Some policyholders received stock from their insurance company when the company converted from a mutual form of ownership to a stock insurance corporation. In the past, the IRS has said that such shares had a cost basis of zero. Several Federal court cases that dispute the IRS position and claim that cost basis existed have been working their way through the court system.
A recent court decision was handed down by a California court in January 2013 that was favorable to the position of the IRS. Two previous court cases were favorable to the taxpayer. Most recently, in an Arizona case, the court ruled that the taxpayer had basis of IPO value in the shares from forfeiting voting rights. As a result, protective refund claims that were filed will still be held up until the issue is finally resolved at a higher level.
The U.S. Court of Appeals issued a ruling in a case brought by trustee Eugene Fisher on behalf of taxpayer Seymour Nagan Irrevocable Trust (who will now be famous in the tax accounting world.) The Court found that the ownership rights in the demutualized shares should in theory receive an allocation of basis from the insurance policy.
However, considering the particular facts and circumstances of demutualization, the Court ruled that the value of the ownership rights was not discernible apart from the value of the insurance policy and therefore an allocation of basis cannot be made currently. Therefore, the "open transaction" method applies and the sales proceeds of the demutualization stock are treated as a return of capital up to the amount of cost basis in the insurance policy as a whole. Only amounts received in excess of the combined cost basis (an unlikely event) are taxable as capital gain.
The combined cost basis in the insurance policy plus the ownership rights to demutualization shares is the cumulative premiums paid less any dividends received.
This ruling is far better than the interim Court rulings that the initial public offering price would be the cost basis of the shares. The Court has essentially declared a complete victory for the taxpayer. Instead of the IRS position that all of the sales proceeds are capital gain, the Court basically ruled that none of the proceeds are taxable. Hurray!
However, the IRS does not agree and continues to litigate this issue in the courts.
News Update of July 2012: Latest news is that the Arizona Federal District Court rejected the IRS claim that demutualized shares have a cost basis of zero. There is still no clarity on the way to calculate basis, though. The valuation method will be established at a future date by the outcome of a court case on how to apportion basis between the shares and the insurance policy. Refund claims will continue to be held up by the IRS until the final ruling.
News update of January 2013: A California court has ruled for the IRS position that demutualized shares carry zero basis.
News update of March 2013: The Dorrance decision found that the taxpayer had cost basis from a combination of forfeiture of voting rights and past premium payments.
To report the sale of demutualization shares on your Form 1040 Schedule D Capital Gains and Losses, just report the net amount of sales proceeds as your cost basis and declare a capital gain of zero. (This assumes that you paid more in insurance premiums than the total IPO value of the demutualized shares.) Your new cost basis in the insurance policy is the cumulative premiums you paid less any dividends received less the return of capital in the amount of the net sales proceeds for the demutualization shares.
This case was originally pursued by a Minnesota accountant, Charles Ulrich, CPA, in the spirit of public service. He just thought the IRS position was unjust to taxpayers.
The Investor Relations websites of some of the demutualized insurance companies may provide further information. Some are relying on the IRS position and providing guidance that the cost basis is zero. The IRS instructions now specifically state that demutualized shares have a cost basis of zero. However, at the time this page was updated, the issue is still up in the air as far as the Courts are concerned. To be on the safe side, you could pay the long-term capital gain tax using a cost basis of zero and then immediately file a protective refund claim for the amount of tax paid.
The IPO (initial public offering) prices for various demutualized companies were as follows: AmerUs Life (received Amerus Group Co shares, bought by Aviva)...............$26.00
Indianapolis Life (received Amerus Group Co shares, bought by Aviva)........$35.63
State Mutual Life Assurance Co (received Allmerica Financial Corp shares). $21.00 Your holding period (date of purchase) for the shares would be the date you originally started paying insurance premiums to the company.
The largest life insurance companies that have demutualized include the following firms:
A resource which explains how to file an amended return for refund of capital gain taxes (if you already sold the shares and declared a tax basis of zero or the IPO price) can be found at: www.kiplinger.com/letterlinks/demutualization
A legal case decided in 2012 related to demutualization refund claims is explained in a recent Forbes article by contributor Peter J Reilly, CPA. Basically a timely-filed refund claim for capital gains tax paid on the sale of demutualization shares was rejected by the IRS because the taxpayer did not mention the specific name of the Fisher case! See the complete article by clicking on this link: Time Limit on Demutualization Refund Claims