Stock Received in Demutualization Has Zero Basis per Ninth Circuit, Creating Split with Federal Circuit

In the case of Dorrance v. United States, CA9, 116 AFTR 2d ¶2015-5505, reversing DC Arizona, 111 AFTR 2d 2013-1280 a divided panel concluded that stock received from demutualization of an insurance company has a basis of zero.  Note that this viewpoint is at odds with the holding of Federal Circuit Court of Appeals in the case of Fisher v. United States, 102 AFTR 2d 2008-5608 (2008), affd 105 AFTR 2d 2010-35 (2009) creating a split in the circuits on this issue.

An individual who purchases insurance from a mutual insurance company gains a form of ownership interest in the carrier at the same time as the policy is purchased.  As the majority opinion explained:

For centuries, mutual insurance companies have provided a structure for collecting policyholder premiums and spreading risk and surplus among policyholders, while maintaining policyholder ownership of the company. Mutual insurance companies are distinct from stock companies in that they are owned by the policyholders, not by stockholders.

For a number of reasons, not the least of which being having a simpler access to additional capital, mutual insurance companies converted to stock based companies.  As part of that process the companies issued shares of stock to policyholders on the date of the conversion. 

The key question which the court had to face here was what basis, if any, did a policyholder obtain in those shares.  In the Fisher case, cited above, the Court of Claims determined that the open transaction doctrine should apply in such a case.  Under that doctrine the basis of the policy prior to demutualization consisted of both the ownership rights and the contract rights to the insurance, with basis being recovered against proceeds from the disposal of either the stock or insurance policy as they were received, with any gains taking place only after the entire basis had been recovered.

However the District Court in this case rejected that view, holding instead that the value of the stock on the date of demutualization should calculated as explained below in the majority opinion:

The district court calculated the Dorrances' basis in the stock using the following formula: (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. Applying this formula, the court found that the Dorrances were required to pay taxes on $1,170,678, rather than on the full $2,248,806 value of the stock. Because in 2003 the Dorrances had paid taxes based on a zero basis calculation in the stock, the district court found that they were entitled to a refund.

However, the majority rejected that view, instead determining the rights had a zero basis.  The majority found:

In analyzing the insurance policies, it pays to bear in mind that, “[a]s an overarching principle, absent specific provisions, the tax consequences of any particular transaction must reflect the economic reality.” Washington Mut. Inc., 636 F.3d at 1217 (citing Kraft, Inc. v. United States, 30 Fed. Cl. 739, 766 [73 AFTR 2d 94-912] (Fed. Cl. 1994); United States v. Winstar Corp., 518 U.S. 839, 863 (1996)). The reality here is that the Dorrances acquired the membership rights at no cost, but rather as an incident of the structure of mutual insurance policies.

The Court found that everything the Dorrances had paid related to the contract rights to insurance coverage and nothing was paid for the membership rights, which existed only so long as they maintained a policy with the entity. 

The difference between contract rights and membership rights is critical to resolution of this case. The premiums paid covered the rights under the insurance contract, not any membership rights. Notably, the policies themselves generally make no reference to any such membership rights. In other words, premium payments go toward the actual cost of the life insurance benefits provided. The mutual companies did not count membership rights as having a cost (apart from minimal administrative costs, if there is a policyholder vote), so they did not charge policyholders for such rights.

The Court justified this view as follows:

The membership rights were assigned a monetary value at the time of the exchange only as a consequence of the demutualization process. The error of the Dorrances and the district court was to assume that the value received upon demutualization was linked with some premium value paid by the policyholders in the past. But the stock the Dorrances received in exchange for the membership rights cannot be understood as a partial return on their past premium payments and it is well understood that policyholders do not contribute capital to the companies.

By the time of the demutualization, the lion's share of the surplus that fed valuation of the newly issued stock could not be traced to payments made by current policyholders. Nearly all of the surplus held by the companies at that time was attributable to former policyholders, not current policyholders like the Dorrances. For example, at the time of demutualization, less than 10% of the Sun Life surplus was attributable to current policyholders; premiums paid by former policyholders accounted for over 90% of the surplus. Thus, the value at demutualization was not derived from something paid for by the Dorrances.

Or, to put it simply, the vast majority of “value” for such rights was surrendered by prior policyholders over the years, either when they allowed their policies to lapse, or a death benefit was paid on the passing of the policyholder.  Thus the majority concluded:

The district court skipped a critical step by examining thevalue of the mutual rights without evidence of whether the Dorrances paid anything to first acquire them. The basis inquiry is concerned with the latter question. The district court also erred when it estimated basis by using the stock price at the time of demutualization rather than calculating basis at the time the policies were acquired. The stock value post-demutualization is not the same as the cost at purchase.

…This analysis brings us back to the Dorrances' burden and the economic realities of this case. Because the Dorrances offer nothing to show payment for their stake in the membership rights, as opposed to premium payments for the underlying insurance coverage, the IRS properly rejected their refund claim. The district court erred when it held that there was a calculable cost basis in the Dorrances' membership rights.

However the majority failed to convince the third judge on their panel, who noted in his dissent:

For thousands of years, philosophers, theologians, and now physicists, have debated whether the earth was created ex nihilo, i.e., out of nothing. Whatever the answer to that question, there is little doubt that my colleagues in the majority have performed a notable miracle of their own in this case, by creating nothing out of something, i.e., nihil ex aliquo.

The Court points out that the majority erred by claiming policyholders weren’t the source of capital, asking if they weren’t the source via their premiums, then where had that surplus come from.  As well, the Court (correctly in the author’s view) rejected the view that a tax free exchange meant implicitly that the basis had to be zero, as §358(a)(1) only required the value of what was received be equivalent to the value of what was given up. 

The dissent held that the District Court was correct in its calculation of basis and that it should not have been disturbed.

Neither opinion specifically addresses the open transaction doctrine that the Federal Circuit hung its hat on, but both effectively disagree with it.  The majority in a footnote points out that, having decided the rights had no basis, clearly the open transaction question was no longer relevant.  Similarly, as the dissent accepted the District Court calculation, it also implicitly accepts the District Court’s rejection of the open transaction doctrine.

What this means now is that the proper treatment of the sale of stock received in a demutalization is far from clear.  Obviously, any taxpayer whose case would normally go to the Ninth Circuit must recognize that if the IRS disallows any basis (which they almost certainly will on any exam where the issue is recognized), the only recourse for the taxpayer would be to pay the tax and then bring suit in the Court of Claims—a cost-prohibitive option for many taxpayers.

Outside the Ninth Circuit taxpayers at least retain the option of going to Tax Court, but then we are looking at a lack of guidance of how that court will rule and, as well, what the applicable Circuit would decide if asked.

Ultimately advisers need to explain the issues and options to affected clients, assisting the client in deciding what position the taxpayer wishes to adopt with regard to their own situation.