The happy fun times may be ending for recipients of insurance company stock when mutual companies go public. A U.S. district court in Arizona has ruled that the “open transaction” rule is not the right way to tax sale of stock received in a demutualization transaction. He instead said that the cost of insurance policies needs to be allocated between the stock and the insurance policy value, and he ordered a trial to be held on how that should be done.
When a mutual insurance company becomes a stock company — usually so it can go public — its policyholders receive shares of the company based on their policy and business history with the mutual company — which they own as mutual policyholders. Des Moines’ Principal Financial Group, for example, demutualized in 2001. The IRS has long argued that taxpayers should receive no basis in stock received when mutual insurance companies convert to stock companies. That would require taxpayers receiving such stock to pay capital gain taxes on 100% of proceeds received when demutualization stock is sold.
A Minnesota CPA has long argued against this treatment, and his position won out when the Court of Claims in Washington, D.C. ruled in Fisher that the “open transaction” rule applied to demutualizations. This position was upheld on appeal by the Court of Appeals for the Federal Circuit. Under this rule all policy premiums paid could be considered to apply to the stock, and the reported gain would normally be zero. Because most life insurance proceeds are non-taxable, there would be no gain on the insurance policies either.
The Arizona court held that neither the IRS approach or the Open Transaction approach were proper in the case under consideration:
The Court does not lightly disagree with another federal district court, and relies in some degree on arguments that do not appear to have been made before the Fisher court. But given the limited arguments at trial, it is not surprising that the Fisher court found that it was limited to deciding only whether “none of the basis of the originally-acquired property is allocable to the part disposed of or that all of it is allocable thereto until exhausted?” Id. at 784 (double emphasis in original). At summary judgment, this Court is not so limited, and finds neither argument convincing.
The judge said that there is no good reason the amount paid over the years in policy premiums can’t be allocated between the policies and the shares:
Since the value of both the mutual rights and the policy itself at the time of demutualization can be determined, there is no concern here that the taxpayer will be forced to pay tax on a transaction that is later proven to show a loss. The Ninth Circuit has confirmed that “taxation of an ‘open’ transaction is deferred only to the extent that consideration received by the seller consists of property having no ascertainable fair market value in the year of sale.”
The court ruling was a “summary judgment” holding that the taxpayer cannot rely on the Open Transaction rule. There will now be a trial to determine how the basis will be allocated:
Neither party has yet presented evidence from which the Court could equitably apportion the premiums paid before demutualization as basis in the mutual rights and basis in the policies themselves. The Court has noted that previous Ninth Circuit caselaw suggests that the best method for such apportionment would be to compare the cost of Plaintiffs’ policies to the cost of comparable policies issued by non-mutual insurance companies at the time of issuance. Gladden, 262 F.3d at 856. On the other hand, commenters writing specifically about the issue of applying basis to mutual rights have suggested that comparing the market value of the policy and the stock at the time of demutualization, and applying that ratio to the premium payments, would be more appropriate.
The Court need not address, at summary judgment, which method of apportionment is appropriate. Plaintiffs have shown that they may have paid something for the mutual rights. The open transactions doctrine does not apply because the facts here do not present “elements of value so speculative in character as to prohibit any reasonably based projection of worth.”
Whatever the district court decides can be appealed to the Ninth Circuit Court of Appeals. If it upholds the ruling against Open Transaction treatment, the stage may be set for a Supreme Court resolution of a conflict between the D.C Circuit and the Ninth Circuit.
What should taxpayers do? Right now the Arizona ruling is only law in that district. Taxpayers can continue to file based on the Fisher Open Transaction holding. Because they are filing in opposition to a long-standing IRS position, they should disclose their position on Form 8275. Meanwhile, taxpayers who filed refund claims based on the Open Transaction rule can expect a long wait now before they can hope to get any cash.