that none of the premiums were specifically dedicated to acquiring the ownership rights, that there was no available market for the ownership rights, and that it was highly unlikely, at the time the policy was acquired, that a demutualization would occur. According to the IRS, the stock distributions made with respect to the ownership rights were a windfall, the entire amount of which was taxable.

In Fisher v. U.S., 82 Fed. Cl. 780 (Fed. Cl. 2008), aff'd, 333 Fed. App'x 572 (2009), the court held that that the value of the ownership rights was not discernible and that this was a situation in which it was appropriate to apply the "open transaction" exception to Reg. Sec. 1.61-6. The court concluded that since the amount received by the trust was less than its cost basis in the insurance policy as a whole, the trust did not realize any income on the sale of the stock in question and, therefore, was entitled to a full tax refund.

The Next Best Possible Outcome - the Dorrance Decision

Bennett and Jacquelynn Dorrance formed the Dorrance 1995 Legacy Trust (the Legacy trust), which in turn purchased five life insurance policies in 1996. In the aggregate, the policies provided $88 million in coverage. The Legacy trust purchased the policies in the anticipation that the benefits would provide liquidity to pay the Dorrances' estate taxes upon their death, so that their heirs would not need to liquidate the family stock portfolio to pay such taxes.

Along with insurance benefits, those policies granted the Dorrances' mutual ownership rights in the companies (i.e., mutual rights) for as long as they paid premiums. These mutual companies later demutualized and converted into stock-based companies. The mutual companies compensated the Dorrances for the loss of their mutual rights with shares of stock that they later sold at a gain. The Dorrances listed a zero cost basis when reporting their proceeds for 2003 and paid taxes on the full amount of the gain. Subsequently, they filed a claim for a refund, arguing that they did not owe tax on their proceeds.

The IRS argued that the couple had no basis in the stock received as a result of the demutualization. Citing the Fisher case, the Dorrances countered that the demutualization should be governed by the open transaction doctrine such that proceeds from the stock sale would be considered a return of capital from their premiums, and they would thereby owe no tax. In Dorrance v. U.S., 2012 PTC 199 (D. Ariz. 2012), the court held that the open transaction doctrine did not apply because the Dorrances' mutual rights were not elements of value so speculative in character as to prohibit any reasonably based projection of worth. However, the district court also held that the Dorrances had met their burden of showing they paid something for the mutual rights because they paid premiums for policies that included both policy rights and mutual rights.

In January 2013, in Dorrance v. U.S., 2013 PTC 34 (D. Ariz. 2013), the same court was asked to determine an equitable method to allocate the premiums paid by the Dorrances before demutualization and to apply that amount as a cost basis to calculate the taxable gain, if any, on their sale of stock. The court found that, although the Dorrances' mutual rights contributed to the insurance policies' value from the time the policies were purchased, the cost of the mutual rights could not be determined before demutualization. The mutual rights were not separable from the policy rights and could not be sold. Therefore, the court found that the cost associated with acquiring mutual rights could not be established exclusively through the Dorrances' payment of premiums. Instead, the court concluded that the stock basis was equal to the combination of the initial public offering (IPO) value of the shares allocated to the Dorrances for (1) the fixed component representing compensation for relinquished voting rights (i.e., fixed shares) and (2) 60 percent of the variable component representing their past contributions to surplus (i.e., variable shares).

Thus, the court concluded that the Dorrances paid for shares of stock in the demutualized companies by contributing to the companies' surplus and by relinquishing voting rights in exchange for the shares. Accordingly, the court said they had a cost basis in their shares of the amount calculated using the above formula and were entitled to a partial tax refund.

The Worst Possible Outcome - The Reuben Decision

In 1989, the Don H. and Jeannette H. Reuben Children's Irrevocable Trust (i.e., the Reuben Trust) purchased an insurance policy from Manulife, a mutual life insurance company. The Reuben Trust made premium payments on its policy in excess of $1.7 million from 1989 until 1999. In 1999, Manulife demutualized and eligible members of Manulife were entitled to receive common shares, cash, a combination of shares and cash, or policy credits in exchange for their membership interests. On December 9, 1999, the Reuben Trust received 40,307 shares of stock in connection with the demutualization.

On December 9, 2004, 5,001 of these shares were distributed to Timothy Reuben by the trust. In 2005, Timothy sold 4,000 of the Manulife shares for approximately $205,000. On his 2005 tax return, Timothy listed the basis of the shares as zero. He subsequently filed a claim for refund, based on the Fisher decision, and asserted a value of over $41 for each share sold. The IRS rejected the claim and Timothy appealed. On October 13, 2011, the IRS informed Timothy that it was suspending action on his appeal until the conclusion of proceedings in the Dorrance case.

The IRS argued that Timothy had not satisfied his burden of establishing the basis for his Manulife shares and, thus, the IRS was entitled to summary judgment. Timothy, on the other hand, argued that (1) the Reuben Trust's ownership rights in Manulife had some value before the demutualization of Manulife, and this value was not de minimis; (2) because it was impossible or impracticable to determine the value of these ownership rights, the open transaction doctrine applied to the calculation of the basis value in the Manulife shares, allowing Timothy to apply gains received from the sale of the Manulife shares to the basis for all of the Manulife shares received by Timothy without apportioning basis between the sold Manulife shares and the retained Manulife shares; and (3) applying the open transaction doctrine resulted in a basis value of $42 per share, which value was derived by dividing the total amount of premiums paid by the Reuben Trust by the amount of shares of Manulife stock received by the Reuben Trust upon demutualization.

In March 2013, in Reuben v. U.S., 2013 PTC 74 (C.D. Calif. 2013), the court rejected the taxpayer's claim that the decision in the Fischer case controlled the outcome of the case. The court noted that the Fisher decision has drawn criticism and that the only other court to have considered it (i.e., the Dorrance court) rejected its reasoning. According to the court, the issue in Reuben was whether the taxpayer paid anything for the membership rights in the insurance policy, not whether those membership rights had any value. The court noted that the premiums paid for the life insurance policies were identical before and after the insurance company demutualized. To the court's view, this supported the proposition that all of the premiums paid before the demutualization were for the underlying life insurance policy and not for the membership rights. Thus, the court concluded that the taxpayer had zero basis in the stock sold after the demutualization and was not entitled to any tax refund.

Staff Editor Parker Tax Publishing



Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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