Insurance company demutualizations became popular in the late 1990s. Facilitated by revised state laws, mutual insurance companies were attracted to conversion to stock companies for the same reasons that companies have long sought to be publicly held - greater access to capital. The policyholders of mutual insurance companies were generally granted cash or stock in return for their interest in the mutual insurance company.

The Internal Revenue Service took the position that policyholders have a zero basis in the cash or stock received in demutualization, and a carryover basis from their time as a policyholder. This has meant that policyholders receiving cash were subject to tax on the cash received in the year of the demutualization. Policyholders receiving stock were not subject to tax until the stock was sold.


Some commentators have questioned the logic of the IRS position that policyholders in mutual insurance companies have zero basis in their interests. The argument is basically that a portion of the premium payments made over the years were not for insurance coverage, but for the voting and liquidation rights as a policyholder. Policyholders who have paid in the most premiums over the years were generally entitled to a larger cash or stock distribution as part of the demutualization transaction.

While it seems logical that the voting and liquidation rights of a policyholder must have value, the difficulty comes in determining what they have paid for those rights. A taxpayer must generally be able to support any basis claimed on the sale of an asset to offset gain, or otherwise the basis may be presumed to be zero. In paying an insurance premium, policyholders pay only a premium amount; nothing is specified as being paid for any other purpose.

Some mutual companies maintain subscriber accounts for their policyholders that represent part of the reserves of the company. Mutual companies may make distributions from these subscriber accounts when performance is good and cash reserves exceed projected needs. Other companies may not maintain subscriber accounts, as such, but may still occasionally rebate premiums to policyholders when performance is such that reserves exceed projected needs. A policyholder ceasing to place policies with a mutual insurance company may be entitled to a distribution of their subscriber savings account, or to nothing at all.


The case of Fisher v. United States, working its way through the U.S. Court of Federal Claims, seeks to challenge the IRS position that policyholders of mutual insurance companies are entitled to only zero basis for their interest in a mutual insurance company. In November 2006, in ruling on summary judgment motions on both sides, the court rejected all motions for summary judgment, finding that the issue of basis in liquidation and voting rights of the mutual company was a material question of fact to be decided by a trial.

That trial is scheduled for the summer of 2007.

The plaintiff had sought summary judgment that the distribution received in the demutualization represented the basis in the interest. The IRS had sought summary judgment that the voting and liquidation rights were worthless, based on what the court called "the meager evidence in the record." The court went on to state in its ruling: "Indeed, while questions on this issue abound ... there is some indication that the voting and liquidation rights may have had some value, not only because Sun Life had a surplus of nearly over $5.7 billion as of June 30, 1999, but also because the Sun Life stock exchanged, at least in part, for those rights apparently had value. To the extent that the voting and liquidation rights had some value, that would diminish the amount of income that would be taxed here."

Fisher also sought to have the court certify a class action on behalf of similarly situated policyholders. In January, the court ruled that the plaintiff had failed in several respects to meet the requirements for class certification, but left the door open for more information to be supplied to try to certify a class. One of those requirements will be to show that there are so many policyholders who have filed a claim for refund based on challenging zero basis in a distribution that they would be too numerous to join in the complaint.


Over 30 life insurance companies have demutualized since the mid-1990s, involving as many as 30 million policyholders. For those who received cash distributions prior to 2003 or who took stock and sold it prior to 2003, the statute of limitations may have already run on their ability to file a protective refund claim seeking to recover the tax paid based on the distribution. For those taxpayers, however, who have received cash since 2002, or who received stock and still hold it or sold it after 2002, the statute of limitations may still be open to file a claim. For 2003 transactions, the deadline may have expired on April 15, 2007, unless the taxpayer filed for an extension to file their 2003 return.

Tax practitioners with clients with 2003 transactions who filed for extensions that year will want to monitor the Fisher case to see if a decision comes before the statute of limitations expires in 2007, and consider filing a protective claim before the deadline, unless the Fisher trial is decided in favor of the IRS in the interim. Tax practitioners with clients still holding stock received in distributions or with transactions after 2003 will want to monitor the results of the trial this summer. If that trial determines that the basis in the voting and liquidation interests is something other than zero, practitioners will want to consult with their clients about filing refund claims in line with the trial's results.

Practitioners with clients who received stock in a demutualization distribution but sold the stock within one year should also be aware that, if basis is determined to be something other than zero, the carryover holding period from the time as a company policyholder may also be lost, resulting in a transaction that was properly reported as a long-term capital gain on the original return being treated as a short-term capital gain on the amended return. The wisdom of filing an amended return for such a taxpayer will depend on the degree to which the available basis offsets the effect of the more adverse tax rate.

George G. Jones, JD, LL.M, is managing editor, and Mark A. Luscombe, JD, LL.M, CPA, is principal analyst, at CCH, a Wolters Kluwer business.

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