John Bullis: No basis in stock received in demutualization

The Ninth Circuit Court of Appeals (our area) has held that policyholders in mutual insurance companies have no tax basis in the stock issued to them when the insurance company demutualizes.

There are two ways to own stock in an insurance company. A Stock insurance company issues stock to purchasers of the stock, just like other stock companies. They can raise capital by selling stock on the open market.

A mutual insurance company is owned by the owners of the policies it issued (sold). Those policyholders can vote on corporate issues such as liquidation. Usually each policy holder has one vote, no matter how big or little the amount or benefit for which the policy is issued.

Bennett Dorrance received stock from five mutual insurance companies when those companies changed from mutual life insurance companies to stock life insurance companies. That change is called demutualization.

When the stock was sold, a portion of the premiums that were paid for the life insurance policies was claimed as cost or tax basis when the stock was sold. Mr. Dorrance purchased a total of about $88 million of life insurance with policies from five different companies. The purchases in 1996 were to provide money to help pay the death tax in the future. Since the total premiums were about $15,265,608, you can see the reasons for the purchases, but that is how life insurance works.

In 2000 and 2001, all five of the insurance companies demutualized — changed from owned by policyholders to a stock mutual insurance company. The policies continued, unchanged in coverage or premiums and stock was issued to Mr. Dorrance for his “membership” rights. The IRS determined the value of the stock was basically nothing so the tax basis of the stock certificates received was zero.

In 2003, all of the stock was sold for $2,248,806. The income tax return Dorrance filed for 2003 showed zero basis and taxable capital gain of $2,248,806. Then, later, an amended return was filed for a full refund. The claim was no gain was owed because the sales proceeds represented a return on previously paid insurance policy premiums.

Since IRS never did pay or respond the to amended return, a complaint was filed in district court asking for the refund. The district court listened to the experts from both sides and decided the gain to be taxed was only $1,170,678. Both parties appealed that decision.

The Ninth Circuit Court of Appeals found a difference between the contract rights and the membership rights. It said the premiums paid covered the rights under the insurance contract, not the membership rights. That means the value of the membership rights, the tax basis in the stock certificates received, is zero and the full proceeds are taxable gain.

If you sold stock you received from demutualization, you might check your tax return.

Did you hear? “Behind every argument is someone’s ignorance,” by Louis D. Brandies.

John Bullis is a certified public accountant, personal financial specialist and certified senior adviser who has served Carson City for 45 years. He is founder emeritus of Bullis and Company CPAs.