Demutualization Did Not Render Policyholder's Ownership Interest Zero for Purposes of Federal Tax Code; No Capital Gains Due on Cash for Stock

In an opinion that may have enormous consequences for the demutualization of insurance companies, a federal court of claims ruled that a policyholder of a mutual insurance company that was transforming into a public stock company did not have to pay capital gains on an exchange of its interest in the mutual company for shares in the new company that the policyholder then sold in a cash election. The policyholder’s ownership rights did have value, said the court, and, that being the case, the amount it received being less than its cost basis in the insurance policy as a whole, the policyholder did not realize any income on the sale of the stock in question and, therefore, was entitled to a refund. Fisher, Trustee for Seymour P. Nagan Irrevocable Trust v. United States, US Court of Federal Claims, Aug. 6, 2008).

Since its infancy, federal income tax law has provided that gross income includes gains derived from dealings in property and that such gains generally equal the amount realized less the seller’s cost basis in the property sold. For generations, courts faced with this scenario have grappled with two possibilities: to treat the property sold as having little or no cost basis, so that the sale proceeds are taxable, or, the course taken here, to treat the property as sharing the cost basis of the entire bundle, such that no gain is realized until all the capital represented by that basis is recovered.

A mutual insurance company has no shareholders, but instead is owned by policyholders possessing both ownership rights and contractual insurance rights. The insurance company converted into a publicly-traded stock company through a process known as demutualization. Under the plan, the policyholders received shares of stock in a new company in exchange for their ownership rights. They could elect to sell their shares in a cash election.

When the demutualization took effect, the policyholder received 3,892 shares, opted for the cash election, received $31,759.00 and paid a tax of $5,725. Later, the policyholder requested a refund of that amount.

The court rejected the contention that the ownership rights had no value.
Reg. § 1.61-6(a) provides that when property is acquired for a lump sum and interests therein are subsequently disposed of separately, in order to compute the gain or loss from each disposition an allocation or apportionment of the cost or other basis to the several units must be made. Of course, for this formula to work, one must be able to derive the fair market values of the component parts of the larger property. The regulations presume these values are obtainable, stating that only in ``rare and extraordinary’’ cases will property be considered to have no fair market value.

This was a such a ``rare and extraordinary’’ case, said the court, adding that irreducible values could exist, with the effect of postponing the recognition of income. The court applied the judicially-created open transaction doctrine, which coexists with the regulation and endures as a viable, albeit limited, exception to the general rule enunciated in Reg. § 1.61-6.

The ownership rights were, at the outset, inextricably tied to the underlying insurance policy and were not separately sellable. This fact is an important indication that the ownership rights lacked a determinable fair market value at the time the policy in question was first acquired. But this limitation did not mean that the value of the ownership rights was zero. Unless the Internal Revenue Code specifies otherwise, noted the court, appraisers must take an asset as they finds it.

One of the critical features that could not be ignored was the fact the ownership rights were indivisible from the insurance policy. The fact that future financial benefits associated with the ownership rights were speculative did not mean they should be valued at zero.