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IRS Hungry To Tax Demutualization Payouts

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IRS Hungry To Tax Demutualization Payouts


The Internal Revenue Service is currently locked in a dispute with a Minnesota accountant who believes the IRS is wrong in contending that payments, whether cash or stock, made available by mutual insurance companies to policyholders when the insurer converts to stock status are totally taxable when the cash is received or the stock is sold.

The dispute at this time only involves so-called “mom and pop” policyholders who receive a small amount of cash or a distribution of stock when a mutual insurer converts.

But, according to Walker Johnson and Arthur Bailey, partners at Steptoe & Johnson in Washington, D.C., the stakes could be much higher if corporations receive such distributions because they are the owners of life insurance.

Among major companies that have demutualized are Prudential, MetLife, Principal, John Hancock, Sun Life, Manulife, Clarica, Canada Life, AmerUs, Provident Mutual and Phoenix Home Life.

The accountant, C.D. Ulrich of Baxter, Minn., agrees. “We are having difficulty contacting the shareholders involved but think that there are 15 million policyholders who have been affected or will be affected,” Ulrich says.

The IRS did not respond to requests for comment.

The scope of the potential litigation, and Ulrich does believe he will have to go to Tax Court to get relief for policyholders, is enormous. “We know that in terms of cash or market value of stock that has been distributed beginning with 1999, there are 15 companies who have distributed in excess of $100 billion in cash or stock to policyholders.”

Ulrich says, “Its a huge issue and it is unbelievable that something like this could occur.”

Bailey says, “It is pretty evident that the result favors the IRS and allows it to maximize the taxes paid on mutual-to-stock conversions.”

Ulrich contends it is wrong for the IRS to insist that the basis of such distributions for the purposes of paying taxes on them is the total amount of cash or stock you receive in such a distribution. Under the IRS theory, the tax on the full amount is payable immediately if the distribution is in cash but payable only when there is a change in controlfor example, a saleif the distribution is in stock.

“To put it simply,” Ulrich says, “the basis in your ownership interest is created by your premium payments on the policy. And the mutual companies charge a higher premium than they need to operate at cost, and therefore, the resulting overpayment is retained in this account called policyholder surplus.”

The IRS, by contrast, claims that policyholders paid nothing for the distributions, and therefore must pay taxes on the full amount.

Ulrich argues that the mutual companies “dont tell you what your ownership interest is as a policyholder based on the profitability of the company.” As a result, he says, “the surplus of the company belongs to the policyholders, but you are never informed by the insurance company as to the value of your ownership interest. Theres no reporting requirement to advise policyholders of their ownership interest on an annual basis, or any basis, so the only time they are held accountable to the policyholders as to the value of their investment is when they go through a liquidation, a dissolution or a demutualization.”

Johnson and Bailey say, “The IRS perception is that the policyholders equity stems from the value of the policy.”

“Therefore,” because of that, “the IRS contention is that no basis attaches to the cash or stock that is received,” they say.

The effect, say Johnson and Bailey, is that the “IRS position, right or wrong, has the effect of watering down the value of a policyholders basis in his policy. Thats because the basis will be of no use if the policy is surrendered and there is a loss, because the IRS doesnt allow deduction of a loss on a life insurance policy by individuals and also because, if the proceeds are paid because of the death of the insured, the proceeds are tax-free and the basis disappears.

“On the other hand,” they say, “if a portion of the basis is allocated to the stock, there is a high likelihood that the policyholder will benefit from the basis when there is a sale of the stock.”

Last November, the IRS office in Brooklyn Center, Minn., notified Ulrich that the tax agency “is considering possible actionrelating to penalties and an injunction action for promoting abusive tax shelters,” and requested extensive information “used to describe, promote and sell this promotion.”

Ulrich maintains a Web site,, and says he uses the site to keep policyholders who have participated in demutualizations informed of his views on the issue, of their rights, “and to solicit them as clients, if they have paid taxes following the IRS present zero basis position.”

Reproduced from National Underwriter Edition, October 14, 2004. Copyright 2004 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.


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