On December 9, in Dorrance v. The United States, the Ninth Circuit overturned a favorable district court decision for taxpayers in demutualizations. The Ninth Circuit ruled that a taxpayer owning insurance policies in a mutual insurance company had a zero tax basis in the attendant membership rights which accompanied such policy ownership. As a result, the taxpayer was required to recognize taxable income equal to the full amount of the proceeds received on a subsequent sale of stock received in the demutualization of such company (which, under applicable tax rules, inherited this same zero basis).
Policyholders owning membership interests in a mutual insurance company often receive consideration in a conversion of the company to stock form (a demutualization). This consideration can take the form of either stock of the newly-existing stock company (often received on a tax deferred basis) or taxable consideration in the form of cash or other rights. In either case, the tax basis of the policyholder in the membership interest deemed surrendered in this exchange is relevant in determining the basis of stock received in a tax-deferred exchange (and therefore gain recognized on a subsequent sale of such stock) or the amount of gain recognized on the transaction in a taxable exchange.
The Internal Revenue Service has long held that a policyholder’s premium payments to a mutual insurance company are applicable entirely to the policy rights, and that no portion of such payments therefore creates any basis in the separate membership interests. The district court in Dorrance had held that a policyholder’s basis in the underlying membership interests should include an allocable portion of such premium payments. The Ninth Circuit decision overturned the district court, upholding this longstanding IRS policy.
The Dorrance ruling also creates a conflict among appellate courts. A 2008 Federal Circuit decision, which can be found here, ruled that basis should be assigned to mutual company membership interests, and as a result to shares received on a demutualization, under a very taxpayer-favorable “open transaction” approach. This sets up a possible Supreme Court decision to resolve the split.