A district court in Arizona has rejected cross motions for summary judgement filed by the taxpayers and the government in a tax refund case involving the amount of basis that could be established with respect to "equity" type rights that a policyholder had in several life insurance policies issued by a mutual insurance company which was demutualized into a stock company. The taxpayers received cash for the "equity" rights. The court rejected: (1) IRS's position that the trust had a zero basis in the stock, which would have caused it to have a large gain, and (2) the trust's position that it should be permitted to use the open transaction doctrine, which would have allowed it to report zero gain by treating past premium payments as basis in the stock. Bennett and Jacquelynn Dorrance v. United States, (DC AZ 7/9/2012) 110 AFTR 2d ¶ 2012-5067
In 1995, Plaintiffs formed a Trust, which presumably was a grantor trust for federal income tax purposes, that purchased five life insurance policies in 1996. The policies were purchased with 5 different insurances for coverage of close to $88M in scheduled death benefits. The trust was designed to implement the clients’ efforts to provide liquidity to pay Plaintiffs' estate taxes upon their death. All of the polices were purchased with mutual insurance companies where the policyholder, i.e., the Trust, had an “equity” type interest in the company in addition to owning the policy. This interest provides the policyholder with certain rights, including the right to vote on corporate decisions and the right to receive the mutual company's surplus should the company liquidate. Policyholders cannot sell the mutual rights separately from their underlying policies. Where a life insurance policy held with a mutual insurance company is terminated, the mutual rights are extinguished as well.
The five mutual life insurance companies for which policies were owned by the Trusts were demutualized over a 5 year period ending in 2001. In a demutualization, a mutual life insurance company changes its corporate structure into that of a stock company, often through a procedure governed by state statute. Policyholders must vote to approve a demutualization before the process can proceed. Prior to seeking policyholder approval, at least one of the companies promised policyholders that if they voted for demutualization, premiums would not increase, and in fact none of the premiums Plaintiffs paid increased after demutualization.
From a federal income tax standpoint the demutualization process, in general, does not present the policyholder with a taxable event. In Rev. Rul. 2003-19, 2003-1 C.B. 468, the Service ruled that the conversion of a state mutual insurance company to a stock insurance company qualified as both a Type E recapitalization per §368(a)(1)(E) and a Type F reorganization under §368(a)(1)(F). Under Rev. Rul. 2003-19, supra, one scenario described that the mutual company members surrendered their membership interests in exchange for all of the stock company's voting common stock. In a second scenario, the mutual company formed a mutual holding company, which incorporated into a stock holding company. The mutual company's members received membership in and controlled the mutual holding company, which planned to maintain control of the stock holding company. The mutual holding company would then control the stock company. In a third situation, the mutual holding company owned all of the stock in the stock holding company, which owned all of the stock company. Each situation was determined to be a tax-free Type E and as a Type F reorganization. See also PLRs 954004, 9834019 and 9835009. Still, where the policyholder is paid cash for the release or conversion of their policy rights, the gain is treated as taxable “boot”.
Where mutual (life insurance) companies demutualized, the policyholders, e.g., the policyholders (including Plaintiffs) retained their policies and continued to pay premiums as previously prescribed. Their “equity” type rights were eliminated and the companies provided policyholders with the option of receiving stock in the new companies or receiving a cash payment in lieu of stock. When determining how much stock to give policyholders, the companies calculated a “fixed” component to correspond to policyholders' loss of voting rights, and a “variable” component designed to measure “the policyholders' contribution to the surplus of the company.” Although the companies used slightly different methods to measure their policyholders' contribution to the company's surplus, all obtained independent actuarial opinions that the methods were “fair and equitable.” See Tancredi v. Metropolitan Life Ins. Co., 149 F. Supp. 2d 80, 86–87 (S.D.N.Y. 2001).
In this case the stock the Trust received during the demutualizations had a total value of $1,794,771. The Trust sold all the stock on June 23, 2003, for an aggregate price of $2,248,806. The Trust reported its stock basis in the mutual company stock at zero. Plaintiffs paid tax on the reported gain (for cash payments received) and then filed a claim for refund, and after denial of the claim by the Service, filed a tax refund suit in federal district court.
The Service argued, in its motion for summary judgment, that no part of Plaintiffs' periodic payments for their original insurance policies was paid to acquire the mutual rights under the policy, and therefore all of the premium was paid to purchase the policies. This would result in a zero stock basis for the “equity” type rights so that any cash received was taxable as "boot". The Plaintiffs, in their motion for summary judgment, argued that the demutualization should be governed by the open transaction doctrine, which is employed in circumstances where the basis in property that is split cannot be allocated to the resulting assets. See Treas. Reg. § 1.1001-1(a). Burnet v. Logan, 283 US 404, 412 (1931) Under the “open transaction” approach, which the regulations provide should only be allowed in “rare and extraordinary” circumstances, all of the proceeds from Plaintiffs' sale of stock would be considered return of capital from their payment of insurance premiums, and therefore not taxable.
Under FRCP 56(c), the trial court stated summary judgment is only appropriate where the evidence reflecting in the pleadings and supporting affidavits, interrogatories, depositions, documents produced during discovery, etc., viewed in the light most favorable to the nonmoving party, shows “that there is no genuine issue as to any material fact and that the movant is entitled to judgment as a matter of law.” Only disputes over facts that might affect the outcome of the suit will preclude the entry of summary judgment, and the disputed evidence must be “such that a reasonable jury could return a verdict for the nonmoving party.” Anderson v. Liberty Lobby, Inc., 477 U.S. 242, 248 (1986). “[A] party seeking summary judgment always bears the initial responsibility of informing the district court of the basis for its motion, and identifying those portions of [the record] which it believes demonstrate the absence of a genuine issue of material fact.” Celotex Corp. v. Catrett, 477 U.S. 317, 323 (1986).
The government argued that the Plaintiffs are not entitled to the refund based on its motion for summary judgment. Plaintiffs cited Fisher v. United States, 82 Fed. Cl. 780, 795 (Fed. Cl. 2008), aff’d w/o opin., 333 Fed. App’x 572 (2009), for support that as a matter of law the demutualization of a mutual insurance company is indeed one of the “rare and extraordinary” circumstances in which the open transaction doctrine should apply.
Thus, the question that needed to be addressed by the Court was whether summary judgment was appropriate, and if so, for which party. The issue was that of determining the Plaintsiffs’ stock basis in the demutualized stock. See §1012. The taxpayer has the burden of proof with respect to establishing basis. Coloman v. Commissioner, 540 F.2d 427 (9th Cir. 1976). What is required, the Court opined, is that the taxpayer prove by objective evidence some investment into the property. Here, the problem was indeed the mutual insurance policy itself. The taxpayer could easily prove up the premiums paid, but what portion of the premiums paid were for “basis” or “cost” in the equity features of the various policies. Court such “cost” be estimated? See Cohan v. Commissioner, 39 F.3d 540 (2nd Cir. 1930). Indeed, the Ninth Circuit, to which an appeal in this case would lie, has shown a liberal attitude to granting a taxpayer basis even if the “cost” can not be demonstrated with exactitude. United States v. Marabelles, 724 F.3d 1374 (9th Cir. 1984).
The Court rejected the government’s “zero basis” approach and therefore denied it its motion for summary judgment. Indeed, in the Court's eyes, something was in fact paid for the equity rights. The question therefore was how basis should be allocated among the two assets created, the life insurance rights as distinct from the equity or ownership rights, when the companies demutualized. Again, the Plaintiffs received cash for their sale of equity rights in the mutual company.
After examining the “open transaction doctrine” emanating from Burnet v. Logan, supra, and its progeny, the District Court closely examined the Fisher, supra, case. In 2008, the Court of Federal Claims in Fisher, supra, applied the open transaction doctrine in a case where a taxpayer had received a cash payment in exchange for his mutual rights during the demutualization of a life insurance company. The government argued in Fisher the mutual rights had no value. Nevertheless, the Court of Federal Claims found for the taxpayer noting that “the ownership rights were, at the outset, inextricably tied to the underlying insurance policy and were not separately sellable.” It applied the open transaction doctrine, permitting the tax free recovery of basis to the extent of all premium payments he had made during the course of the policy as capital investment, and deferring any payment on the proceeds that the taxpayer had received in exchange for his rights. The Federal Circuit affirmed without opinion. Fisher v. United States, 333 Fed. Appx. 572 (2009). But see Cadrecha v. United States, ____Fed. Cl.__ (Fed. Cl. 4/2/2012) (declining to apply Fisher when the taxpayer's claim was untimely). See Olsen, Chuck v. Goliath: Basis of Stock Received in Demutualization of Mutual Insurance Companies, 9 Hous. Bus. & Tax L.J. 360, 382–83 (2009); Galindo,Revisiting the “Open Transaction” Doctrine: Exploring Gain Potential and the Importance of Categorizing Amounts Realized , 63 Tax Lawyer 221, 234 (2009).
Despite Fisher, supra, the trial court was unpersuaded that “open transaction” reporting was appropriate, i.e., the Plaintiffs have failed to show that allocating basis between the mutual rights and the stock is so difficult that this case requires applying the open transactions doctrine. Despite the parties as to what Plaintiffs may have paid for their mutual rights, there is no question that at the time of demutualization, both the value of the stock and the market value of the policy itself could be calculated. Summary judgment for the Plaintiffs was also denied.
The Court was of the view that the facts particular at bar required rejection of the application of the open transaction doctrine. In Fisher, supra, the plaintiff opted for the “cash election” upon demutualization, and thereby received an immediate payment in exchange for his mutual rights. Here, Plaintiffs received stock, held it for years, and sold it for $454,035 more than its market value at the time of demutualization. The open transactions doctrine would therefore allow Plaintiffs to apply this gain to basis accrued through policy payments made before mutualization, even though the increase in value took place entirely after the rights were split. At the same time, since the open transaction doctrine would not recognize any separate bases in the policy and the stock, policy payments made after the companies demutualized would increase the total basis towards which the stock sale would be applied, even though these payments were not made to obtain the mutual rights or the stock. Without engaging in further speculation on when the open transaction doctrine could apply, the trial court ruled that there was indeed value to the equity rights purchased for cash and that Treas. Reg. §1.61-6 applied. It found that the record did not convince it what method should be used to make such equitable apportionment. In rejecting therefore the Plaintiffs motion for summary judgment the case will proceed to trial unless the parties agree to the basis from which apportionment should be made and file a settlement document with the Court.