145 / What is the tax treatment when shares of stock received in a demutualization are sold?

A “demutualization” occurs when a mutually-owned life insurance company (i.e., a company owned by its policyholders, or “members”) converts into a publicly-owned company (i.e., a company owned by its shareholders). Essentially, the members exchange their rights in the mutual life insurance company (i.e., voting and dividend rights) for shares of stock in the “demutualized” company.

In one case, a taxpayer (a trust) was a former policyholder in a mutual life insurance company and received shares of stock when that company “demutualized.” The taxpayer sold its shares and then reported gain, based on the then-prevalent belief that the “basis” of such stock was zero. The U.S. Court of Federal Claims held that the taxpayer was entitled to a refund of tax paid. The court analyzed the application of the “open transaction doctrine” to the transaction, and then determined that because the amount received by the trustee was less than the trust’s cost basis in the policy as a whole, the taxpayer, in fact, did not realize any income on the sale of the shares.¹

However, in two more recent published opinions, courts reached what appear to be inconsistent decisions on the issue of basis in demutualization stock making the law in this area very unclear. In Reuben v. US,² the court found that no portion of premiums paid prior to demutualization created basis; therefore the taxpayer had no basis at all in stock received in a demutualization. As a result, all of the proceeds from sale of demutualization stock represented capital gain. This decision appears to be totally inconsistent with the holding in Fisher. While in Dorrance v. U.S.,³ the lower court allowed “equitable apportionment” of premiums to determine basis in the demutualization stock, the Ninth Circuit reversed, finding that the taxpayers had zero basis in the mutual rights that were eliminated in the demutualization. The Ninth Circuit rejected the district court finding that the taxpayers had basis in the stock, finding instead that they had not shown that they had paid for the stock (after demutualization, the taxpayers retained their life insurance contracts and continued to pay premiums). The distribution of stock occurred because of the requirement that the insurance company fairly allocate its surplus upon demutualization, not based on premiums that the taxpayers had paid in the past. Because of the uncertainty in this area, a taxpayer considering sale of stock received in a demutualization should consult his or her tax advisor before completing the sale.

1. Fisher. v. U.S., 2008-2 USTC ¶ 50,481 (Ct. Cl. 2008), aff’d per curiam, No. 2009-5001 (Fed. Cir. 2009).