Many seniors own stock they received because they owned life insurance policies in mutual insurance companies that demutualized. Demutualization means the company converted from a mutual (member owned) to a shareholder owned organization.
During the stock market boom of the late 1990s many mutual insurance companies converted to stockholder owned corporations in order to enhance their access to capital. Examples include insurance giants Metropolitan Life, John Hancock, Mutual of New York and Prudential.
How Demutualization Works
Mutual insurance companies are owned by their participating policyholders. Policyholders of mutual insurance companies have two sets of rights: ownership rights (such as voting rights) and the more commonly recognized contractual insurance rights. The ownership rights in a mutual insurance company cannot be sold or traded.
When a mutual insurance company converts to a stock based company it distributes the ownership rights to its participating policy holders. Generally, the demutualization itself is a tax-free reorganization under Internal Revenue Code section 368.
Usually the policyholders are given the option to receive either cash or stock. If the policyholder receives cash, a taxable event occurs. The Taxpayer is deemed to have received shares of stock and then to have sold the shares back to the corporation. If the taxpayer owned the insurance policy for more than one year as of the date of the demutualization, the gain is treated as long-term capital gain. If the policy was owned for a year or less, the gain is short-term capital gain. See, IRS Tax Topic 430 (last updated February 27, 2014).
In terms of federal income tax, taxpayers who elect to receive stock generally will not recognize any gain or loss on the exchange until the stock is sold. Their holding period for the new stock includes the period they held the policy in the former mutual company. When the stock is eventually sold the taxpayer generally will have to pay capital gains tax on the difference between the amount received on the sale and the seller’s tax basis in the stock. (If the stock is held until death, the inheritor will likely receive a step-up in tax basis to its value on the decedent’s date of death).
Confusion over Tax Basis
Whether the policyholder elects to receive cash or stock, the difficult question is – what is their tax basis in the stock that was received via demutualization.
In a number of cases the IRS has claimed that the stockholder’s tax basis in the stock received in a demutualization is zero. This means the entire sale proceeds will be subject to tax. Several of these cases have gone to court.
Unfortunately, the decisions in these cases have been at wide variance with each other.
One court has agreed with the IRS position that the taxpayer has a zero tax basis and the entire sale proceeds are subject to capital gains. Reuben v. U.S., 2013 PTC 74 (C.D. Calif. 2013). At the other extreme, the court in Fisher v. U.S., 2008 PTC 2 (Fed. Cl. 2008), aff’d, 333 Fed. App’x 572 (2009) permitted the taxpayer to use his basis in the entire insurance contract as his basis for the stock. This approach should usually result in the avoidance of any capital gains tax. And a third court has taken a complicated in-between approach: Dorrance v. U.S., 2013 PTC 34 (D. Ariz. 2013).
So, when you sell your demutualized stock, this may be an issue you should raise with your CPA or other tax preparer. Don’t be surprised if your preparer suggest you adopt the IRS zero basis position. But, if a lot of tax is involved, you may want to list a zero cost basis when reporting the sale proceeds and pay the taxes – and then file a claim for a refund.
Pennsylvania Income Tax
The compensation received by policyholders of demutualized insurance companies may also be subject to Pennsylvania income tax. The PA Department of Revenue has specified that there is a rebuttable presumption that the ownership rights relinquished in a demutualization should be valued at $0. See Personal Income Tax Bulletin 2009-01 (April 27, 2009).
In addition, for Pennsylvania income tax purposes, taxpayers must recognize gain at the time the cash or stock is received in a demutualization transaction.
Department of Revenue Tax Bulletin 2009-01 is available online at http://tinyurl.com/kcon7c8.
Courts Split on Tax Treatment of Gain on the Sale of Demutualized Stock
(Parker’s Federal Tax Bulletin: May 10, 2013).