By Michael D. Koppel, CPA, MBA, MSA, PFS, CITP
Gray, Gray & Gray, LLP
May 2013
Many insurance companies were originally formed as mutual insurance companies. Instead of issuing stock the company was, in effect, owned by its policyholders – the people and entities that purchased policies.
In the past 15 or so years, approximately 35 insurance companies have chosen to convert from mutual to stock ownership, a process called “demutualization.” The reasons include gaining the desire to raise money through a public offering, more flexibility for mergers and acquisitions, and a change in tax policies that reduced the benefits of the mutual format.
Upon conversion, policyholders (the owners) were offered stock in the company or money. While the non-taxable dividends they once enjoyed are gone, policyholders who are now stockholders may still benefit from gains in the value of the company’s stock.
This conversion process has affected a huge number of individuals, as well as corporate investors, trusts and partnerships. For example, it is estimated that Metropolitan Life had approximately 11.2 million policyholders and Prudential had over 11 million policyholders. It is important to remember that shares were issued not only to individuals, but also to other entities – it is estimated that more than half of the shares in demutualization went to corporations, trusts and partnerships.
One burning question about mutual conversions remained unanswered until recently: When a taxpayer or tax paying entity sells stock that was received in demutualization, what is their cost basis? Are they to be treated as if they actually paid for the stock? As you can imagine, taxpayers and the Internal Revenue Service (IRS) have vastly differing views on the subject.
The landmark case on the topic is a U.S. Court of Appeals case brought by trustee Eugene Fisher on behalf of a taxpayer, Seymour Nagan Irrevocable Trust. In August, 2008 the court ruled that the ownership rights in the shares distributed in demutualization should, in theory, have an allocation of basis from the insurance policy. However, the court could not determine what the actual value of the demutualized shares should be. The court used the “open transaction” method under which the proceeds of the demutualized shares were treated as a return of capital up to the amount the policyholder had paid for the insurance. Since the taxpayer had paid more for the insurance than the amount received in demutualization there was no gain and therefore no tax.
The IRS disagreed with the court’s interpretation. This was clearly demonstrated in a letter sent on May 23, 2011 to Senator Tom Harken of Iowa. A constituent taxpayer had requested that Senator Harken intervene on a request for a tax refund based on the Fisher case. The IRS issued the refund, and their response said, in part, “The IRS does not agree with Fisher. The IRS view is that a taxpayer realizes income to the extent that the stock sales proceeds exceed the taxpayer’s payments (cost basis), if any, for the equity interest. The taxpayer has the burden of proving the amount paid for the equity interest. Because the IRS disagrees with the Fisher holding, we continue to litigate the issue. (See Dorrance v. United States, Civil Action No. 09-cv1284-PHXROS (D. Arizona). Pending final resolution of the issue, the IRS is not issuing refunds based on the Fisher decision.”
The court case cited in the IRS letter was being litigated in the U.S. District Court in Arizona. That court recently issued their opinion on the Dorrancecase, concluding that the taxpayer’s request for a refund of taxes should be granted. Although it is still possible that the IRS will appeal the ruling, the Dorrance ruling is good news for potentially millions of taxpayers.
However, we cannot assume this is the final resolution of the situation. The IRS can – and almost certainly will – challenge the court’s decision.
But for now the millions of shares of stock that have been issued for demutualized insurance companies have a stronger position for a cost basis. Although there is no guarantee that the IRS will start issuing refunds, taxpayers who sold stock they had received in demutualized insurance company, and who filed tax returns in the last three years, should consider filing amended returns requesting refunds. Taxpayers who still hold shares received in demutualization should discuss the tax status of their shares with a qualified tax advisor.
The question of taxability of shares received in demutualization is very complex. It is important to obtain guidance from a qualified tax advisor before making any decisions.
Michael D. Koppel, CPA, MBA, MSA, PFS, CITP is a tax advisor at Gray, Gray & Gray, LLP Certified Public Accountants in Westwood, MA (www.gggcpas.com).