Policyholder lacks basis in mutual insurance company’s membership rights

Ruling on mutual insurance company’s rights

The U.S. Court of Appeals for the Ninth Circuit today in a case of “first impression” held that the taxpayers—life insurance policyholders—did not have any basis in a mutual life insurance company’s membership rights, and thus, their basis in the stock derived from the demutualization of the mutual insurance companies was zero ($0).

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The case is: Dorrance v. United States, Nos. 13-16548 and 13-16635 (9th Cir. December 9, 2015). Read the Ninth Circuit’s decision [PDF 147 KB] that includes a dissent.

Summary

The taxpayers received and then sold stock derived from the demutualization of five mutual life insurance companies from which they had purchased life insurance policies. On filing their individual income tax return, the taxpayers initially asserted a zero cost basis in the stock and paid tax on the gain. Later, they filed a claim for a refund of the full amount of taxes paid on the stock sale. They asserted that the stock represented a return of previously paid policy premiums or, alternatively, that the premiums paid would be counted toward their basis in the stock because their mutual rights were incapable of valuation.

The IRS denied the refund claim, and the taxpayers filed a refund action in federal district court. The lower court held that the taxpayers had a calculable basis in the stock (but not at the level claimed by the taxpayers) and determined that they were entitled to a partial refund. 

The Ninth Circuit today reversed, finding that taxpayers who sell stock obtained through demutualization cannot claim a basis in that stock for tax purposes because they had a zero basis in the mutual rights that were extinguished during the demutualization. 

KPMG observation

The difference between contract rights and membership rights was critical to the resolution of this case.  The Ninth Circuit found that the premiums paid covered the rights under the insurance contract, but not any membership rights. Thus, the value at demutualization was not derived from something paid for by the taxpayers.  

The “zero basis” issue and the open transaction doctrine were also considered in prior cases—one in 2009 in the Federal Circuit (Fisher) that affirmed a U.S. Court of Federal Claims decision for the taxpayer, and the other from 2013 in the D.C. Circuit (Reuben) that was decided in favor of the government. With today’s Ninth Circuit decision for the government, the split among the circuit courts continues, until or unless the taxpayers seek review by the U.S. Supreme Court to resolve the issue. 

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