Demutualization Income Tax Class Action Litigation
Tax Practice and Accounting News Tax Notes
Aug. 4, 2003, p. 681 100 Tax Notes 681 (Aug. 4, 2003) Life Insurance, Stock, Tax Basis, and Demutualization By Burgess J.W. Raby and William L. Raby
In the past several years, few tax practitioners or their clients have been fully able to ignore life insurance company demutualization. They owned life insurance contracts with mutual insurance companies pursuant to which they also owned an equity interest in the company. When the company ceased being a mutual, they received stock in the company (or its holding company) as a result of that equity interest.
Charles D. Ulrich, a Baxter, Minnesota, CPA, has provided material on web page http://www.demutualization.org/offer.html that tells tax practitioners and taxpayers alike that what they did (or are going to do) is wrong -- if tax practitioners have been following advice of the IRS and the insurance companies.
Zero Basis or Basis Recovery?
That bad advice has been to ascribe zero tax basis to the equity position of the mutual company policyholder. In this article, we will advance the proposition that a "recovery-of-basis" approach is more appropriate, with the tax basis of the insurance policy as the basis that is being recovered. If we are right, there are millions or billions of dollars of tax refund opportunities potentially available. Note that we are dealing here with life insurance policies that are not held in qualified plans, and not dealing with annuity contracts, even though both of these also may be involved in demutualization transactions.
Tax Basis of Insurance Policy
In our article, "The Tax Treatment of Life Insurance Settlements," Tax Notes, July 17, 2000, p. 387, we said that the tax basis for figuring gain on life insurance policy sales is the amount of the premiums paid, less any tax-free returns of premium. In a mutual company, the policy can be thought of as a contract that both provides life insurance coverage and also represents an ownership interest in the company. A threshold question then is whether that basis can be factored into an amount representing what was paid for the insurance portion and the amount that was paid for the equity position of the policyholder, or whether there is one amount that is the tax basis up to the moment when the equity ownership interest is separated from the policy contract.
The answer seems to be that there is one amount. In Moseley v. Commissioner, 72 T.C. 183 (1979), for example, the IRS sought to fragment a policy into its component parts. One of those parts was an investment fund and the other the life insurance protection itself. When the investment feature matured, the IRS allowed as the tax basis the premiums paid for that part of the policy in measuring the gain on the amount received. "Respondent [IRS] maintains that the special reserve and death benefit provisions constitute two distinct and economically independent policies. Hence, he would have us hold that the section 72(e)(1)(B) term 'aggregate premiums,' as applied to the facts of this case, refers only to those premiums credited to the special reserve account," explained the court. The amount received for the investment fund (in other words, the "special reserve account") was more than the aggregate premiums allocable to that reserve but less than the aggregate premiums paid on the policy, so the result that the IRS sought was to hold that part of the amount received when the investment fund matured was taxable income.
The Section 72(e) Recovery of Basis Approach
The court disagreed. "The special reserve provisions are inseparable from the life insurance provisions of the policy," it concluded. In fact, if the insurance company had sold the special reserve provisions separately, those would not even have been life insurance -- rather, they would have constituted an investment contract requiring registration with the Securities and Exchange Commission. The court held that "aggregate premiums," for purposes of calculating gain on the policy, "refers to all premiums paid under the policy, including the portion credited to the special reserve." Thus, "the dividend received under the special reserve provision constituted a partial recovery of the premiums paid for all rights under the policy." Mr. Ulrich's position is that the demutualization distributions also call for this recovery-of-basis approach, and for the reasons cited by the court in Moseley. Thus, he contends that so long as the cash and stock received did not exceed the aggregate of the net premiums that had been paid on the policy, there would be no gain on a cash distribution and the distribution date fair market value of the stock would constitute its tax basis for subsequent gain or loss on disposition.
The Tax Court in Moseley applied section 72(e)(1)(B), which provides that if any amount is received under a life insurance contract and if that amount is not received as an annuity, the amount is included in gross income "only to the received when the investment fund matured was taxable income. extent that it...exceeds the aggregate premiums or other consideration paid." The Tax Court noted that earlier cases "have construed this cost recovery rule of the predecessor of this section as excluding from income dividends received under a life insurance contract until amounts received under the contract exceed the aggregate premiums paid. Helvering v. Meredith, 140 F.2d 973, 974 (8th Cir. 1944), aff'g. per curiam a Memorandum Opinion of this Court; see Estate of Wong Wing Non v. Commissioner, 18 T.C. 205, 209 (1952). Sec. 19.22(b)(2)-1, Regs. 103; sec. 29.22(b)(2)-1, Regs. 111."
This is still the rule under current law. It is important to note, however, that then and now the statute has qualified this basis recovery treatment with the clause, "if no other provision of this subtitle applies." The position taken on the demutualization Web site seems to ignore that clause in its conclusion that the distributions received in a demutualization are no different from any other policy distributions that might be made, albeit some may be in property (stock) rather than cash. The cash or fair market value of the stock reduces the remaining tax basis of the life insurance policy, of course, and would be viewed as carved out of that policy. That fair market value then becomes the tax basis of the stock. Thus, if the tax basis of the policy was large enough, the Ulrich conclusion is that policyholders have no gain or loss on the demutualization transaction and those who take stock instead of cash have as their tax basis for that stock its fair market value as of the date of receipt.
Corporate Reorganization
However, it is the IRS position that another provision of "this subtitle" does apply. most recent authoritative statement to that effect is Rev. Rul. 2003-19, 2003-7 IRB 468, Doc 2003-2083 (13 original pages) [PDF], 2003 TNT 15-13. It dealt with three variations on the demutualization theme, of which the first is of most interest to us here because it best fits the classic demutualization picture where the former mutual company simply issues capital stock and drops the "mutual" from its name. The holdings in the second and third situations in the ruling are more complicated because the facts are more complex, but do not change the basic analysis, which is that those demutualizations also constituted corporate reorganizations.
In the simplest situation, the Service held that what was involved was both a section 368(a)(1)(E) recapitalization as well as an "F" reorganization because of the change in name and corporate form from mutual to stock. The policyholders of the mutual company had both membership interests in the mutual company and contractual rights under their policies. Absent the reorganization, those membership rights could not be separated from the contract rights as a matter of state law, said the IRS. Those rights would terminate, with no continuing value, if the contract terminated. The membership interests were to be treated as voting stock, said the ruling, and thus the transaction was not taxable to the shareholders.
Tax Basis of Stock to Shareholder
The ruling did not, however, follow through and deal with the tax basis and holding period of the stock received by former mutual policyholders. ILM 2001131028, Doc 2001-20788 (4 original pages) [PDF], 2001 TNT 151-20 , had pointed out that if a demutualization qualified as a tax-free reorganization, "then Taxpayer's holding period for the stock runs from the date the Taxpayer first held an equity interest in the mutual life insurance company as a policyholder or annuitant. Section 1223(1) of the Code." The ILM went on and stated as a fact that "Taxpayers had a zero basis in their respective equity interests in the mutual companies," thus resulting in a zero basis for the stock received. Note that section 1223(1), which allows the tacking on of holding periods, does so only "if, under this chapter, the property has, for the purpose of determining gain or loss from a sale or exchange, the same basis in whole or in part in his hands as the property exchanged. . . . " Section 358 provides that the basis of property received in a tax- free exchange without recognition of gain or loss is the same as the basis of the property exchanged.
The IRS has commented about demutualization a number of times in recent years, in addition to the ruling and ILM cited. The conclusions reached are consistent. They are reflected in the Service's instructions to taxpayers as to the basic tax alternatives they face in a demutualization. The 2002 version of Publication 550, Investment Income and Expenses (Including Capital Gains and Losses), Doc 2002-25039 (75 original pages) [PDF], 2002 TNT 225-41, explained:
If you were a policyholder or annuitant of the mutual company [involved in a demutualization], you may have received either stock in the stock company or cash in exchange for your equity interest in the mutual company. If the demutualization transaction qualifies as a tax-free reorganization under section 368(a)(1) of the Internal Revenue Code, no gain or loss is recognized on the exchange. Your holding period for the new stock includes the period you held an equity interest in the mutual company as a policyholder or annuitant. . . . If the demutualization transaction does not qualify as a tax-free reorganization under section 368(a)(1) of the Internal Revenue Code, you must recognize a capital gain or loss. Your holding period for the stock does not include the period you held an equity interest. The Schedule D for 2002 was the first to include instructions for dealing with stock received in a demutualization (at p. D-4). The instructions state flatly that "[t]he basis of your equity interest in the mutual company is considered to be zero." All of these zero basis conclusions seem to trace back to Revenue Rulings 71-233, 1971-1 C.B. 113, and 74-277, 1974-1 C.B. 88. The reasoning of the 1971 ruling on this point was that "[p]ayment by each policyholder of the premiums called for by the insurance contracts issued by X [the mutual] represents payment for the cost of insurance and an investment in his contract but not an investment in the assets of X. His proprietary interest in the assets of X arises solely by virtue of the fact that he is a policyholder of X. Therefore, the basis of each policyholder's proprietary interest in X is zero." The 1974 ruling, which dealt with the conversion of an exempt fraternal beneficiary society to a taxable mutual life insurance company, then concluded that "[i]n accordance with section 358(a) of the Code each policyholder will have a zero basis in his proprietary interest in Y [the mutual resulting from the conversion] since the basis of his proprietary interest exchanged was zero."
A Bald-Faced Assertion Isn't Persuasive
Assume that the reorganization analysis for the typical demutualization transaction is correct. It lends no support to the unsupported assertion by the IRS that the tax basis of the policy can and must be allocated in its entirety to the insurance contract with no amount being allocated to the equity rights of the contract holder. If the tax basis of the two features within the Moseley policy could not be separated, even though they could be separately identified and allocated within the Moseley insurance contract, we see no basis for a conclusion that the two features in the contracts involved in demutualization can be separated and one assigned a zero basis. Note that since Moseley was decided in 1979, we consider that its analysis trumps the dicta of the 1971 and 1974 revenue rulings. This is especially true since the zero basis conclusions in those rulings do not come close to meeting the test set by the Supreme Court for judicial deference to an administrative agency's interpretation of a statute. In United States v. Mead Corp., 533 U.S. 218, 228 (2001), the Supreme Court quoted from its own decision in Skidmore v. Swift & Co., 323 U.S. 134, 140 (1944), to the effect that:
The weight [accorded to an administrative] judgment in a particular case will depend upon the thoroughness evident in its consideration, the validity of its reasoning, its consistency with earlier and later pronouncements, and all those factors which give it power to persuade, if lacking power to control.
The zero basis conclusion set forth in those rulings appears to fail the Skidmore v. Swift test.
Linked Securities and Tax Basis
That leaves us with the conclusion that there is one inseparable basis for insurance benefits and equity rights within the one policy, with the equity rights being carved out in the reorganization, and that then leaves us with the question of what amount of tax basis is allocable to those equity rights. The tax law has a long history of dealing with interests in linked or bundled assets. The ones most frequently encountered by practitioners are probably linked security acquisitions, such as a bond with attached stock warrants (section 1273(c)(2)); tax-free distributions of stock or rights to shareholders (reg. section 1.307-1(a)); the relinquishment of development rights or granting of easements (see Rev. Rul. 77-414, 1977-2 C.B. 299); and bargain sales to charity (reg. section 1.170A- 4(c)). We have dealt with this bundled asset question in a prior article, "Linked or Bundled Assets and Tax Basis Allocation," Tax Notes, April 3, 2000, p. 99. Since a corporate reorganization is involved, the cases involving linked securities discussed in that article seem most analogous.
Those cases seem fairly clear as to what should be done in the demutualization situation. One of them, Spreckels-Rosekrans Inv. Co. v. Lewis, 146 F.2d 982 (9th Cir. 1945), involved a shareholder of Chase National Bank who sold its bank stock but retained its stock in Chase Securities Corporation. The bank and the security corporation stock had been linked in the sense that one could not originally be purchased or sold without the other, just as is the case with the insurance policy and the equity rights. The linked bank and security stock package had been purchased in 1930, the bank and security stocks had been unlinked in 1934, and the bank stock was sold in 1936. The question was the appropriate tax treatment of the sale. The taxpayer wanted to deduct a loss. The IRS, which was then the Bureau of Internal Revenue, successfully argued that a recovery of basis approach should be adopted.
"There is no statute or regulation providing specifically for an apportionment of cost under these circumstances," observed the appeals court. "The Government contends that, since the investment was single, the stock of the affiliate as well as of the Bank must be disposed of before any loss may be recognized." The court noted that the U.S. Court of Appeals for the Second Circuit had adopted that view in De Coppet v. Helvering, 108 F.2d 787 (2nd Cir. 1940). In that opinion, the Second Circuit had emphasized that "the beneficial interest [in the security affiliate] was as much an appurtenance of the bank shares as an easement is of the servient tenements; it merely gave them an added value." That Second Circuit opinion went on to point out that "the important matter is . . . whether the investment was single. It was if the investor could not have dealt with the parts separately; and these investors could not." Thus, recovery of the unitary basis was appropriate for the first piece sold.
What this type of basis recovery rationale means, in the context of life insurance policies that also possess equity rights in a mutual insurer, is that the tax basis of the stock received in the demutualization would be the lesser of its then-fair market value or the tax basis of the insurance policy just before the demutualization. While this was the successful IRS position in Spreckels-Rosekrans and De Coppet v. Helvering, it is understandable that the IRS is not eager to embrace it in demutualization. The Chase Securities Corporation stock that was not sold in Spreckels-Rosekrans would likely be the subject of a taxable transaction some day, and the gain in that transaction would be greater because the tax basis had been reduced. However, the reduced basis of the life insurance contract after demutualization normally never will produce any income tax revenue since policy proceeds paid by reason of death are tax free. While the objective of protecting the revenue may explain the IRS position, it does not constitute sufficient authority for it.
The UNUM Complication
Should a life insurance company demutualization be analyzed under the rules relating to life insurance or should it be viewed under the more general corporate restructuring law? As indicated above, the final results of the two approaches actually do not differ when it comes to the question of stockholder tax basis for the stock received. But at least one court has looked at the question of which set of tax rules applies. UNUM Corp., et al. v. United States, 130 F.3d 501, Doc 97-33057 (45 pages), 97 TNT 236-9 (1st Cir. 1997), cert. denied 525 U.S. 810 (1998), involved the conversion of Union Mutual Insurance Company into UNUM Life and its holding company, UNUM Corp., a stock company. The tax issue involved distribution of $129 million in cash to 105,000 eligible policyholders as well as distribution of over 20 million shares of UNUM stock to 58,561 policyholders eligible for that distribution under the plan. Before the stock distribution, UNUM had sought and obtained an IRS ruling that the demutualization transaction was a tax-free exchange under section 368(a)(1)(e).
Note, however, that in the arcane world of life insurance tax accounting, there is a deduction allowed under section 805(a)(3) for something called "policyholder dividends" as determined under section 808(c). This can be viewed as the insurance company side of distributions that would generally be treated as a recovery of policy basis under section 72(e), as discussed earlier in this article. However, the two terms are not necessarily identical in every instance. In any event, UNUM decided that its distributions of both cash and stock in redemption of the equity interests of its policyholders were deductible "policyholder dividends" and duly filed a refund claim for $652 million, followed by a refund suit.
In her opinion, Circuit Judge Sandra L. Lynch wrestled mightily with how the subchapter C corporate reorganization provisions of the code interacted with the life insurance company taxation provisions of subchapter L, part I. "The question that this case poses," she explained, "is whether the cash and stock distributions made by UNUM during its conversion are made specifically deductible by section 808 and section 805 of subchapter L, notwithstanding that they are clearly not deductible under section 162, section 311, section 354, section 1032, and other relevant provisions of the Code." She added that UNUM had a heavier than normal burden of proof on this question since "[s]ubchapter L has been subject to narrow construction because its provisions 'give life insurance companies tax benefits over other taxpayers.'"
Judge Lynch concluded that nothing in section 808 specifically overrode the general rules of subchapter C and the rest of the code. "Indeed," she noted, "section 808 does not even MENTION these rules [and this] suggests that it may have nothing to do with capital transactions altogether. Congress has been explicit in those situations when it wished subchapter L to modify subchapter C." She added that "for a distribution to qualify as a 'policyholder dividend,' the distribution must occur to policyholders 'in their capacity as such' -- i.e., in their capacity as policyholders, not owners."
If Judge Lynch's UNUM conclusions turn out to be the controlling law, and we think that they will, then the section 72(e) argument will ultimately not fly. Recipients of cash and stock in demutualization are then left with the general tax rules as determinants of their taxation. But those general rules, as discussed above, still lend little support to the zero basis argument of the IRS that was so readily adopted by the insurance companies in their advisories to their policyholders on the tax consequences of the stock distributions made in demutualizations.
Class Action Tax Litigation
It would be convenient if one policyholder/stockholder could challenge the IRS position in a class action instituted on behalf of all taxpayers similarly situated. In our "Class Action Income Tax Litigation," Tax Notes, Oct. 28, 2002, p. 517, we explained, however, why class action suits could not be maintained in the United States Tax Court and are generally impractical in U.S. District Courts or the Court of Federal Claims. Tax Court cases involving a common issue can be consolidated for trial and briefing, of course, but that is a far different matter.
The Court of Federal Claims requires that a taxpayer seeking a refund must have first paid the tax and filed a claim for refund with the IRS. Its Rule 23, adapted from the Federal Rules of Civil Procedure Rule 23 applicable district courts, specifically provides for class actions. To bring a class action, the representative taxpayer(s) would have to assert:
(1) the class is so numerous that joinder of all members is impracticable;
(2) there are questions of law or fact common to the class;
(3) the claims of the representative parties are typical of the claims of the class; and
(4) the representative parties will fairly and adequately protect the interests of the class.
If those prerequisites are met, and "the court finds that the questions of law or fact common to the members of the class predominate over any questions affecting only individual members, and that a class action is superior to other available methods for the fair and efficient adjudication of the controversy," then the court may issue an order determining that a class action may be maintained. But who will be the permissible members of that class if such an order is issued? In Saunooke v. United States, 8 Cl. Ct. 327, 85 TNT 115-23 (Ct. Cl. 1985), Claims Court Judge Christine Cook Nettesheim discussed various facets of the use of the class action device in federal income tax refund claims in her court. She noted that "none of the members of the proposed class [in that case], with the exception of the named plaintiffs, have complied with the jurisdictional in the preconditions for a tax refund action in this court -- payment of any assessed deficiency and timely claim for refund." Only those taxpayers can be included in the class. She added that "plaintiffs seek to recharacterize the class to include only those . . . taxpayers who have filed timely claims for refund." Such a requirement, that each member of the class to be certified must have personally filed a claim, eliminates much of the power -- and fee award potential -- of the class action when dealing with a multiplicity of small claims. In fact, Judge Nettesheim suggested that when that has occurred, the appropriate procedure in the Court of Federal Claims might well not be a class action at all. The thing to do would be to file individual actions and then consolidate the various individual claims into one action for purposes of trial and briefing. That, of course, presupposes some sort of a concerted effort to get the taxpayers involved, working together, and on somewhat the same schedule. So while there is a large amount of tax refund money potentially involved in these demutualization transactions, it may be locked in the bank vault of a tax system that no one tax practitioner working alone can ever open.
Conclusion
The recovery of basis approach is supported by either of two lines of analysis -- (1) the section 72(e) approach that treats the distribution as a recovery of investment in the contract, or (2) the recapitalization approach (in conjunction linked assets that have a unitary basis). While we think that the UNUM opinion casts doubt on whether the section 72(e) approach would prevail, either alternative produces a refund result for any taxpayer who has filed a return reporting the receipt of cash or the sale of stock received in a demutualization on the basis that the equity interest in the insurance company had a zero basis.
One way to deal with this in the preparation of returns is to claim basis in the stock when the return is filed. That basis would be the lesser of the tax basis (cumulative net premiums) of the life insurance policy or the fair market value of the stock when received. When dealing with that vast majority of policyholders who already have filed, or will file, based on the zero basis information received from the insurance companies, the practical problem for the tax practitioner is that the refund potential per taxpayer tends to be small compared to the likely cost of a tax controversy. The practitioner who might do only one or a few such claims often will be intimidated by the amount of research and thinking needed to conclude that there is a reasonable basis for the refund position. The time may be disproportionate to the potential fee that could be charged for preparing the refund claim and handling any subsequent audit of that claim.
This is the type of situation where practitioners may well find it worthwhile to pool their efforts locally or nationally, as was, for example, done some years ago when small pension plan assumptions were being challenged wholesale by the IRS. Practitioners in Phoenix pooled their efforts and ultimately triumphed in court. The economies of scale apply to even tax controversies. This pooling could be done through state CPA or EA societies or chapters, or even through their tax committees. It might be done through a Web site, such as the demutualization Web site referred to earlier. What is needed is to put together a critical mass of refund claims and thus make it possible to coordinate the refund litigation that would follow when the IRS, as is likely, fails to voluntarily abandon its current zero basis position. That critical mass would then mean that the cost per taxpayer seeking a refund would be relatively nominal.
FOOTNOTE 1 We thank Chuck Ulrich for calling our attention to this situation.
Aug. 4, 2003, p. 681 100 Tax Notes 681 (Aug. 4, 2003) Life Insurance, Stock, Tax Basis, and Demutualization By Burgess J.W. Raby and William L. Raby
In the past several years, few tax practitioners or their clients have been fully able to ignore life insurance company demutualization. They owned life insurance contracts with mutual insurance companies pursuant to which they also owned an equity interest in the company. When the company ceased being a mutual, they received stock in the company (or its holding company) as a result of that equity interest.
Charles D. Ulrich, a Baxter, Minnesota, CPA, has provided material on web page http://www.demutualization.org/offer.html that tells tax practitioners and taxpayers alike that what they did (or are going to do) is wrong -- if tax practitioners have been following advice of the IRS and the insurance companies.
Zero Basis or Basis Recovery?
That bad advice has been to ascribe zero tax basis to the equity position of the mutual company policyholder. In this article, we will advance the proposition that a "recovery-of-basis" approach is more appropriate, with the tax basis of the insurance policy as the basis that is being recovered. If we are right, there are millions or billions of dollars of tax refund opportunities potentially available. Note that we are dealing here with life insurance policies that are not held in qualified plans, and not dealing with annuity contracts, even though both of these also may be involved in demutualization transactions.
Tax Basis of Insurance Policy
In our article, "The Tax Treatment of Life Insurance Settlements," Tax Notes, July 17, 2000, p. 387, we said that the tax basis for figuring gain on life insurance policy sales is the amount of the premiums paid, less any tax-free returns of premium. In a mutual company, the policy can be thought of as a contract that both provides life insurance coverage and also represents an ownership interest in the company. A threshold question then is whether that basis can be factored into an amount representing what was paid for the insurance portion and the amount that was paid for the equity position of the policyholder, or whether there is one amount that is the tax basis up to the moment when the equity ownership interest is separated from the policy contract.
The answer seems to be that there is one amount. In Moseley v. Commissioner, 72 T.C. 183 (1979), for example, the IRS sought to fragment a policy into its component parts. One of those parts was an investment fund and the other the life insurance protection itself. When the investment feature matured, the IRS allowed as the tax basis the premiums paid for that part of the policy in measuring the gain on the amount received. "Respondent [IRS] maintains that the special reserve and death benefit provisions constitute two distinct and economically independent policies. Hence, he would have us hold that the section 72(e)(1)(B) term 'aggregate premiums,' as applied to the facts of this case, refers only to those premiums credited to the special reserve account," explained the court. The amount received for the investment fund (in other words, the "special reserve account") was more than the aggregate premiums allocable to that reserve but less than the aggregate premiums paid on the policy, so the result that the IRS sought was to hold that part of the amount received when the investment fund matured was taxable income.
The Section 72(e) Recovery of Basis Approach
The court disagreed. "The special reserve provisions are inseparable from the life insurance provisions of the policy," it concluded. In fact, if the insurance company had sold the special reserve provisions separately, those would not even have been life insurance -- rather, they would have constituted an investment contract requiring registration with the Securities and Exchange Commission. The court held that "aggregate premiums," for purposes of calculating gain on the policy, "refers to all premiums paid under the policy, including the portion credited to the special reserve." Thus, "the dividend received under the special reserve provision constituted a partial recovery of the premiums paid for all rights under the policy." Mr. Ulrich's position is that the demutualization distributions also call for this recovery-of-basis approach, and for the reasons cited by the court in Moseley. Thus, he contends that so long as the cash and stock received did not exceed the aggregate of the net premiums that had been paid on the policy, there would be no gain on a cash distribution and the distribution date fair market value of the stock would constitute its tax basis for subsequent gain or loss on disposition.
The Tax Court in Moseley applied section 72(e)(1)(B), which provides that if any amount is received under a life insurance contract and if that amount is not received as an annuity, the amount is included in gross income "only to the received when the investment fund matured was taxable income. extent that it...exceeds the aggregate premiums or other consideration paid." The Tax Court noted that earlier cases "have construed this cost recovery rule of the predecessor of this section as excluding from income dividends received under a life insurance contract until amounts received under the contract exceed the aggregate premiums paid. Helvering v. Meredith, 140 F.2d 973, 974 (8th Cir. 1944), aff'g. per curiam a Memorandum Opinion of this Court; see Estate of Wong Wing Non v. Commissioner, 18 T.C. 205, 209 (1952). Sec. 19.22(b)(2)-1, Regs. 103; sec. 29.22(b)(2)-1, Regs. 111."
This is still the rule under current law. It is important to note, however, that then and now the statute has qualified this basis recovery treatment with the clause, "if no other provision of this subtitle applies." The position taken on the demutualization Web site seems to ignore that clause in its conclusion that the distributions received in a demutualization are no different from any other policy distributions that might be made, albeit some may be in property (stock) rather than cash. The cash or fair market value of the stock reduces the remaining tax basis of the life insurance policy, of course, and would be viewed as carved out of that policy. That fair market value then becomes the tax basis of the stock. Thus, if the tax basis of the policy was large enough, the Ulrich conclusion is that policyholders have no gain or loss on the demutualization transaction and those who take stock instead of cash have as their tax basis for that stock its fair market value as of the date of receipt.
Corporate Reorganization
However, it is the IRS position that another provision of "this subtitle" does apply. most recent authoritative statement to that effect is Rev. Rul. 2003-19, 2003-7 IRB 468, Doc 2003-2083 (13 original pages) [PDF], 2003 TNT 15-13. It dealt with three variations on the demutualization theme, of which the first is of most interest to us here because it best fits the classic demutualization picture where the former mutual company simply issues capital stock and drops the "mutual" from its name. The holdings in the second and third situations in the ruling are more complicated because the facts are more complex, but do not change the basic analysis, which is that those demutualizations also constituted corporate reorganizations.
In the simplest situation, the Service held that what was involved was both a section 368(a)(1)(E) recapitalization as well as an "F" reorganization because of the change in name and corporate form from mutual to stock. The policyholders of the mutual company had both membership interests in the mutual company and contractual rights under their policies. Absent the reorganization, those membership rights could not be separated from the contract rights as a matter of state law, said the IRS. Those rights would terminate, with no continuing value, if the contract terminated. The membership interests were to be treated as voting stock, said the ruling, and thus the transaction was not taxable to the shareholders.
Tax Basis of Stock to Shareholder
The ruling did not, however, follow through and deal with the tax basis and holding period of the stock received by former mutual policyholders. ILM 2001131028, Doc 2001-20788 (4 original pages) [PDF], 2001 TNT 151-20 , had pointed out that if a demutualization qualified as a tax-free reorganization, "then Taxpayer's holding period for the stock runs from the date the Taxpayer first held an equity interest in the mutual life insurance company as a policyholder or annuitant. Section 1223(1) of the Code." The ILM went on and stated as a fact that "Taxpayers had a zero basis in their respective equity interests in the mutual companies," thus resulting in a zero basis for the stock received. Note that section 1223(1), which allows the tacking on of holding periods, does so only "if, under this chapter, the property has, for the purpose of determining gain or loss from a sale or exchange, the same basis in whole or in part in his hands as the property exchanged. . . . " Section 358 provides that the basis of property received in a tax- free exchange without recognition of gain or loss is the same as the basis of the property exchanged.
The IRS has commented about demutualization a number of times in recent years, in addition to the ruling and ILM cited. The conclusions reached are consistent. They are reflected in the Service's instructions to taxpayers as to the basic tax alternatives they face in a demutualization. The 2002 version of Publication 550, Investment Income and Expenses (Including Capital Gains and Losses), Doc 2002-25039 (75 original pages) [PDF], 2002 TNT 225-41, explained:
If you were a policyholder or annuitant of the mutual company [involved in a demutualization], you may have received either stock in the stock company or cash in exchange for your equity interest in the mutual company. If the demutualization transaction qualifies as a tax-free reorganization under section 368(a)(1) of the Internal Revenue Code, no gain or loss is recognized on the exchange. Your holding period for the new stock includes the period you held an equity interest in the mutual company as a policyholder or annuitant. . . . If the demutualization transaction does not qualify as a tax-free reorganization under section 368(a)(1) of the Internal Revenue Code, you must recognize a capital gain or loss. Your holding period for the stock does not include the period you held an equity interest. The Schedule D for 2002 was the first to include instructions for dealing with stock received in a demutualization (at p. D-4). The instructions state flatly that "[t]he basis of your equity interest in the mutual company is considered to be zero." All of these zero basis conclusions seem to trace back to Revenue Rulings 71-233, 1971-1 C.B. 113, and 74-277, 1974-1 C.B. 88. The reasoning of the 1971 ruling on this point was that "[p]ayment by each policyholder of the premiums called for by the insurance contracts issued by X [the mutual] represents payment for the cost of insurance and an investment in his contract but not an investment in the assets of X. His proprietary interest in the assets of X arises solely by virtue of the fact that he is a policyholder of X. Therefore, the basis of each policyholder's proprietary interest in X is zero." The 1974 ruling, which dealt with the conversion of an exempt fraternal beneficiary society to a taxable mutual life insurance company, then concluded that "[i]n accordance with section 358(a) of the Code each policyholder will have a zero basis in his proprietary interest in Y [the mutual resulting from the conversion] since the basis of his proprietary interest exchanged was zero."
A Bald-Faced Assertion Isn't Persuasive
Assume that the reorganization analysis for the typical demutualization transaction is correct. It lends no support to the unsupported assertion by the IRS that the tax basis of the policy can and must be allocated in its entirety to the insurance contract with no amount being allocated to the equity rights of the contract holder. If the tax basis of the two features within the Moseley policy could not be separated, even though they could be separately identified and allocated within the Moseley insurance contract, we see no basis for a conclusion that the two features in the contracts involved in demutualization can be separated and one assigned a zero basis. Note that since Moseley was decided in 1979, we consider that its analysis trumps the dicta of the 1971 and 1974 revenue rulings. This is especially true since the zero basis conclusions in those rulings do not come close to meeting the test set by the Supreme Court for judicial deference to an administrative agency's interpretation of a statute. In United States v. Mead Corp., 533 U.S. 218, 228 (2001), the Supreme Court quoted from its own decision in Skidmore v. Swift & Co., 323 U.S. 134, 140 (1944), to the effect that:
The weight [accorded to an administrative] judgment in a particular case will depend upon the thoroughness evident in its consideration, the validity of its reasoning, its consistency with earlier and later pronouncements, and all those factors which give it power to persuade, if lacking power to control.
The zero basis conclusion set forth in those rulings appears to fail the Skidmore v. Swift test.
Linked Securities and Tax Basis
That leaves us with the conclusion that there is one inseparable basis for insurance benefits and equity rights within the one policy, with the equity rights being carved out in the reorganization, and that then leaves us with the question of what amount of tax basis is allocable to those equity rights. The tax law has a long history of dealing with interests in linked or bundled assets. The ones most frequently encountered by practitioners are probably linked security acquisitions, such as a bond with attached stock warrants (section 1273(c)(2)); tax-free distributions of stock or rights to shareholders (reg. section 1.307-1(a)); the relinquishment of development rights or granting of easements (see Rev. Rul. 77-414, 1977-2 C.B. 299); and bargain sales to charity (reg. section 1.170A- 4(c)). We have dealt with this bundled asset question in a prior article, "Linked or Bundled Assets and Tax Basis Allocation," Tax Notes, April 3, 2000, p. 99. Since a corporate reorganization is involved, the cases involving linked securities discussed in that article seem most analogous.
Those cases seem fairly clear as to what should be done in the demutualization situation. One of them, Spreckels-Rosekrans Inv. Co. v. Lewis, 146 F.2d 982 (9th Cir. 1945), involved a shareholder of Chase National Bank who sold its bank stock but retained its stock in Chase Securities Corporation. The bank and the security corporation stock had been linked in the sense that one could not originally be purchased or sold without the other, just as is the case with the insurance policy and the equity rights. The linked bank and security stock package had been purchased in 1930, the bank and security stocks had been unlinked in 1934, and the bank stock was sold in 1936. The question was the appropriate tax treatment of the sale. The taxpayer wanted to deduct a loss. The IRS, which was then the Bureau of Internal Revenue, successfully argued that a recovery of basis approach should be adopted.
"There is no statute or regulation providing specifically for an apportionment of cost under these circumstances," observed the appeals court. "The Government contends that, since the investment was single, the stock of the affiliate as well as of the Bank must be disposed of before any loss may be recognized." The court noted that the U.S. Court of Appeals for the Second Circuit had adopted that view in De Coppet v. Helvering, 108 F.2d 787 (2nd Cir. 1940). In that opinion, the Second Circuit had emphasized that "the beneficial interest [in the security affiliate] was as much an appurtenance of the bank shares as an easement is of the servient tenements; it merely gave them an added value." That Second Circuit opinion went on to point out that "the important matter is . . . whether the investment was single. It was if the investor could not have dealt with the parts separately; and these investors could not." Thus, recovery of the unitary basis was appropriate for the first piece sold.
What this type of basis recovery rationale means, in the context of life insurance policies that also possess equity rights in a mutual insurer, is that the tax basis of the stock received in the demutualization would be the lesser of its then-fair market value or the tax basis of the insurance policy just before the demutualization. While this was the successful IRS position in Spreckels-Rosekrans and De Coppet v. Helvering, it is understandable that the IRS is not eager to embrace it in demutualization. The Chase Securities Corporation stock that was not sold in Spreckels-Rosekrans would likely be the subject of a taxable transaction some day, and the gain in that transaction would be greater because the tax basis had been reduced. However, the reduced basis of the life insurance contract after demutualization normally never will produce any income tax revenue since policy proceeds paid by reason of death are tax free. While the objective of protecting the revenue may explain the IRS position, it does not constitute sufficient authority for it.
The UNUM Complication
Should a life insurance company demutualization be analyzed under the rules relating to life insurance or should it be viewed under the more general corporate restructuring law? As indicated above, the final results of the two approaches actually do not differ when it comes to the question of stockholder tax basis for the stock received. But at least one court has looked at the question of which set of tax rules applies. UNUM Corp., et al. v. United States, 130 F.3d 501, Doc 97-33057 (45 pages), 97 TNT 236-9 (1st Cir. 1997), cert. denied 525 U.S. 810 (1998), involved the conversion of Union Mutual Insurance Company into UNUM Life and its holding company, UNUM Corp., a stock company. The tax issue involved distribution of $129 million in cash to 105,000 eligible policyholders as well as distribution of over 20 million shares of UNUM stock to 58,561 policyholders eligible for that distribution under the plan. Before the stock distribution, UNUM had sought and obtained an IRS ruling that the demutualization transaction was a tax-free exchange under section 368(a)(1)(e).
Note, however, that in the arcane world of life insurance tax accounting, there is a deduction allowed under section 805(a)(3) for something called "policyholder dividends" as determined under section 808(c). This can be viewed as the insurance company side of distributions that would generally be treated as a recovery of policy basis under section 72(e), as discussed earlier in this article. However, the two terms are not necessarily identical in every instance. In any event, UNUM decided that its distributions of both cash and stock in redemption of the equity interests of its policyholders were deductible "policyholder dividends" and duly filed a refund claim for $652 million, followed by a refund suit.
In her opinion, Circuit Judge Sandra L. Lynch wrestled mightily with how the subchapter C corporate reorganization provisions of the code interacted with the life insurance company taxation provisions of subchapter L, part I. "The question that this case poses," she explained, "is whether the cash and stock distributions made by UNUM during its conversion are made specifically deductible by section 808 and section 805 of subchapter L, notwithstanding that they are clearly not deductible under section 162, section 311, section 354, section 1032, and other relevant provisions of the Code." She added that UNUM had a heavier than normal burden of proof on this question since "[s]ubchapter L has been subject to narrow construction because its provisions 'give life insurance companies tax benefits over other taxpayers.'"
Judge Lynch concluded that nothing in section 808 specifically overrode the general rules of subchapter C and the rest of the code. "Indeed," she noted, "section 808 does not even MENTION these rules [and this] suggests that it may have nothing to do with capital transactions altogether. Congress has been explicit in those situations when it wished subchapter L to modify subchapter C." She added that "for a distribution to qualify as a 'policyholder dividend,' the distribution must occur to policyholders 'in their capacity as such' -- i.e., in their capacity as policyholders, not owners."
If Judge Lynch's UNUM conclusions turn out to be the controlling law, and we think that they will, then the section 72(e) argument will ultimately not fly. Recipients of cash and stock in demutualization are then left with the general tax rules as determinants of their taxation. But those general rules, as discussed above, still lend little support to the zero basis argument of the IRS that was so readily adopted by the insurance companies in their advisories to their policyholders on the tax consequences of the stock distributions made in demutualizations.
Class Action Tax Litigation
It would be convenient if one policyholder/stockholder could challenge the IRS position in a class action instituted on behalf of all taxpayers similarly situated. In our "Class Action Income Tax Litigation," Tax Notes, Oct. 28, 2002, p. 517, we explained, however, why class action suits could not be maintained in the United States Tax Court and are generally impractical in U.S. District Courts or the Court of Federal Claims. Tax Court cases involving a common issue can be consolidated for trial and briefing, of course, but that is a far different matter.
The Court of Federal Claims requires that a taxpayer seeking a refund must have first paid the tax and filed a claim for refund with the IRS. Its Rule 23, adapted from the Federal Rules of Civil Procedure Rule 23 applicable district courts, specifically provides for class actions. To bring a class action, the representative taxpayer(s) would have to assert:
(1) the class is so numerous that joinder of all members is impracticable;
(2) there are questions of law or fact common to the class;
(3) the claims of the representative parties are typical of the claims of the class; and
(4) the representative parties will fairly and adequately protect the interests of the class.
If those prerequisites are met, and "the court finds that the questions of law or fact common to the members of the class predominate over any questions affecting only individual members, and that a class action is superior to other available methods for the fair and efficient adjudication of the controversy," then the court may issue an order determining that a class action may be maintained. But who will be the permissible members of that class if such an order is issued? In Saunooke v. United States, 8 Cl. Ct. 327, 85 TNT 115-23 (Ct. Cl. 1985), Claims Court Judge Christine Cook Nettesheim discussed various facets of the use of the class action device in federal income tax refund claims in her court. She noted that "none of the members of the proposed class [in that case], with the exception of the named plaintiffs, have complied with the jurisdictional in the preconditions for a tax refund action in this court -- payment of any assessed deficiency and timely claim for refund." Only those taxpayers can be included in the class. She added that "plaintiffs seek to recharacterize the class to include only those . . . taxpayers who have filed timely claims for refund." Such a requirement, that each member of the class to be certified must have personally filed a claim, eliminates much of the power -- and fee award potential -- of the class action when dealing with a multiplicity of small claims. In fact, Judge Nettesheim suggested that when that has occurred, the appropriate procedure in the Court of Federal Claims might well not be a class action at all. The thing to do would be to file individual actions and then consolidate the various individual claims into one action for purposes of trial and briefing. That, of course, presupposes some sort of a concerted effort to get the taxpayers involved, working together, and on somewhat the same schedule. So while there is a large amount of tax refund money potentially involved in these demutualization transactions, it may be locked in the bank vault of a tax system that no one tax practitioner working alone can ever open.
Conclusion
The recovery of basis approach is supported by either of two lines of analysis -- (1) the section 72(e) approach that treats the distribution as a recovery of investment in the contract, or (2) the recapitalization approach (in conjunction linked assets that have a unitary basis). While we think that the UNUM opinion casts doubt on whether the section 72(e) approach would prevail, either alternative produces a refund result for any taxpayer who has filed a return reporting the receipt of cash or the sale of stock received in a demutualization on the basis that the equity interest in the insurance company had a zero basis.
One way to deal with this in the preparation of returns is to claim basis in the stock when the return is filed. That basis would be the lesser of the tax basis (cumulative net premiums) of the life insurance policy or the fair market value of the stock when received. When dealing with that vast majority of policyholders who already have filed, or will file, based on the zero basis information received from the insurance companies, the practical problem for the tax practitioner is that the refund potential per taxpayer tends to be small compared to the likely cost of a tax controversy. The practitioner who might do only one or a few such claims often will be intimidated by the amount of research and thinking needed to conclude that there is a reasonable basis for the refund position. The time may be disproportionate to the potential fee that could be charged for preparing the refund claim and handling any subsequent audit of that claim.
This is the type of situation where practitioners may well find it worthwhile to pool their efforts locally or nationally, as was, for example, done some years ago when small pension plan assumptions were being challenged wholesale by the IRS. Practitioners in Phoenix pooled their efforts and ultimately triumphed in court. The economies of scale apply to even tax controversies. This pooling could be done through state CPA or EA societies or chapters, or even through their tax committees. It might be done through a Web site, such as the demutualization Web site referred to earlier. What is needed is to put together a critical mass of refund claims and thus make it possible to coordinate the refund litigation that would follow when the IRS, as is likely, fails to voluntarily abandon its current zero basis position. That critical mass would then mean that the cost per taxpayer seeking a refund would be relatively nominal.
FOOTNOTE 1 We thank Chuck Ulrich for calling our attention to this situation.
posted by unclel at Friday, December 16, 2005
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