BENNETT DORRANCE; JACQUELYNN DORRANCE, Plaintiffs-Appellees/Cross-Appellants,
UNITED STATES OF AMERICA, Defendant-Appellant/Cross-Appellee
Argued and Submitted April 9, 2015, Pasadena, California
Appeal from the United States District Court for the District of Arizona. D.C. No. 2:09-cv-01284-GMS. G. Murray Snow, District Judge, Presiding.
The panel reversed the district court's denial of the government's motion for summary judgment in a tax refund action involving the calculation of the cost basis of stock received through demutualization.
Taxpayers received and then sold stock derived from the demutualization of five mutual insurance companies from which they had purchased life insurance policies. Taxpayers initially asserted a zero cost basis in the stock and paid tax on the gain, but later claimed a full refund. The district court held that taxpayers had a calculable basis in the stock and were therefore entitled to a partial refund.
The panel held that the Internal Revenue Service properly denied the refund claim and that the district court had erred in its cost basis calculation because taxpayers had not met their burden of showing that they had in some way paid for the stock.
The panel explained that under the life insurance policies, taxpayers were entitled to certain contractual rights such as a death benefit, the right to surrender the policy for cash value, and annual dividends. After demutualization, taxpayers retained their contractual interests and continued to pay the same premiums. Taxpayers as policyholders also had certain membership rights for which they received nothing upon demutualization. The stock they received was due to the legal requirement that the insurance companies produce a " fair and equitable" allocation of each company's surplus at the time of demutualization, but evidence showed that this was not based on some premium value that taxpayers had paid in the past.
Judge M. Smith dissented. He agreed with the district court's cost basis calculation, and disagreed with the majority's view that taxpayers paid nothing for their membership rights.
M. Todd Welty (argued) and Laura L. Gavioli, McDermott Will & Emery LLP, Dallas, Texas, for Plaintiffs-Appellees/Cross-Appellants.
Kathryn Keneally, Assistant Attorney General; Tamara W. Ashford, Principal Deputy Assistant Attorney General; Gilbert S. Rothenberg, Jonathan S. Cohen, and Judith A. Hagley (argued), Attorneys, United States Department of Justice, Tax Division, Washington, D.C., for Defendant-Appellant/Cross-Appellee.
Before: Stephen Reinhardt, M. Margaret McKeown, and Milan D. Smith, Jr. Circuit Judges.
M. Margaret McKeown, Circuit Judge:
This appeal requires us to " return to the very basics of tax law" and consider whether taxpayers had a cost basis in assets that they later sold, but for which they paid nothing. Washington Mut. Inc. v. United States, 636 F.3d 1207, 1217 (9th Cir. 2011). The specific question we address is whether a life insurance policyholder has any basis in a mutual life insurance company's membership rights. This issue, one of first impression in our circuit, arises out of a trend in the late 1990s and early 2000s towards the " demutualization" of mutual life insurance companies. As many mutual insurance companies transformed into stock companies, the surplus resulting from the sale of shares in the company was divided among current policy holders, often in the form of stock.
Bennett and Jacquelyn Dorrance received and then sold stock derived from the demutualization of five mutual life insurance companies from which they had purchased policies. The Dorrances initially asserted a zero cost basis in the stock and paid tax on the gain. They later claimed a full refund on the taxes they paid upon on the sale of the stock, either because the stock represented a return of previously paid policy premiums or because their mutual rights were not capable of valuation and, therefore, the entire cost of their insurance premiums should have been counted toward their basis in the stock. The government takes the position that the Dorrances are not entitled to any refund; since they paid nothing for their membership rights, their basis was zero. The district court held that the Dorrances had a calculable basis in the stock, albeit not at the level the taxpayers claimed, and thus they were entitled to a partial refund from the Internal Revenue Service (" IRS" ). We disagree. Taxpayers who sold stock obtained through demutualization cannot claim a basis in that stock for tax purposes because they had a zero basis in the mutual rights that were extinguished during the demutualization.
A. Mutual Insurance Companies
The first life insurance company in America was a mutual company called the Presbyterian Minister's Fund, organized in 1759 in Philadelphia. For centuries, mutual insurance companies have provided a structure for collecting policyholder premiums and spreading risk and surplus among policyholders, while maintaining policyholder ownership of the company. Mutual insurance companies are distinct from stock companies in that they are owned by the policyholders, not by stockholders. See Edward X. Clinton, The Rights of Policyholders in an Insurance Demutualization, 41 Drake L.Rev. 657, 659 (1992). To ensure that they can pay all of the contractual benefits, these mutual insurance companies generally charge slightly higher rates than other life insurance providers. Surplus is returned to the policyholders in dividends. For decades (and even more than a century for some mutual companies) policyholders joined, became members, and terminated their policies without getting anything back for membership rights.
Starting in the middle of the twentieth century and increasing through the 1980s,
the mutual model became less economically advantageous when compared to stock companies. Id. See also Paul Galindo, Revisiting the ' Open Transaction' Doctrine: Exploring Gain Potential and the Importance of Categorizing Amounts Realized, 63 Tax L. 221, 226 (2009). The economic advantage of stock companies comes, in large part, from the fact that they can raise capital by selling shares, whereas mutual companies are able to raise capital only by increasing the number of policies sold or by reducing costs. Additionally, stock companies have a greater capacity to diversify, which provides an additional layer of financial stability. See Clinton, supra, at 667.
In response to the challenges faced by mutual insurance companies, in the mid-to-late 1990s many states changed their insurance laws to permit " demutualization" of mutual insurance companies. Demutualization entails the legal transformation of a mutual company into a stock company. See Jeffrey A. Koeppel, The State of Demutualization, at v (2d ed. 1996). As a consequence, by the late 1990s and early 2000s, many mutual insurance companies had transformed into stock companies.
The rapid shift toward demutualization was made possible only by this widespread change in state insurance law. Clinton, supra, at 674. Although state laws vary, including in the scope of regulatory oversight, the demutualization process occurred under operation of law and was monitored by external insurance regulators. Id. at 665. Because policyholders exert only weak influence over the mutual company's governance (each policyholder has only one vote, out of possible thousands, regardless of the size of the policy), external regulators focused on ensuring a fair and equitable legal transformation of the insurance companies. Id. at 678.
B. The Dorrances' Mutual Life Insurance Policies
Bennett Dorrance is the grandson of the founder of the Campbell Soup Company. At the time the Dorrances purchased life insurance policies from five mutual insurance companies in 1996, their net worth was approximately $1.5 billion. They bought the policies to cover estate tax for their heirs. Over time, the Dorrances paid premiums totaling $15,265,608. While that sum is definitely substantial, the face value of the policies totaled just under $88 million, such that they would have received a huge contractual payout upon death.
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 the policyholder's 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. 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. Post-demutualization, the Dorrances no longer held any mutual membership rights, but they retained their contractual interests under the insurance policies and continued to pay the same premiums.
Government regulators (both in the United States and Canada) required the insurance companies to produce a " fair and equitable" allocation of the company's surplus at the time of demutualization. Mutual insurance companies complied with this requirement in a variety of ways, but the companies in question here opted to issue stock to their policyholders.
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. As the government's expert report explained, each company used a different allocation calculation to arrive at a distribution that was " fair and equitable" to policyholders. MetLife, for example, " aimed for around 20%" for the fixed portion, but stated this was a " general target." Sun Life did not ...