Taxpayer Victory in Demutualization Case
Refunds owed to many taxpayers
By Kaye A. Thomas
Posted August 12, 2008
Court rejects IRS position that shares have zero basis.
The Court of Federal Claims has at long last issued decision in a case challenging the IRS position on stock received in a demutualization — that is, a transaction in which a mutual insurance company, which is owned by its policyholders, converts into a company owned by stockholders. If you had an insurance policy with a company that went through this conversion, you may have received shares of stock without paying for them. The IRS has consistently maintained that these shares have zero basis, so the full amount received in a sale of the shares must be reported as capital gain. Your right to receive the shares was based on your having paid premiums on the insurance policy, however, so it makes sense that you would have basis in the shares, reducing the amount of gain reported on the sale. The court ruled for the taxpayer and, in the case before it, ordered a full refund of the tax paid on the sale of these shares. Based on the court's reasoning, many thousands of other taxpayers — perhaps hundreds of thousands — may be entitled to refunds as well.
The decision in this case is supported by a thoroughly researched, carefully reasoned opinion (click for PDF). Judge Allegra displayed literary flair as well, for example comparing the development of the open transaction doctrine and the relevant tax regulation to a pavane. None of that is likely to discourage the IRS from appealing the decision. A final resolution may still be years away.
For many thousands of taxpayers it's already too late. As a general rule you have to file a refund claim within three years after filing the return to which it relates. People who sold shares before 2004 are generally out of luck, as are those who sold in 2004 if they filed their returns more than three years ago.
If you've reported gain from selling demutualization shares on returns filed within the last three years, you can preserve your rights by filing either a refund claim (demanding a refund now) or a protective claim (notifying the IRS of a claim that will become active upon a final decision in the case). For more information, visit Demutualization.biz, a website maintained by C.D. Ulrich, the Minnesota CPA who has spent the past seven years bringing this issue to public attention.
If you've received demutualization shares and haven't yet sold them, it might be a good idea to postpone a sale if possible. Apart from the problem that we still don't have a final resolution of this matter, the court's decision leaves some question as to the precise manner in which these sales are to be reported. If you've already sold shares this year, or feel that you must do this while the issue remains unresolved, you'll face a dilemma on your tax return. Should you claim basis in the shares, reducing or eliminating gain on the sale, in the face of a contrary position by the IRS? Or should you report zero basis, paying more tax than necessary according to the Court of Federal Claims?