The plaintiff obtained shares of stock upon demutualization of an insurance company. The plaintiff later sold some of the shares of stock and the defendant asserted that the plaintiff's income tax basis in the stock was zero triggering 100 percent gain on the sale of the shares. The trial court rejected the defendant's position, and set forth the computation for calculating basis in stock shares received upon demutualization. The court grounded the computation of stock basis in the same manner in which the insurance company determined the value of demutualized shares for initial public offering (IPO) for purposes of determining how many shares to issue to a policyholder. Based on that analysis, the court noted that the company calculated a fixed component for lost voting rights based on one vote per policy holder and a variable component for other rights lost based on a shareholder's past and anticipated future contributions to the company's surplus. The court estimated that 60 percent of the plaintiff's past contributions were to surplus and 40 percent was for future contributions to surplus which the plaintiff had not actually yet paid before receiving shares and are not part of stock basis; thus, plaintiff's basis in stock comprised of fixed component for giving up voting rights and 60 percent of the variable component representing past contributions to surplus the end result was that the plaintiff's stock basis was slightly over 60 percent of IPO value of stock. On further review, the U.S. Court of Appeals for the Ninth Circuit reversed in a split opinion. The court determined that the plaintiff's didn't pay any additional amount for the mutual rights and that treating the premiums as payment for membership rights was inconsistent with how tax law treats insurance premiums. The court noted that under the tax code gross premiums paid to buy a policy are allocated as income to the insurance company and no portion is carved out as a capital contribution.
Conversely, the policyholder can deduct the "aggregate amount of premiums" paid upon receipt of a dividend or cash-surrender value. No amount is carved out as an investment in membership rights. Because of that, the court held that the plaintiff's couldn't have a tax-free exchange with zero basis and then an increased basis upon later sale of the stock. Accordingly, the court held that the trial court erred by not determining whether the plaintiffs paid anything to acquire the mutual rights, and by estimating basis by using the stock price at the time of demutualization instead of calculating basis at the time of policy acquisition. Thus, because the taxpayers did not prove that they paid for their membership rights as opposed to premiums payments for the underlying insurance coverage, they could not claim any basis in the demutualized stock. Dorrance v. United States, No. 13-16548, 2015 U.S. App. LEXIS 21287 (Dec. 9, 2015), rev'g., No. CV-09-1284-PHX-GMS, 2013 U.S. Dist. LEXIS 37745 (D. Ariz. Mar. 19, 2013).