The court had previously decided in favor of the taxpayers, on cross-motions for summary judgment, that their basis in such shares was not zero.
Read the court’s decision [PDF 67 KB]
The taxpayers (married individuals) in 1996 purchased, through a trust, life insurance policies from five different mutual life insurance companies. Along with insurance benefits, the policies granted the taxpayers mutual ownership rights in the companies for as long as the premiums on the policies were paid.
The mutual companies later demutualized and converted into stock life companies. In 2000 and 2001, the mutual companies compensated the taxpayers for the loss of their mutual rights with shares of stock valued at approximately $1.8 million in the aggregate. In June 2003, the taxpayers sold these shares for over $2.2 million. Consistent with IRS policy that policyholders have no basis in stock received during demutualization of a life insurance company (the “zero basis” position), the taxpayers listed a zero ($0) cost basis when reporting their income from the stock sale for the 2003 tax year, and paid taxes on the full amount.
In October 2007, the taxpayers filed a refund claim with the IRS, asserting they did not owe tax on the proceeds of the stock sale. When the IRS did not issue a final determination regarding the refund, the taxpayers brought a refund action in federal district court.
The federal district court held that the taxpayers were entitled to a refund of tax.
The court examined the government’s claims that the taxpayers did not pay an additional amount for their mutual rights and did not have a realistic expectation of demutualization and, therefore, that the taxpayers were not entitled to an allocation of any basis from the premium payments that they made. The court distinguished the present case from Gladden v. United States, where the taxpayers did not own the asset at issue at the time of a land purchase but rather, obtained unvested water rights contingent on the execution of a government irrigation project, on the basis that in the instant case, the taxpayers obtained vested mutual rights when they bought the insurance policies. At the time of purchase, the taxpayers had voting rights and the ability to participate in any distribution of the company's surplus—whether or not that distribution was triggered by a demutualization. Therefore, the federal district court found that the Gladden "expectation test" did not apply to these facts.
The district court went on to address how to allocate cost between mutual rights and policy rights under Reg. section 1.61-6(a). The court noted that, while the taxpayers’ mutual rights contributed to the insurance policies' value, the cost of the mutual rights could not be determined prior to demutualization. In other words, the mutual rights were not separable from the policy rights and could not be sold; and thus, the taxpayers’ cost basis in the mutual rights could not be established exclusively through their payment of premiums.
The court found the first valuation of what the taxpayers paid for the mutual rights was the IPO price of the shares they received pursuant to demutualization. Because the companies determined that the fair market value of the shares was equivalent to the value of the mutual ownership rights, and also because the shares were allocated in exchange for mutual rights in a fair and equitable manner, the court concluded that the mutual rights had a basis essentially reflecting the IPO value.
The valuation at demutualization had two components—a fixed and a variable component. The fixed component was received in exchange for voting rights. The variable component was made up of a combination of a policyholder’s past contribution to surplus (60%) and an estimate of the policyholder’s future contributions (40%). Accordingly, the court determined that 100% of the fixed component and 60% of the variable component were includable in basis.
The “zero basis” and “open transaction” issues continue to be litigated. The IRS position historically has been that a life insurance policyholder does not separately purchase—and does not have a separately determinable basis in—the ownership rights he / she acquires when purchasing a life insurance policy from a mutual life insurance company. Taxpayers, on the other hand, have argued that a policyholder has some basis in the shares of stock in a life insurance company that are received pursuant to the liquidation of a mutual company, and that at least part of the proceeds received when the stock is sold represents a recovery of basis, which must be taken into account to reduce taxable income from the sale.
The courts have wrestled with whether to apply the open transaction doctrine (when less than 100% of the shares received is sold), and how to value a taxpayer’s basis. Here, the court generally followed the IPO share price, and separated the value received into past and future components. The court determined that amounts attributable to premiums already paid constitute basis, while amounts attributable to future premiums do not constitute basis.
For more information, contact a KPMG tax professional:
(312) 665 5267