Tax & Accounting Blog

Open Transaction Doctrine does not apply in insurance company demutualization case.

1099, Cost-Basis Reporting, Information Reporting for Wealth Management, ONESOURCE, Tax Information Reporting, Trust & Estate Administration, Trust Tax, Trusts July 16, 2012

On July 9, 2012, a federal district court in Arizona ruled that the taxpayer could not apply the “open transaction” doctrine in a case involving stock received from an insurance company that demutualized.

Background.

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.   A taxpayer who holds a mutual insurance policy 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.

In a 2008 case, Fisher v. U.S., a taxpayer argued that it was impossible to ascertain the value of the ownership rights the taxpayer surrendered in the demutualization.  Therefore, the taxpayer did not have to recognize gain until he recovered his original, unallocated basis.  The Court of Federal Claims ruled in the taxpayer’s favor in that case.  The government appealed, but the Federal Circuit Court of Appeals affirmed the decision without issuing an opinion.  The Fisher case had no value as a precedent.  The IRS disagrees with the Fisher decision, and it has continued to litigate the issue in other cases.

The Dorrance case.

The taxpayers in Dorrance v. U.S. received stock from mutual 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 purchase the insurance policy.  Therefore, the government claimed that the taxpayers had no basis in the stock received in exchange for the ownership rights.

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.  When a taxpayer shows that he has made some investment in property, but cannot establish the value of that investment, his basis should not be zero on the ground that it is impossible to tell how much he had in fact spent.

However, the court found 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 discussed various methods for allocating the basis of property that is divided.  One possible method would be to allocate the basis to each piece in proportion to their relative fair market values.  But the court left the exact method to be decided after a trial.

Effect of the Dorrance case.

The ruling in Dorrance was only an interim decision.  The case will proceed to trial on the issue of how to allocate the taxpayer’s basis between the ownership rights represented by the stock received, and the policyholder rights.  Further, the decision is authority in only one federal district court.

However, the decision is important.  It is likely to influence other courts that might consider the same issue.  It could also affect how the IRS and taxpayers approach the issue.

The court decisively rejected the IRS’s longstanding position that stock received in a demutualization has no basis.  That was a partial victory for taxpayers.  However, taxpayers will likely not be able to apply the open transaction doctrine to defer gain recognition until they recover their entire basis in the insurance policy.  Instead, taxpayers will need to allocate their basis based upon some reasonable method.