Last year a Federal judge in Arizona dampened the hopes of recipients of stock in insurance company demutualizations by ruling that the “open transaction” rule didn’t apply. That rule, first used in the Fisher case, would make all IPO gain go away for some taxpayers receiving stock when insurance companies go from “mutual” to “stock” format.
Cheer up, stockholders. The same judge this week determined that mutual policyholders still get a much better result than the IRS “zero basis” rule. The IRS rule gives shareholders no basis in their mutual shares, making all proceeds taxable.
The plaintiffs in this case sold the shares of a number of insurance companies, including Des Moines-based Principal Financial Group; apparently they were wonderful insurance policy customers. The judge looked to how the insurance companies determined demutualization IPO values and applied their analysis to determine the basis of the shares issued.
When determining how many shares of stock to give policyholders, the 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.
The Companies allocated shares to Plaintiffs based on (1) the value of voting rights, (2) past contributions to surplus, and (3) projected future contributions to surplus. Effectively, Plaintiffs paid for shares of stock in the demutualized Companies by relinquishing voting rights and making contributions to surplus. However, projected future contributions to surplus are a portion of premiums which Plaintiffs had not actually paid before receiving shares and cannot be considered as a part of basis.
Therefore, Plaintiffs’ basis is equal to the combination of the IPO value of shares allocated to Plaintiffs for (1) the fixed component representing compensation for relinquished voting rights (“fixed shares”) and (2) 60% of the variable component representing past contributions to surplus (“variable shares”).
In short, the shareholders got a little more than 60% of the IPO value as share basis.
While this is a defeat for the IRS, it is not as taxpayer-favorable as the Fisher case. If this new case is upheld on appeal, there will be a conflict among the circuits as to which rule applies. Whether the IRS will continue to litigate or will settle based on this case is anyone’s guess. In the meantime, if you have demutualized shares, or sold them in an open year, be sure you have a refund claim in to preserve your refund rights.