Court Rules on Sale of Ownership Rights in Insurance Company Demutualization

By James Beavers, J.D., LL.M., CPA

Applying the open transaction doctrine, the Court of Federal Claims held that a trust was entitled to a refund of taxes paid on the proceeds of the sale of stock the trust received in exchange for its ownership rights in a mutual life insurance company when the company was demutualized.


In December 1999, the holders of participating life insurance policies (the policyholders) issued by Sun Life Assurance Company (Sun Life), a mutual life insurance and financial services company based in Canada, approved a demutualization plan for the company that was effective in March 2000. Under the plan, the policyholders were to receive stock in the successor company to Sun Life in exchange for the voting and liquidation rights (ownership rights) in Sun Life they held by virtue of being participating policyholders. The plan included a cash election option, under which policyholders who had held their policies on January 27, 1998, could receive cash instead of stock by authorizing Sun Life to sell the stock they were issued under the plan immediately in connection with the company’s public offering.

The Seymour P. Nagan Irrevocable Trust (whose trustee was Eugene Fisher) was a holder of a participating Sun Life policy on January 27, 1998. The trust made the cash election and in 2000 received $31,759 from the sale of its stock in the successor company. After demutualization, the trust continued to hold its insurance policy, and its dividend and other rights under the policy (other than its ownership rights) remained the same.

The trust reported the full amount of the proceeds from the sale as income on its 2000 tax return and paid $5,725 tax on the income. In 2004, the trust filed a claim for refund for the tax paid on the proceeds from the sale. The IRS denied the claim, maintaining that the trust received the stock it sold in return for its ownership rights in Sun Life; because the trust had a zero basis in those ownership rights, it likewise had a zero basis in the stock and the entire proceeds from the sale of the stock were taxable gain. The IRS asserted that the ownership rights had a zero basis because they had no value when the trust acquired its insurance policy from Sun Life in 1990. The trust subsequently filed a refund suit in the Court of Federal Claims.

The Parties’ Arguments

The trust argued that it had a basis in the ownership rights from the time it originally purchased the Sun Life policy. According to the trust, the basis in the overall life insurance policy was the total premiums the trust had paid on the insurance policy and the basis of the ownership rights was a portion of the basis in the insurance policy. However, the trust contended that the ownership rights were inseparable from the other rights embodied in the insurance policy and, because they were inseparable, it was impossible to accurately determine a separate basis for them. Therefore, the gain on the sale of the ownership rights could not be properly determined, and a basis recovery approach (with the fair market value of the stock sold being used as the basis of the ownership rights) should be applied to the sale. Under this approach, any gain on the sale would not be determined until the trust disposed of the insurance policy that it retained.

The IRS in turn argued that the time for determining the basis of the trust’s ownership rights in Sun Life was the time of the original purchase of the Sun Life insurance policy. The IRS contended that the trust had no realistic expectation of receiving anything for those rights at that time and that all the premiums it initially and subsequently paid were for the insurance coverage and related dividend rights that the insurance policy provided. Therefore, the trust had no basis in the ownership rights under any of the commonly accepted methods of determining basis.

The Service also argued that any increases in the value of the rights that occurred after the original purchase of the policy were not included in basis. Therefore, even though the value of the ownership rights had increased dramatically when the policyholders adopted the demutualization plan, the trust had no basis in the ownership rights when it sold them, and the full proceeds from the sale were taxable. The IRS further argued that based on the type of property involved in the case, the basis recovery approach suggested by the trust did not apply.

The Court’s Decision

The Federal Court of Claims sided with the trust and held that the open transaction doctrine applied to the sale of the trust’s ownership rights in Sun Life. Therefore, the trust did not have a gain on the sale of the rights in the year of the demutualization.

In coming to this conclusion, the court found that the IRS was clearly in error in assigning a zero value to the trust’s ownership rights. The court decided that although the value of those rights was speculative, as an actuarial study undertaken by Sun Life prior to its demutualization indicated, they did have a value. However, according to the court, because a policyholder could not sell the ownership rights separately on the open market and there were no assets comparable to the ownership rights that the court could use to establish their value, there was no reasonable way to determine the basis of the ownership rights.

It being impossible to determine the basis of the trust’s ownership rights, the court held that the open transaction doctrine, originally expressed in the case Burnet v. Logan, 283 U.S. 404 (1931), should be applied. In Logan, the Supreme Court held that where a taxpayer sells property in return for an uncertain stream of future payments, due to the uncertainty of the total amount of future payments to be received, the gain on the transaction cannot be determined at the time of the sale. Therefore, the taxpayer is allowed to recover his or her basis in the property in its entirety before recognizing gain on the transaction (the capital-recovery method).

Although there was no question of basis allocation in Logan, the Court of Federal Claims, relying primarily on the holdings in Pierce, 99 Ct. Cl. 355 (1943), Inaja Land Co., 9 T.C. 727 (1947), and Warren, 193 F.2d 996 (1st Cir. 1952), found that the open transaction doctrine had been expanded to cover cases in which a portion of a property purchased for a single price is sold and it is impossible or impracticable to apportion the basis of the property to the part of the property sold and the part retained by the seller. Applying the open transaction doctrine in the trust’s case, the court held that the trust had no gain in the year of demutualization and was entitled to a refund under the capital-recovery method because the price paid for the trust’s ownership rights was less than its basis in its insurance policy as a whole.

The court noted that, in enacting the installment sales rules in Sec. 453, Congress intended to restrict the application of the judicial open transaction doctrine and the cost-recovery method to "rare and extraordinary cases." However, the court held that based on the unique and unusual facts involved, this was one of the rare and extraordinary cases in which the open transaction doctrine applies.


Although this case represents a significant win for taxpayers who have received stock in a life insurance demutualization, they might want to wait before planning how to spend their refunds. Although the IRS has not yet announced whether it will appeal this decision, it is almost certain to do so and to continue to contest this issue vigorously in other circuits.

In its decision, the Court of Federal Claims adopts the trust’s basis recovery argument and then uses the Inaja Land Co. and Pierce cases as the foundation for its novel conclusion that a policyholder’s sale of ownership rights in the demutualization of a life insurance company is one of the "rare and extraordinary" cases in which the open transaction doctrine applies.

While Inaja Land Co., as demonstrated in Gladden, 262 F.3d 851 (9th Cir. 2001), is still good precedent in cases involving real property, it is a stretch to apply it to a case involving insurance policies issued by and ownership rights in a mutual insurance company. Due to the changes in the law regarding the computation of gain (including the enactment of Sec. 453) in the many years since the Pierce decision, it is not entirely clear that it is even a viable precedent in the Federal Circuit in cases involving common stock, much less the case at hand. Given that the court based its decision on cases of very questionable application, it would be premature to say that it has come up with the definitive resolution of this issue.
—Fisher, No. 04-1726-T (Ct. Cl. 8/6/08)

The reports of cases, rulings, etc., herein, except for the Reflections, are edited versions of the relevant court opinion, published ruling, etc.


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