Court rebuffs IRS and allows policyholder to escape gain on demutualization
Eugene A. Fisher et al. v. U.S. (Ct Cl 8/6/2008) 102 AFTR 2d ¶ 2008-5150
The Court of Federal Claims has applied a variation of the open transaction doctrine with the result that a policyholder had no gain to report when it chose a cash option in connection with a demutualization of an insurance company. Under this option, the shares awarded to the policyholder were immediately sold by the company and the proceeds were then paid to the policyholder in cash. IRS said that the policyholder was taxable on the full amount of the gain without being able to allocate any of his basis in the contract to offset the sales proceeds. The Court allowed the policyholder to use his basis in the contract (which greatly exceeded the amount of the sales proceeds) to fully offset the proceeds and thus to report no gain.
Background on demutualizations. Mutual insurance companies are owned by their policyholders, whose “membership interests” give them the right to vote on corporate governance issues. Mutual insurance companies can only raise capital by retaining earnings or charging excess premiums. Stock insurance companies, on the other hand, are owned by their shareholders. They can raise capital more easily by selling stock on the open market. In addition, they can diversify more easily by creating upstream holding companies that can own subsidiaries engaged in other businesses.
An increasing number of mutual insurance companies have converted to stock companies to gain the capital raising and diversification opportunities enjoyed by stock companies. These demutualizations, as the conversions are called, can take different forms. One form is a full demutualization in which the company is transformed into a stock company and its surplus is distributed to policyholders as stock, cash or policy credits. Each policyholder’s share of the distribution is determined under an allocation formula devised by the company and reviewed by state insurance regulators.
Facts. Before 2000, Sun Life Assurance Company (Sun Life) was a Canadian mutual life insurance and financial services company that conducted business in Canada, the U.S. and other countries. On June 28, ’90, the Seymour P. Nagan Irrevocable Trust (the Trust) purchased a life insurance policy from Sun Life on Seymour Nagan and Gloria Hagan. The policy was for $500,000, with annual premiums at $19,764.
On Oct. 29, ’99, Sun Life proposed a plan to its policyholders 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. Under the plan, eligible policyholders–those that had policies in force as of Jan. 27, ’98–did not have to take stock in exchange for their shares. Those in the U.S., for example, could elect to sell the shares issued in connection with a planned initial public offering, an option referred to as the “cash election.”
On Dec. 15, ’99, the demutualization plan was approved by the eligible policyholders and in early March of 2000, Sun Life began its initial public offerings and received various regulatory approvals to proceed with the demutualization. On May 19, 2000, IRS issued PLR 200020048, ruling that, under Code Sec. 354(a)(1), no gain or loss would be recognized by the Eligible Policyholders on the deemed exchange of their Ownership Rights solely for Company stock. IRS further concluded that the basis of the Company stock deemed received by the Eligible Policyholders in the exchange will be the same as the basis of the Ownership rights surrendered in exchange for such Company Stock, that is, zero. IRS did not rule on the tax treatment to be afforded the cash received in lieu of shares exchanged for ownership rights.
When the demutualization took effect, Trust received 3,892 shares of Financial Services stock in exchange for its voting and liquidation rights. At that time, Trust had paid premiums of over $194,000. Opting for the cash election, Trust permitted Sun Life to sell those shares on the open market for $31,759. It reported this amount, unreduced by any adjustment for any portion of its over $194,000 basis for premiums paid, on its federal income tax return for 2000 and paid the resulting tax of $5,725. It subsequently filed a claim for refund, which IRS denied. The matter ultimately wound up in the Court of Federal Claims where Trust took the position that it should be able to use $31,759 of its basis to offset the proceeds. This would result in no gain and a refund for Trust.
Background on basis and gain. Gross income includes gains derived from dealings in property. (Code Sec. 61(a)(3)) Under Code Sec. 1001(a), gain from the sale or other disposition of property is the excess of the amount realized on the disposition over the adjusted basis provided in Code Sec. 1011 for determining gain. Adjusted basis is usually cost (Code Sec. 1012) with certain adjustments not relevant in this case.
The rules become a bit more complicated when a taxpayer transfers only a portion of an asset previously-acquired. Then, the basis of the latter asset generally must be apportioned between the portions disposed of and retained. (Reg. § 1.61-6(a)) As established in numerous cases, this apportionment is done by dividing the cost basis of the larger property among its components in proportion to their fair market values at the time they were acquired.
Open transaction applied here. Under the open transaction doctrine, if the sale remains open, the deferred payments are applied in reduction of basis as received, and only when the amount received exceeds the basis is there a taxable gain. The Court of Claims concluded that a variation of the open transaction doctrine should be applied in this case as an exception to Reg. § 1.61-6(a). The facts in this case were different from the typical open transaction case where it is uncertain how much will be received for the stock or other item being sold. Here, that amount was determinable. In this case, the Court found that there was no way to determine the value of the ownership rights that were transferred. Since their value could not be determined, the Court felt it was proper to allow basis to be recovered fully against the cash received for the shares under a variation of the open transaction doctrine.
Bottom line. The Court said that, based on the record, it simply could not credit the zero valuation of the ownership rights, as put forth by IRS‘s experts. Rather, the record supported the opinion rendered by Trust’s valuation expert that the value of the ownership rights was not discernible. This, in turn, led the Court, to conclude that Trust met its burden of proof in this case. The facts showed that this was an appropriate situation in which to apply the “open transaction” exception to Reg. § 1.61-6. That being the case, and the amount received by Trust being less than its cost basis in the insurance policy as a whole, the Court found that Trust did not realize any income on the sale of the stock in question and, therefore, was entitled to the requested refund.
Observation: While the tax dollars in this case were not large, the implications for the government can be huge if other taxpayers sue in the Court of Claims or if other courts follow its decision. IRS consistently issued private rulings to the effect that basis of a policyholder’s membership interest is zero and thus, under Code Sec. 358(a)(1), the basis of stock received in exchange for the membership interest also is zero. The Court’s decision turns this proposition on its head. Affected taxpayers who previously reported gain without applying any basis, if not time-barred, should file refund claims on the strength of the Court’s decision. Those who have yet to file should apply basis to wipe out or reduce gain on the strength of the Court’s decision while at the same time being mindful that IRS could appeal this case, possibly with success.
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