Stock Received in Demutualization Has No Basis

The Ninth Circuit, creating a circuit split, held that the taxpayers, heirs to the Campbell Soup fortune, had a zero basis in the stock of five insurance companies that they received when the companies demutualized.

Background

Bennett Dorrance, grandson of the founder of the Campbell Soup Co., and his wife, Jacquelyn Dorrance, purchased life insurance policies from five mutual insurance companies in 1996 to cover estate tax for their heirs on their approximately $1.5 billion fortune. Over time, the Dorrances paid premiums totaling $15,265,608 on the insurance policies, and the face value of the policies totaled just under $88 million. The Dorrances’ contractual rights under the policies entitled them to (1) a death benefit; (2) the right to surrender the policy for “cash value”; and (3) annual policyholder dividends representing their portion of the company’s “divisible surplus.”

As policyholders, they also had certain membership rights. Specifically, they were entitled to a portion of any surplus in the event of a solvent liquidation and to certain voting rights. The Dorrances’ membership rights in the mutual insurance companies were not transferable or separable from the insurance policy, and, if the policies terminated, so too would the membership rights, without any rebate or additional compensation. Voting and other membership rights were governed by state law and company charter.

In 2000 and 2001, each of the insurance companies from which the Dorrances bought policies demutualized. After demutualization, the Dorrances no longer held any mutual membership rights in the companies but retained their contractual interests under the insurance policies and continued to pay the same premiums. In return for their portion of the surplus of each company at the time of demutualization, the Dorrances received stock in the respective company.

When determining how many shares of stock to distribute to each policyholder, the insurance companies calculated (1) a fixed component for the loss of voting rights, as every policyholder was entitled to a single vote regardless of policy size, and (2) a variable component for the loss of other membership rights, which was calculated based on the policyholder’s past and projected future contributions to the company’s surplus. Each of the companies the Dorrances held policies with used a different formula to determine the amount of stock that they and other policyholders received.

Upon demutualization, the Dorrances received stock from the companies with an aggregate fair market value of $1,794,771. In 2003, the Dorrances sold all of the stock for $2,248,806, and on their 2003 tax return they listed their basis in the stock as zero and paid capital gains tax on the full amount of the proceeds from the sale.

The Dorrances later decided that they should not have paid tax on the stock sale because it represented a return on previously paid premiums on their policies, and in 2007 they filed a refund claim. The IRS, contending that the Dorrances had a zero basis in their stock because the insurance premiums that they paid were not in exchange for membership rights in the insurance policies, denied their claim. The Dorrances subsequently filed a refund suit in district court.

In district court, the Dorrances made an open transaction doctrine argument that had previously been espoused by the Federal Circuit (Fisher, 333 Fed. Appx. 572 (Fed. Cir. 2009)). The district court, while determining that the Dorrances’ full basis and the IRS’s no-basis arguments were incorrect, found that the Dorrances had paid some amount for their membership rights in the insurance companies and that amount, which was the Dorrances’ basis in the stock, was calculable. Under the formula it came up with, the district court held that the Dorrances had a basis of $1,170,678 in the stock sold and consequently were entitled to a refund. Both the IRS and the Dorrances appealed the decision.

The Ninth Circuit’s Decision

The Ninth Circuit reversed the district court and held that the Dorrances had no basis in the stock they received in the demutualization transaction and were liable for tax on the full proceeds from the stock sale. The court found that they had no basis in their membership rights in the insurance companies before demutualization because none of the premiums they paid before demutualization were payments for the membership rights in the insurance companies. Consequently, because the membership rights were traded for stock in the tax-free demutalization transactions, the stock’s basis was zero.

The court explained that the Dorrances, like any other mutual insurance policyholder, received two sets of rights when they purchased their insurance policies: (1) their contract rights, consisting of a death benefit, a cash value surrender right, and annual surplus dividends; and (2) nontransferable membership benefits, consisting of voting rights and rights to a portion of the insurance companies’ surplus in liquidation. The court concluded, based on the language of the insurance policies, which did not mention the membership rights, and expert testimony presented at trial, that all of the premiums paid under the policies were for the contract rights, and that no part of the premiums was for the membership rights. The court found that this point was “underscored by Mr. Dorrance’s testimony that, at the time he bought the policies, he actually understood that he would pay less for a policy from a mutual insurance company than he would for one from a stock company.”

The court then explained that the error made by the Dorrances and the district court was that they both assumed that the value received at the time of demutualization (i.e., the shares of stock) by the Dorrances was somehow linked to the premiums they had paid. The court gave two reasons why this was not true. First, the court observed that the overwhelming majority of the surplus that gave rise to the valuation of the newly issued stock of the insurance companies was not attributable to the Dorrances and other current policyholders; instead it was attributable to former policyholders. Thus stock was not something the Dorrances paid for and was better seen as a windfall they received for being policyholders at the time of demutualization.

Second, the court noted that, after the demutualization, with respect to the contract rights under the insurance policy, nothing changed. The Dorrances continued to pay the same premiums for their policies for the same insurance coverage, reinforcing the idea that the Dorrances and other policyholders were not paying anything for their membership rights through premium payments. According to the court, the stock exchange, for which the Dorrances paid nothing, was the only part of the demutualization transaction related to the membership rights.

Having determined that the Dorrances exchanged their membership rights for the insurance company stock, the Ninth Circuit then analyzed the tax effects of that transaction. Because the demutualization transaction was a tax-free transaction under Sec. 354, under Sec. 358(a)(1), the basis of the property received in the transaction by the policyholders was the same as the property they gave up. The Dorrances recognized no gain from the demutualization transaction; therefore, the court concluded that the stock they received was a direct exchange for the membership rights they gave up. Since the membership rights had no basis in the Dorrances’ hands, the stock likewise had no basis. The court pointed out that this was consistent with the advice given by the insurance companies on the effects of demutualization and IRS rulings dating back to Rev. Rul. 71-233.

Besides finding that the district court had erred in determining the Dorrances had any basis in the stock they sold, the Ninth Circuit asserted that the district court had also erred in estimating the stock’s basis by using the stock price at the time of demutualization to calculate basis rather than calculating basis at the time the Dorrances acquired the policies. As the court stated, “The stock value post-demutualization is not the same as the cost at purchase.”

Reflections

The dissenting opinion in this case asks the reasonable question of why, if the Dorrances paid nothing for their membership rights, did government regulators require that the companies issue the stock to their policyholders to compensate them for the loss of their rights? It also notes that “tax-free exchange” is not synonymous with “zero basis”—a tax-free exchange merely requires that the stock value equal the value of the property exchanged—and faults the majority for creating “nothing out of something.”

Dorrance, No. 13-16548 (9th Cir. 12/9/15)