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Demutalization of Insurance Company

Click here to return to the Tax Planning Guide Index * Go Back to Portfolio Income * Next Topic - Passive Income

The most common active income is wages (W2), sole proprietorship business income (SchC) and farming income (SchF). Since retirement income and Social Security benefits were generated from active earned income, they are also included in the active income category. S corporation (1120S) and partnership (1065) income where the taxpayer materially participates in the business operation would also be considered active income. Following is a discussion of other active income and the tax treatment.

Demutalization of Insurance Company

In August, a federal court decided an important tax case and it was a victory for taxpayers. The U.S. Court of Federal Claims ordered the IRS to pay a refund to a taxpayer who had been a policyholder in a mutual insurance company. The decision could open the door to many more refund claims, possibly including one from you.

The case (Eugene A. Fisher, Trustee, Seymour P. Nagan Irrevocable Trust v. U.S., August 6, 2008) involved a Canadian insurance company that did business in the U.S. The Canadian insurance company operated for many years as a mutual insurance company. A mutual insurance company has no shareholders. It is owned by its participating policyholders, who have ownership rights, such as voting and distribution rights, as well as contractual insurance rights. Many policyholders are unaware of whether the company that insures them is a mutual and non-mutual company, with policyholders in either entity merely concerned about the bottom-line premiums that must be paid. One tip-off for participating in a mutual insurance company is that, aside from a bill for premiums, you may receive a voting proxy each year in the mail.

Once the mutual company pays its claims and operating expenses, the profits belong to the policyholders. Typically, some of those profits are returned to the policyholders as dividends, which reduce premium payments, while the remainder is retained as surplus, often accumulating from year to year. The ultimate goal of this arrangement is to provide insurance at the lowest possible cost.

In 1999, the insurance company decided to demutualize. Instead of operating as a mutual insurance company, the company would covert into a publicly-traded stock company. Policyholders would keep their insurance coverage at premiums that would be unaffected by the demutualization but would receive shares of stock in the new entity. Alternatively, policyholders could elect to sell the shares.

In this case, the policyholder received 4,000 shares in the new company. The policyholder decided to sell the shares and received $32,000. The policyholder reported this amount, unreduced by any basis adjustment, on its 2000 federal income tax return and paid about $5,000 in tax. In 2004, the policyholder changed his mind on the amount of tax he should have paid and filed suit in the Claims Court for a refund.

At trial, the IRS argued that the policyholder had a zero basis in the cash or stock received in the demutualization and a carryover basis from its time as a policyholder. Policyholders receiving cash would be subject to tax on the cash received in the year of demutualization. Policyholders receiving stock were not subject to tax until the stock was sold.

The court did not have an easy job. It had to decide if the policyholder's ownership rights had a determinable fair market value at the time the insurance policy was acquired. This required the help of experts.

Naturally, the experts did not agree. The policyholder's expert testified that the ownership rights did not have a fair market value when the policy was first acquired. The court noted that if an expert lacks any rational basis on which to value an asset, the expert's finding should be a strong indication that the asset cannot be valued.

The court applied what is known as the open transaction doctrine. This complex doctrine is an exception to the general rule requiring an allocation of basis on the disposition of a portion of an asset. Ultimately, the court found that the policyholder did not realize any income on the sale of the 4,000 shares because the amount received was less than its cost basis in the insurance policy as a whole.

What does this recent case mean for you? If you sold shares from a demutualization, you may also be eligible for a refund of tax paid. You must file an amended federal tax return and it must be timely filed. The rules for filing amended returns, just like the facts of this case, are complex. Also, keep in mind that the IRS may appeal the court's decision. A higher court could decide in favor of the IRS. Our office will keep you posted. If you sold demutualized stock close to three years ago, you might need to worry about the statute of limitations and file a protective refund to preserve your claim. Please call or email our office if you have any questions.

Reproduced with permission from CCH’s Client Letter, published and copyrighted by CCH Incorporated, 2700 Lake Cook Road, Riverwoods, IL 60015.

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