Demutualization and the Mitigation Provisions — Part I

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Anyone want to start a really bad band with me that plays songs about tax law?  That could be the name.  We’d be a hit on the accounting firm picnic circuit, although we might steal some work from the Traveling Helverings (not that I’m implying they are bad, like my band would be).

In July last year, Illinois Lumber & Material Dealers v. United States was decided by the Eighth Circuit, and I started rewriting a post I had started when the District Court decided the case in 2014.  The case is very interesting procedurally, dealing with the use of the tax mitigation provisions found in Sections 1311 to 1314 by taxpayers to reopen years outside of the statute of limitations where tax had been paid on the sale of stock received in the demutualization of insurance companies.  I recently assisted Les in revising content for Chapter 5 of SaltzBook dealing with the mitigation of the statute of limitations (which will be included in the new edition coming soon-shameless plug #1).  Writing about the case also allows me to highlight the fact that the Eighth Circuit cited perhaps the most engaging, entertaining, and educational law review article ever written on the topic of the sale of stock in a demutualized insurance company, Chuck vs. Goliath: Basis of Stock Received in Demutualization of Mutual Insurance Companies (shameless plug #2 – I wrote the article in 2009).

In the post below, I’ll discuss the Illinois Lumber case, and a few others, which are reviving the issue of the treatment of basis with demutualized insurance companies, which now likely has a split in the circuits.  I’ll then discuss the mitigation provisions and how the IRS has been found not to have taken an inconsistent position for obtaining relief – even though its positions were diametrically opposite.

First, The Facts

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The plaintiff in this case was a voluntary employee benefit plan (“VEBA”), which held life insurance.  As a VEBA, it was exempt from tax unless it had unrelated business income.  Prior to ’03, Illinois Lumber obtained a membership interest, presumably by buying insurance, in Great American Mutual Holding Company, which demutualized in 2003 (more on that below).  In 2004, 2006, and 2008, Illinois Lumber obtained over $1.5MM in distributions in exchange for its membership interest.  In 2008, as discussed below, the IRS acquiesced to a court holding that reversed the Service’s position on the tax treatment of demutualization of insurance companies, allowing basis to be allocated to the shares/membership units in the insurance companies.  In 2008, Illinois Lumber amended its returns, and obtained refunds on tax paid for the 2006 and 2008 returns.  The 2004 statute of limitations for refund claims had already passed, and the IRS disallowed the refund claim, indicating the statute of limitations had passed, but if it had not, the Service would have refunded the tax…well, at the time it would have, but now the applicable circuit for appeal might matter.  Before discussing the mitigation issues, let’s take a detour to explain demutualization and the current landscape.

Demutualization – Sounds made up.

Insurance companies can generally be created as either stock companies or mutual companies.  Stock companies have shareholders as the owners, who benefit from the profits of the company.  In mutual insurance companies, the insurance policy holders are the “owners”, and any dividends of profits are applied to premiums or cash value in policies.  Sometimes, for tax or other business reasons, a mutual insurance company will become a stock insurance company in a process called demutualization, where the policy holders are provided shares in the company (in a tax free distribution).  Prior to 2009, the Service took the position that there was no basis in the shares received.  Taxpayers, however, felt that was unfair, and that some portion or all of the policy premiums paid should have been allocated to the stock as basis.  Folks debated whether the basis should be allocated to the shares as they were sold, while others advocated for a proportionate allocation based on the FMV of the policy and the shares.

This disagreement moved to the courts, and in 2009, the Court of Appeals for the Federal Circuit in Fisher v  United States affirmed in an unpublished opinion the Court of Federal Claims which held under the open transaction doctrine the taxpayers should only pay gain on the shares after all basis had been used.  333 Fed. Appx. 572 (Fed. Cir. 2009).  The IRS acquiesced shortly thereafter.  Some taxpayers who had previously paid tax on the sale of shares filed refunds, but others were outside of the statutory period.  A dilly of a pickle (which some hoped to remedy with mitigation).

Naively, I thought the acquiescence by the IRS to the decision in Fisher meant this debate was over.  Two recent Ninth Circuit cases have held that members have no basis in the shares received in a demutualization, so upon the sale the entire amount is subject to capital gains tax.   Dorrance v. US and Reuben v. US were decided in December 2015 and January 2016, respectively.  Dorrance involves Bennett Dorrance, a name those of us in the Philly area are familiar with, as one of the heirs to the Campbell’s Soup fortune.  As he is a billionaire, it is unsurprising that when he sold the shares he received in the demutualization, the gain was roughly $2.2MM (assuming no basis).

The Dorrances sought a refund in ’07, which the IRS did not act on, so the taxpayers took it to the District Court.  The District Court determined that he (they) are/were entitled to a partial refund, allocating basis based on a formula off the IPO value and the amount paid on the policies, and both sides appealed.  In an unfortunate turn of events, the Ninth Circuit did not cite my law review article.  If this goes to SCOTUS, and you know a law clerk, please forward this post to them.  Together, we can get SCOTUS to cite me (the article doesn’t really say anything earth shattering, but I’ll take a citation to general background info).

The Ninth Circuit rejected the open transaction doctrine (recoup all basis first as sales occur), and the allocation of basis between the economic rights (my fave).  Instead, the Ninth Circuit indicated the Dorrances did nothing to meet their burden that they had made a payment for their stake in the membership rights, and therefore no basis could be allocated.

Circuit split!  Hopefully, SCOTUS takes this up, and reads our blog!

Obviously, I am a super cool guy (I write for a tax procedure blog).  So, it should come as a surprise to no one that I elected to purchase life insurance from a mutual insurance company, because a portion of what I was buying was an ownership right that would reinvest in my policy (or I would get stock eventually in a demutualization).    I did intentionally buy that right, but I’m not sure how I would prove that.

This was all a bit substantive, but somewhat procedural.  Part II will focus on the mitigation provisions that Illinois Lumber tried to use to obtain a refund for the closed tax year.

About Stephen Olsen

Stephen J. Olsen’s practice includes tax planning and controversy matters for individuals, businesses and exempt entities for the law firm Gawthrop Greenwood, PC.

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