IRS Asked To Review Cost Basis Ruling On Demutualization Payouts

Drexler said that the TAO itself has not yet reached a decision about what it thinks the right answer is. On the one hand, there is a reasonable theoretical argument that policyholders should be able to allocate some of their basis to the equity they receive in a demutualization, he said. On the other hand, that basis is probably very small since most people are primarily spending their money to buy an insurance product, and as a practical matter, its hard to see what standard would be used to bifurcate the basis between the insurance product and the equity interest.

The decision of the Taxpayer Advocates Office to review the issue is perceived as a victory in itself for a group, either beneficial owners or as trustees or accountants for owners, who contend the IRS decision on the issue is wrong.
They include an accountant, C.D. Ulrich, of Baxter, Minn., who has been accused of marketing an illegal tax shelter, and Larry Mueller, of Springfield, Missouri, who is trustee for someone who has received such stock.

Ulrichs argument is that it is wrong for the IRS to rule that the basis of such distributions for the purposes of paying taxes on them is the total amount of cash or stock you receive in such a distribution. Under the IRS theory, the tax on the full amount is payable immediately if the distribution is in cash, but payable only when there is a change in control, for example, a sale, if the distribution is in stock.

To put it simply, Ulrich says, the basis in your ownership interest is created by your premium payments on the policy. And the mutual companies charge a higher premium than they need to operate at cost, and therefore, the resulting overpayment is retained in this account called policyholder surplus. The IRS, by contrast, claims that policyholders paid nothing for the distributions, and therefore must pay taxes on the full amount.

Ulrich argues that the mutual companies dont tell you what your ownership interest is as a policyholder based on the profitability of the company. As a result, he said, the surplus of the company belongs to the policyholders, but you are never informed by the insurance company as to the value of your ownership interest. Theres no reporting requirement to advise policyholders of their ownership interest on an annual basis, or any basis, so the only time they are held accountable to the policyholders as to the value of their investment is when they go through a liquidation, a dissolution or a demutualization.

Drexler, a tax lawyer, says the problem is practical. How do you decide what the basis is? On a theoretical basis, he says, it can be argued that some of the premiums paid on a life insurance policy should be assigned to the equity interest, especially when the premiums create excess capital when there has been a good year.

But how do you allocate the premiums to the policy and to the equity side of the equation? There is no obvious benchmark that tells you what it should be, Drexler said.

Reproduced from National Underwriter Edition, November 24, 2004. Copyright 2004 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.