Revisiting Allocation Of Basis Issues: 'Dorrance'

The courts have taken varying approaches to determining the basis of stock that is received by an insurance policyholder in exchange for the policyholder's surrender of membership rights in a mutual insurance company, in a "demutualization" transaction. While this may seem to be a narrow and abstruse question, the approaches taken by the courts may have application in other areas of the tax law affecting analogous transactions.

Most recently, the Court of Appeals for the Ninth Circuit, in Dorrance v. United States,1 reversed the district court decisions in that case,2 agreed with the government position that the policyholder's basis in the stock did not include any part of the premiums paid by the policyholder for insurance, and concluded that the entire proceeds from the subsequent sale of the stock by the policyholder constituted gain.

Background

Mutual insurance companies are owned by policyholders, rather than by shareholders. Policyholders who purchase insurance from a mutual company typically obtain, without payment of additional consideration beyond stated premiums, "membership rights," including voting rights and the right to participate in the distribution of surplus in the event of the dissolution of the company. Ordinarily the membership rights in a mutual insurance company have no significant value: each policyholder typically has only one vote, regardless of the amount of insurance purchased, and the record before the Court of Appeals included expert testimony indicating that none of the testifying experts could recall a dissolution of a solvent mutual insurance company that resulted in distributions to its members.

By the 1990's, it became clear that an insurer's doing business as a stock company rather than as a mutual company could result in significant advantages with respect to, for example, raising additional capital and diversification. Changes in state law were then made to facilitate "demutualization" (that is, conversion from a mutual company to a stock company). As a condition to the approval of such transactions, however, state insurance regulators required that mutual policyholders be compensated for the surrender of their voting rights and rights to surplus through the receipt of stock in the stock company or cash in connection with the demutualization transaction. The IRS issued a series of private letter rulings confirming that the receipt of stock would generally be nontaxable, on the theory that the demutualizations qualified as "reorganizations" for income tax purposes.

Bennett and Jacquelynn Dorrance (the Dorrances) purchased in 1996, through a trust formed by them, life insurance policies with an aggregate face value of approximately $88 million from five mutual insurance companies. The policies were purchased to fund the anticipated payment of estate taxes upon the Dorrances' death.

Upon the demutualization of each of...