Three Court Opinions on the Tax Impact of Demutualization - Three Different Outcomes
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Three Court Opinions on the Tax Impact of Demutualization - Three Different Outcomes 2321 N. Loop Drive, Ste 200 Ames, Iowa 50010 www.calt.iastate.edu August 11, 2008 Updated January 26, 2011, July 11, 2012 and February 8, 2013 - by Roger A. McEowen* Overview The demutualization issue raises filing issues for practitioners. In August 2008, the U.S. Court of Federal Claims ruled against the IRS position of What is Demutualization? assigning zero income tax basis to stock received in an insurance company Demutualization is the process through which a demutualization.1 Instead, the court ruled that member-owned company becomes shareholder- basis is to be allocated to the stock of the policy owned; frequently this is a step toward the initial up to the amount of the selling price of the stock. public offering (IPO) of a company. Insurance The court’s opinion comes as no surprise – they companies often have the word "mutual" in their ruled in November of 2006 against an IRS name, when they are mutually owned by their motion for summary judgment. That meant the policy holders as a group. They’ve been around case was to go to trial to determine the basis of a long time. In fact, Benjamin Franklin the shares. If the court had agreed with the IRS, established one of the first mutual insurance it would have granted summary judgment. So, companies. Such a company doesn’t have we have known since that time that IRS would shareholders, but instead is owned by its lose the case – the shares would have a positive participating policyholders who possess both basis and not all of the gain would be taxable. ownership rights, such as voting and distribution What was not known was how income tax basis rights, as well as the more typical contractual would be computed. insurance rights.6 In recent years, however, there has been a strong trend for these In late 2009, the U.S. Court of Appeals for the companies to demutualize, converting to a Federal Circuit affirmed the U.S. Court of shareholder ownership base. Generally, policy Federal Claims by issuing a decision without a holders are offered either shares or money in published opinion.2 However, IRS continued exchange for their ownership rights. Because to litigate the issue in an Arizona federal district shares can be traded or sold - in contrast to court.3 On July 9, 2012, the court, on motion for ownership rights, which cannot - summary judgment, disagreed with both the IRS demutualization increases the possibility of position and the taxpayer’s position setting the profit for those involved, and tends also to stage for a trial on the issue of how basis is to be benefit the economy. allocated between the premium and the stock.4 Demutualization was originally used to refer On January 15, 2013, a California federal district specifically to this conversion process by court determined, on opposing motions for insurance companies, but the term has since summary judgment, that the taxpayer failed to become more broadly used to describe the establish that the taxpayer had any income tax process by which any member-owned basis in the shares of stock received upon organization becomes shareholder-owned. demutualization.5 Worldwide, stock exchanges have offered another striking example of the trend towards 1 demutualization, as the London, New York and 19. Mutual Life of Canada (2000) Toronto Stock Exchanges and most other 20. Mutual Service Life (2005) exchanges across the globe have either recently 21. National Travelers (2000) converted, are currently in the process, or are 22. Nationwide Life (1997) considering demutualization. 23. Northwestern National (1989) 24. Ohio National (1998) Insurance company demutualizations became 25. Phoenix Home Life (2001); 500,000 popular in the late 1990s. Facilitated by revised policyholders. state laws, mutual insurance companies were 26. Principal Mutual (2001); 925,000 attracted to conversion to stock companies for policyholders the same reasons that companies have long 27. Provident Mutual (2002) sought to be publicly held - greater access to 28. Prudential (2001); 11,000,000 capital. The policyholders of mutual insurance policyholders. companies were generally granted cash or stock 29. Security Mutual Life of Nebraska in return for their interest in the mutual (1999) insurance company. 30. Standard Insurance Co. (1999); 125,000 policyholders. As of August 2008, the following life insurance 31. State Mutual Life (1995); 100,000 companies have demutualized (with the policyholders. approximate number of policyholders affected, 32. Sun Life of Canada (2000) when known): 33. Union Mutual (UNUM) (1986) 34. Western & Southern Life (2000) 1. Acacia Mutual (1997) But, the tax issue is tricky. Federal tax law 2. American Mutual (1996); 300,000 specifies that gross income includes gain from policyholders the sale of property that are equal to the amount 3. American United (2000); 175,000 realized upon sale less the seller’s cost basis in policyholders. the property.7 That’s a simple enough principle, 4. Ameritas (1997) but sometimes its application can be difficult – 5. Canada Life (1999); 388,000 such as in the situation where the property was policyholders. purchased as component of a larger item. With 6. Central Life Assurance (2000); 300,000 a demutualization, insurance policy rights that policyholders. were acquired as an indivisible package are 7. Equitable Life Assurance Society (1992) separated and sold. 8. General American (2000); 330,000 policyholders. The IRS Position 9. Guarantee Mutual Life (1995) 10. Indianapolis Life (2001); 200,000 The IRS position is that policyholders have a policyholders. zero basis in the cash or stock received in 11. Industrial-Alliance (Canada) (1999); demutualization, and a carryover basis from 700,000 policyholders. their time as a policyholder. This means that 12. John Hancock (2000); 3,000,000 policyholders receiving cash are subject to tax policyholders. on the cash received in the year of the 13. Lafayette Life (2000) demutualization. Policyholders receiving stock 14. Manulife (1999) are not subject to tax until the stock is sold. But, 15. Metropolitan Life ((2000); 11,200,000 the IRS position is highly questionable. Clearly, policyholders. a portion of a shareholder’s premium payments 16. Midland Life (1994) made over the years were not for insurance 17. Minnesota Mutual Life (1998) coverage, but for the voting and liquidation 18. Mutual of New York (1998); 800,000 rights as a policyholder. That is evidenced by policyholders. the fact that policyholders who have paid in the 2 most premiums over the years were generally then filed a claim for refund, which the IRS entitled to a larger cash or stock distribution as denied. The plaintiff then sued, seeking part of the demutualization transaction. But, it is summary judgment. IRS also moved for difficult to determine what a shareholder has summary judgment. Alternate dispute resolution paid for those rights. In addition, a taxpayer did not resolve the matter and the U.S. Court of bears the burden to support any basis claimed on Federal Claims, in late 2006, denied both of the the sale of an asset to offset gain. Otherwise, summary judgment motions. The court IRS says the basis is zero. In paying an determined that the proceeds from stock were insurance premium, policyholders pay only a not a distribution by Sun Life of a policy premium amount - nothing is specified as being dividend, its equivalent, so as to be excluded paid for any other purpose. So, that’s what has from gross income as a return of capital under given IRS an argument that the shareholder has the annuity rules.10 The court then concluded zero basis. that it could not resolve the plaintiff’s claim that no capital gain was realized on the sale of the The Fisher8 Case stock because, as the plaintiff claimed, the proceeds were offset by the plaintiff’s income Before 2000 Sun Life Assurance Company (Sun tax basis in the stock. The court found that the Life) was a Canadian mutual life insurance and plaintiff’s claim presented fact questions that financial services company. In 1999, Sun Life’s required a trial on the matter. At trial, the Board certified that eligible policyholders had plaintiff’s expert testified that he couldn’t form approved a demutualization of the company. In an opinion as to the fair market value of the early 2000, the company received the necessary ownership rights because they were tied to the regulatory approvals to proceed with the policy. The rights added value, the expert demutualization and filed a Private Letter Ruling testified, but did not have a separate value. The request with the IRS as to the tax implications of IRS’ expert determined that the ownership rights the demutualization to the policyholders. The had no value, emphasizing that none of the IRS, in the ruling, stated the following:9 premiums were specifically dedicated to acquiring the ownership rights, that there was no Policyholders’ ownership rights could market for the ownership rights, and that it was not be obtained by any purchase highly unlikely, at the time of policy acquisition, separate from any insurance contract that a demutualization would occur. that Sun Life issued. Under I.R.C. §354(a)(1), no gain or loss The court focused on Treas. Reg. §1.61-6(a) would be recognized by the eligible which specifies that when part of a larger policyholders on the deemed exchange property is sold, the cost basis of the entire of their ownership rights solely for property is to be equally apportioned among the company stock several parts, and the gain realized or loss The income tax basis of the company sustained on the part of the entire property sold is the difference between the selling price and stock received by policyholders in the 11 exchange will be the same as the basis the cost basis allocated to the part that is sold.