The Internal Revenue Service was wrong to require a policyholder who received stock through an insurer demutualization to pay taxes on the proceeds when the stock was sold, a federal judge has ruled.

Judge Francis Allegra of the U.S. Court of Claims addresses taxability of stock received in connection with insurer demutualizations in a decision concerning Fisher vs. U.S., No. 04-1726T.

The plaintiff in the case is Eugene Fisher, trustee for the Seymour Nagan irrevocable trust.

When mutual insurers convert to stock company charters, the transactions are similar to an “open transaction,” in which the court cannot distinguish between the value of the life insurance policy to the policyholder and the value of the policyholder’s interest in the insurance company, Allegra writes in an opinion explaining the decision.

The record “supports the opinion rendered by plaintiff’s valuation expert that the value of the ownership rights was not discernible, leading the court to conclude that plaintiff has borne its burden of proof in this case,” Allegra writes.

A spokesman for the Department of Justice, which represented the IRS in the case, says the government has not yet decided how to respond to the decision.

The IRS has contended that a 1971 regulation makes proceeds from the sale of stock received through insurer demutualizations taxable.

“When the [Nagan trust] policy was purchased, the trust had no realistic anticipation of receiving anything of value in exchange for those rights, and none of the policy premium was paid for those rights,” Department of Justice lawyers argue in court papers.

No basis can be allocated to those rights, even though, at a later date, the trust received something of value for the rights, the government lawyers argue, citing a 2001 decision issued by the 9th Circuit U.S. Court of Appeals.

Charles Ulrich, a Baxter, Minn., accountant who advises Fisher, notes that Allegra ruled in November 2006 that the 1971 interpretation and other IRS revenue rulings “are not applicable to this case.”

But “the IRS and insurance companies, in responding to insured’s inquiries, continue to cite the zero basis position of the IRS,” Ulrich says.

As a result, Ulrich says, “policyholders who followed the zero basis direction of the IRS have therefore been damaged by compliance with IRS instructions by losing refund rights due to the statute of limitations.”

Ulrich says the new Allegra decision could potentially affect about 40 conversions, dating from 1986, and about $200 billion in shareholder proceeds.

Donald Alexander, a former IRS commissioner who is now a lawyer in the Washington office of Akin, Gump, Strauss, Hauer & Feld L.L.P., praised the decision.

“I think Judge Allegra has come to the right conclusion,” Alexander says. “He doesn’t establish a tax basis at all. He doesn’t have to. Because as he points out, whatever the number is, the number is sufficient to eliminate any taxable gains on the transaction. As a result, the basis exceeds the amount he gains.”