Tax & Accounting Blog

Federal district court in Arizona issues final decision in demutualization case

Alerts, Cost-Basis Reporting, Information Reporting for Wealth Management, ONESOURCE, Tax Information Reporting, Trust Tax, Trusts May 20, 2013

On April 19, 2013, the federal district court in Arizona issued a final decision in the Dorrance case.  2013 WL 1704907.  This follows a preliminary decision in July, 2012.  See our previous bulletin, “Open Transaction Doctrine does not apply in insurance company demutualization case,” July 16, 2012.


A mutual insurance company has no shareholders.  Instead, the policyholders have an ownership interest in the company, in addition to having contractual rights as a customer holding a policy.  During the 1990s and 2000s, several mutual insurance companies converted to stock companies, in a process called demutualization.  When an insurance company demutualizes, it typically distributes stock or cash to the policyholders, to compensate them for the loss of their ownership rights.

The wave of demutualizations has led to a difficult tax question.  When a taxpayer disposes of the stock received in a demutualization, how should he calculate his basis in the stock?  The Internal Revenue Service has taken the position that the policyholder has no basis in the stock received in a demutualization.

Treasury regulations say that, when a taxpayer acquires property, and then disposes of a portion of the property, for purposes of determining gain or loss on the disposition he must equitably apportion the basis in the original property between the portion disposed of and the portion retained.   Treas. Reg. § 1.61-6(a).  A taxpayer who holds a mutual insurance policy at the time of conversion has a basis in the policy equal to the total premiums paid through the date of the demutualization.  Under the regulations, when the company demutualizes, the taxpayer should allocate that basis between the stock received for his ownership rights, and his policyholder rights.

However, some taxpayers have argued that the open transaction doctrine should apply in such a case.  Under that doctrine, if the property has no ascertainable fair market value, making it impossible to allocate the basis, then the taxpayer recognizes no gain until he fully recovers his original basis in the entire property.

The taxpayers in Dorrance v. U.S. received stock from insurance companies that demutualized.  They later sold the stock.  On their tax returns, the taxpayers claimed no basis in the stock, and they paid tax on the resulting large gains.  Subsequently, the taxpayers sued for a refund, arguing that the open transaction doctrine applied because it was impossible to determine the value of the ownership rights.

The government argued that none of the taxpayer’s premiums were paid to acquire the ownership rights in the company, and that all of the premiums were paid to acquire insurance coverage.  Therefore, the government claimed that the taxpayers had no basis in the stock received in exchange for the ownership rights.

In the July 2012 preliminary decision, the court rejected the government’s argument.  The court said the taxpayers had met their burden of showing they paid something for the ownership rights.

However, the court also ruled that the taxpayers could not apply the open transaction doctrine.  The open transaction doctrine is available only in rare and exceptional circumstances.  The taxpayers failed to show that allocating the basis between the ownership rights and the policyholder rights was so difficult that this case required applying the doctrine.  Both the stock and the policy had a market value that could be determined.  The court would hold a trial to determine how to compute the taxpayers’ basis in the stock.

The final decision in Dorrance:

The court concluded that the value of the policyholders’ ownership rights was equal to the fair market value of the stock at the time of the demutualization.  That fair market value was the initial public offering (IPO) price of the stock.

When determining how many shares of stock to give policyholders, the insurance companies calculated (1) a fixed component for the loss of voting rights, since each policyholder was entitled to one vote, and (2) a variable component for the loss of other rights, measured by the policyholder’s past and projected future contributions to the company’s surplus.  Of the variable component, 60% was an estimate of each policyholder’s past contributions to surplus as of the calculation date, while the remaining 40% was an estimate of future contributions.

Therefore, the court decided that the taxpayers’ basis was equal to the combination of the IPO value of shares allocated to the taxpayers for (1) the fixed component representing compensation for relinquished voting rights, and (2) 60% of the variable component representing past contributions to surplus.  The portion of the variable component representing future contributions to surplus was not considered part of basis.

Based upon this formula, the court determined that the taxpayers had a basis in the stock equal to $1,078,128.  The taxpayers could apply this basis against the stock sale proceeds to calculate gain or loss.  Consequently, the taxpayers were entitled to a refund of $161,719.

Effect of the decision:

The court determined that the taxpayers had substantial basis in the stock received in the demutualizations.  Therefore, the decision was favorable to the taxpayers.  However, the court’s reasoning and methodology might not stand up if the IRS appeals.

As stated above, under Treas. Reg. § 1.61-6(a), the taxpayer allocates his basis in the policy between the policyholder rights and his ownership rights.  The court did not really allocate the basis.  Instead, it said the fair market value of the stock on the date of the demutualizations was equal to the IPO price.  Then, it leapt to the conclusion that the taxpayers’ basis in the stock was equal to that value, minus a carve-out for the portion representing future contributions to surplus not yet paid in at the time of the demutualizations.  In other words, the court seemed to confuse basis with market value.

It remains to be seen whether the Dorrance case will be a helpful precedent for other taxpayers.  First, the IRS might appeal the decision.  Second, the decision is not binding in any other case.  Other courts may disagree with the court’s reasoning.

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