Best Tax Tips

What does this recent case mean for you? If you sold shares from a demutualization, you may also be eligible for a refund of tax paid. You must file an amended federal tax return and it must be timely filed. The rules for filing amended returns, just like the facts of this case, are complex. Also, keep in mind that the IRS

may appeal the court’s decision. A higher court could decide in favor of the IRS

Once the mutual company pays its claims and operating expenses, the profits belong to the policyholders. Typically, some of those profits are returned to the policyholders as dividends, which reduce premium payments, while the remainder is retained as surplus, often accumulating from year to year. The ultimate goal of this arrangement is to provide insurance at the lowest possible cost.

Recently, a federal court decided an important tax case and it was a victory for taxpayers. The U.S. Court of Federal Claims ordered the IRS to pay a refund to a taxpayer who had been a policyholder in a mutual insurance company. The decision could open the door to many more refund claims, possibly including one from you.

In this court case the insurance company decided cease operating as a mutual insurance company and convert to a publicly-traded stock company.  The policyholders would keep their insurance coverage and receive shares of stock in the new entity. Once the policyholders, now stockholders, received their shares they could elect to sell the shares.   That is what the taxpayer in this case did.  They sold their shares.

The policyholder decided to sell the shares and received $32,000. The policyholder reported this amount, unreduced by any basis adjustment, on its 2000 federal income tax return and paid about $5,000 in tax. In 2004, the policyholder changed his mind on the amount of tax he should have paid and filed suit in the Claims Court for a refund.

At trial, the IRS argued that the policyholder had a zero basis in the cash or stock received in the demutualization. The court applied what is known as the open transaction doctrine. This complex doctrine is an exception to the general rule requiring an allocation of basis on the disposition of a portion of an asset. Ultimately, the court found that the policyholder did not realize any income on the sale of the 4,000 shares because the amount received was less than its cost basis in the insurance policy as a whole.

A mutual insurance company is an insurance company whose policy holders own the company, in other words it has no shareholders. The policyholders have ownership rights, such as voting and distribution rights, as well as contractual insurance rights.  As a policyholder you may even be unaware that the company you are dealing with is a mutual insurance company until it decides to demutualize.  If you receive a voting proxy each year as part of your policy you are dealing with a mutual insurance company.