Dorrance v. U.S., 2015 WL 8241954 (9th Cir. 2015)

This case is the latest in the cases involving tax impact of the sale of stock received by a policy holder from a mutual life insurance company on demutualization, and a case of first impression at the Federal circuit court level. Here, the Dorrances purchased life insurance policies from several mutual life insurance companies in 1996 to replace the then estimate of their anticipated estate tax liability. In 2003, the Dorrances received stock in the resulting stock company when each of these mutual life insurance companies demutualized in a tax free transaction into a stock company. The Dorrances then sold this stock also in 2003, and reported the sales on their 2003 income tax return as capital gain transactions, reporting a zero cost basis. The Dorrances later filed a claim for refund, now asserting that the stock received in the demutualization had a cost basis calculated in large part on the premiums paid for the life insurance policies prior to demutualization. When the Service did not respond to the refund claim, the Dorrances filed suit seeking a refund.

In the refund suit, the Dorrances, as the taxpayers, had the burden of proving their cost basis in the stock sold in 2003. They argued that the cost basis was equal to the value of the stock at the time it was received, the time of the demutualization. The government took the position that the stock had zero basis. The district court in Arizona ruled that the stock had some calculable basis, less than the value at the time of demutualization, but greater than zero. Both the Dorrances and the government appealed and the 9th Circuit ruled that the Dorrances had the burden of proving their cost basis and they failed to establish that they had any basis in the membership rights for which they had received the stock distributed in the demutualization.

With a mutual life insurance company, the policyholders own the company. The premiums paid for the life insurance policies, to the extent these premiums exceed the policy expenses, are returned to the policyholders in the form of dividends. Dividends received in cash, used to buy policy riders, to pay premiums or to pay principal or interest on policy loans reduce the policy owner’s investment in the contract, and dividends used to purchase paid-up additional insurance neither increase nor reduce the investment in the contract, since they remain in the policy. Dividends are generally not taxable, unless and until the cumulative dividends, combined with all other non-taxable distributions from the policy, exceed “the aggregate of premiums or other consideration paid or deemed to have been paid by the recipient.” See Reg. Sec. 1.72-11(b)(1). Once the dividends exceed the policyholder’s investment in the life insurance contract, the dividends paid out in cash, or cash withdrawn from the policy as a result of a policy cash-in or partial or complete policy lapse, are taxed as ordinary income. The premiums are treated as payments for the life insurance contract and are not allocated in any part to the membership rights of the policyholders of a mutual life insurance company. There are no excess premiums that would be available to provide basis build up for membership rights of the policyholder of a policy purchased from a mutual life insurance company.

So held the 9th Circuit, that the premiums paid by the Dorrances were for the life insurance policy contract and that none of the premiums were paid for the membership rights. Since the Dorrances had zero basis in the membership rights that were demutualized, when they received stock in a tax free reorganization in which their membership rights were replaced with the stock of the stock life insurance company, they had zero basis in the stock received. As the court expert put it, the stock in the subsequent stock life insurance company was received by the Dorrances as a “windfall”. In fact, in the materials received by the Dorrances from the mutual life insurance companies with regard to the receipt of stock, each of the companies indicated that “the cost basis of these shares for tax purposes will be zero.” The Court agreed.

The government had attempted to suspend action in a similar case involving the same issue that arose in California pending the outcome of the Dorrance case. However, after the government lost its zero basis argument in Fisher v. U.S.,82 Fed. Cl. 780(2008), Timothy Reuben decided to file his Federal refund claim to recover the taxes paid on his sale of the Manulife shares distributed to him from the Don H. and Jeannette H. Reuben Children’s Irrevocable Trust that the Reuben Trust had received on the demutualization of Manulife. Reuben had reported the sale initially showing a zero basis, and later filed his claim for refund claiming that he had a calculated cost basis in these shares on the same basis as the Fisher court had determined.

The Fisher court determined that the “Open Transaction Doctrine” applied. Under that doctrine, where there are several parts to property for which it is “impossible or impractical” to apportion the cost basis among, the taxpayer does not recognize any capital gain on disposition of a part of the property until the entire cost basis of the property has been recovered. The Fisher court determined that the premium paid by Fisher were for the acquisition of both the insurance policy and the ownership rights in Manulife, a mutual life insurance company. When the company demutualized, Fisher elected to receive cash in lieu of stock, which cash reduced his investment in the contract, his basis in the life insurance policy, under the Open Transaction Doctrine. On this ground, the Fisher court ruled that Fisher was entitled to his refund.

In Reuben v. U.S., 2013 WL _____________, the U.S. District Court in the Central District of California issued its opinion on January 15, 2013, denying Reuben’s motion for summary judgment based on the argument that the Open Transaction Doctrine applied in Fisher should be applied here. First noting that the Fisher opinion had been criticized, the Reuben court then noted that Fisher had elected to receive cash, and Reuben had elected to receive share of the stock company, on the demutualization of Manulife, a distinction the court found compelling in its refusal to follow the Fisher decision. The Reuben court then granted the government’s motion for summary judgment, stating that Reuben had the burden of proving his basis in the stock sold, and that Reuben provided no evidence in support of his position that some portion of the premiums were paid for membership interests. The court found that government “adverted to substantial evidence” that no portion of the premiums were paid for the membership interests in Manulife, that is (i) at the time of demutualization, Manulife informed its policyholders that the tax basis in the shares received would be zero, (ii) the actuary hired by Manulife at the time of the demutualization viewed the stock as a windfall to the policyholders, (iii) the actuary hired by the government agreed that the stock had no basis and that the process of demutualization is what gave the shares value, and (iv) the premiums paid for the Manulife policies after the demutualization was the same as before the demutualization, for the life insurance policy and not for the membership rights.

It would seem that Reuben’s rush to court was simply a rush to incur more legal fees that could have been avoided if he had just agreed to suspend the case until the 9th Circuit had issued its opinion in Dorrance.