by Roger Russell

Some taxpayers may be paying tax that they shouldn’t owe on distributions from insurance companies that changed from mutual to stock ownership.

Charles Ulrich, a Baxter, Minn.-based CPA who has been researching the issue for two years, estimates that as many as 15 million taxpayers may be involved in the tax situation caused by the “demutualization” of some 20 life insurance companies during the past decade. Those insurers gave cash or stock in the new company to their policyholders as compensation for the equity that their policies represented.

The Internal Revenue Service’s position is that these distributions should be included in taxable income as capital gain with a zero basis. Those policyholders who received cash are taxed immediately on the full amount, while policyholders who received stock are taxed on the full amount that they receive upon sale of the stock.

Under Ulrich’s analysis, the distribution represents a recovery of basis, so that the cash distribution creates no gain — and the stock distribution is only taxed when sold for more than its fair-market value on the date of distribution.

“The problem is that all of the affected taxpayers are sitting out there with no idea that anyone has raised a question about this,” said Ulrich. “They may lose their rights to challenge the IRS position if they don’t act.”

Former mutual insurance companies demutualized during the 1990s because they wanted to grow larger, according to Ulrich.

Jack Dolan, spokesman for the American Council of Life Insurance, agreed. “The reason was simply to have access to capital markets,” he said. “The investor-controlled company has a greater ability to raise capital than the mutual company — that was the driving force.”

“The reason was the increased competition coming from other financial service industries,” Dolan continued. “To remain competitive they needed to grow, and the mutual structure was limiting their ability to grow.”

In many cases, the process happened very quickly, according to Ulrich. “It took five or six months to look at the process and get it approved at the corporate level, then get the plan documents out and have a membership vote.”

“When they sent the plan documents out they generally had two sets of documents,” he said. “The first one explained what would happen and the second set asked the policyholder to vote.”

“They hired separate companies to get the two documents to members,” said Ulrich, “and the average policyholder could not possibly comprehend what was going on. One document was over 100 pages, and the second was more than 200 pages long. They contained opinions of actuaries and fairness statements couched in technical
jargon. Unless you were an
accounting audit specialist in the insurance industry you couldn’t begin to understand them.”

Ulrich cited the following reasons why the distributions to policyholders are generally excludable from income:

● Under case law, a mutual insurance company’s sole business purpose is to provide insurance at cost, and policyholders are entitled to receive the assets of the company upon liquidation or dissolution. The distribution to policyholders is then treated as a return of premiums paid.

● Internal Revenue Code Section 72 treats the distribution as a return of premiums paid.

● Since the membership rights are tied to the contract, payments received to terminate those rights are a reduction in the premiums paid for the insurance contract.

● The consideration provided by the mutual insurance company to induce the contract purchase was two-fold, both life insurance protection and the right to that insurance at cost.

● The tax benefit rule applies to exclude the distributions to policyholders from income, since the premiums that the payment is tied to were not deducted in the previous years to produce any tax benefit in those years.

Ulrich recommends that taxpayers follow the IRS position, pay the tax, and then immediately file a claim for a refund to protect their right to a refund from expiring. The statute of limitations will be prevented from tolling if an amended Form 1040X is filed within three years of the due date for filing the original 1040 return in which the income was reported, or within two years of payment of the tax, whichever is later.

“Under an ordinary reading of the statute of limitations, the three-year period has already expired for 1999 returns,” said Ulrich. “Meanwhile, 10 companies have demutualized since 2000, so taxpayers have until next April to preserve their right to a refund. Of course, the clock doesn’t start ticking until the stock is sold, so even shareholders in Equitable, which demutualized in 1992, might be able to get a refund if they sold the stock in 2000 or later.”

There are still other ways to deal with the issue.

Lawrence J. Peck, an estate planning attorney in New York City, said, “The potential gain is eliminated if the policyholder holds the stock until death. However, this might not always be a realistic option, and the policyholder might consider giving the stock to a trustworthy elderly or dying family member so that its basis is stepped up at his or her death. The dying person can then give the stock back under his or her will to the policyholder, who receives the stock with a basis equal to its value, provided more than one year has elapsed since the policyholder first gave the stock away. Of course, if the older or dying family member is not a spouse, there may be a gift tax cost to consider.”

Peck also suggested that another way to finesse the issue might be for the policyholder “to give the stock to a charitable remainder trust, which sells the stock without recognizing any gain, enabling it to reinvest the full amount of the proceeds to produce a greater income stream.”

This benefits both the policyholder and the charity, according to Peck. “The policyholder receives payments during his lifetime,” he said, “and the charity will receive some capital in the future. The gift to the trust results in an immediate charitable income tax deduction based on the stock’s market value rather than its basis, and removes the value of the stock from the policyholder’s estate for estate tax purposes.”

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