A U.S. District Court in Arizona has ruled in Bennett Dorrance v. United States (No. 2:09-cv-01284) that policyholders in a mutual insurance company have basis in stock granted as part of a demutualization, but that the open transaction doctrine does not apply.
The District Court reached a different conclusion than the Court of Federal Claims and the Court of Appeals for the Federal Circuit reached in Fisher v. United States (82 Fed. Cl. 780 and Docket No. 2009-5001). Both cases involve mutual insurance companies (i.e., insurance companies owned by their policyholders) that "demutualized" to become publicly traded corporations, a common occurrence in the 1990s and 2000s. In the demutualization process, policyholders are issued shares in the new corporation in exchange for the ownership rights in the mutual insurance company. At issue is the basis policyholders have in the shares received.
The IRS's position has been that the basis is the same as the basis of the ownership rights surrendered in exchange for the stock. The IRS, opining that ownership rights had no value independent of the insurance policies, assigned a value of zero to such rights — meaning a basis of "zero" in the new shares. Policyholders have argued that ownership rights have some value, and basis (the premiums paid for their life insurance policies) should be allocated between the life insurance policies and the shares received in the demutualization. The courts ruled in Fisher that because there is no reasonable way to allocate basis between the life insurance policies and the shares, the open transaction doctrine should apply — allowing policyholders to recover their basis in the assets before gain is recognized.
The District Court in Dorrance agreed with the Court of Federal Claims that the shares received in a demutualization had value, but it did not agree that the open transaction doctrine applied. In Dorrance, a trust owned five life insurance policies with mutual insurance companies that demutualized through processes that began in 1998 and culminated in 2001. After demutualization, none of the premiums on the life insurance policies increased. In 2003, the trust sold all the stock it received in the demutualizations, realizing a gain of approximately $450,000. The trust received Forms 1099-B showing the bases in the stock of $0. The trust paid the taxes and filed for a refund on the basis that under the open transaction theory, it had not yet received a return of its bases in the investment in the life insurance contracts. The IRS denied the refund request on the basis that the trust's bases in the stock were $0.
The District Court first addressed the issue of whether the trust had met its burden of proving it had basis in mutual rights inherent in the life insurance policies. The court determined that the trust had met its burden of showing it paid something for the mutual rights by proving that the trust paid premiums for policies that included the policy rights and the mutual rights.
The District Court then addressed how the basis should be allocated between the two assets that were created when the insurance companies demutualized — the life insurance policy and the company stock. The court analyzed the history of the open transaction theory and the Fisher case, noting that the doctrine must be applied sparingly. The court then determined that the trust had failed to show that allocating basis between the mutual rights and the policy was so difficult that the allocation required applying the open transaction doctrine. It further noted that despite disagreement regarding what the trust may have paid for its mutual rights, there was no question that at the time of demutualization, both the value of the stock and the market value of the policy could be calculated.
In distinguishing the case before it from Fisher, the court noted that given the limited arguments at trial, it was not surprising that the Fisher court found itself limited to deciding only whether (1) none of the basis of the originally acquired property is allocable to the part disposed of, or (2) all of it is allocable thereto until exhausted. The court noted that it was not so limited on a motion for summary judgment and found neither argument in Fisher convincing.
Finally, the District Court surmised how basis might be allocated between the stock and the life insurance policies. It noted two possible ways. First, it cited case law suggesting a comparison of the cost of the trust's policies to the cost of comparable policies issued by nonmutual insurance companies at the time of issuance. Second, it cited commenters who have suggested that comparing the market value of the policy and the stock at the time of demutualization and then applying that ratio to the premium payments would be appropriate. The court determined that it need not resolve the proper method of allocation on summary judgment and encouraged the parties to present evidence regarding an equitable method of allocation at trial.
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