United States

Demutualization and stock basis


When a mutual insurance company demutualizes, policyholders generally receive either shares of the demutualized company or cash along with their continuing policies. The question of what, if any, basis the policyholder receives in the stock of the demutualized company has been an area of significant controversy between taxpayers and the government. The IRS views a demutualization as the exchange of nonrecognition property and has long contended that policyholders have a zero basis in any stock received. Two recent court decisions on this issue are inconsistent with an unpublished opinion in Fisher v. United States, 82 Fed. Cl. 780 (2008), where the court found that the policyholder received a cost basis in stock received in connection with the demutualization and that the open transaction doctrine applied in determining the policyholder’s basis. In Reuben v. United States, 111 AFTR 2d 2013-XXXX (Jan. 15, 2013), and Dorrance v. United States, 110 AFTR 2d 2012-5176 (2012), the courts held that the open transaction doctrine did not apply, but disagreed on whether the taxpayer received basis in the stock of the demutualized company.

In Reuben, a Circuit Court held in favor of the government, disallowing application of the open transaction doctrine and holding that no portion of the premiums paid prior to the demutualization created basis in the mutual rights. Therefore, the stock received had no basis, and all proceeds received upon the ultimate sale of the stock were taxed as capital gain.

The ruling in Reuben appears inconsistent, in part, with the 2012 Dorrance decision. In Dorrance, the District Court also rejected the open transaction doctrine, but disagreed with the government’s argument that the taxpayer had no basis in the stock sold. This allowed the taxpayer to “equitably” apportion the premiums paid before demutualization to basis in the mutual rights, and therefore in the stock of the demutualized company, and basis in the policies. It could be argued that Dorrance and Reuben are not necessarily inconsistent, but rather that factual drivers led to the differing determinations on basis allocation.

These recent decisions reaffirm that application of the open transaction doctrine to determine basis following a demutualization transaction should occur with caution. Reliance on Fisher, an unpublished opinion, should be reviewed in light of these more recent decisions. Furthermore, when applying the Dorrance position, policyholders receiving stock should attempt to contemporaneously document and support their allocation of basis to the stock received in the demutualization, with a view that any basis claimed on the stock will need to be supported upon a sale.



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