7518 / What is a demutualization? What is the tax treatment of stock sold by a taxpayer following a demutualization?

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. Where a taxpayer (trust) was a former policy holder in a mutual life insurance company and received shares of stock when that company “demutualized,” and 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

For guidance on determining the (1) holding period and (2) capital gain treatment of stock received by a policyholder in a demutualization transaction that does (or does not) qualify as a tax-free reorganization, see CCA 200131028.

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1. Fisher v. U.S., 333 Fed. Appx. 572, 2008-2 USTC ¶ 50,481 (Ct. Cl. 2008), aff’d per curiam, 2010-1 USTC ¶ 50,289 (Fed. Cir. 2009).