Nothing out of something, or your stock for free?

Dorrance v. United States, Nos. 13-16548, 13-16635 (9th Cir. Dec. 9, 2015).

A “fascinating tax case” may sound like an oxymoron, but that’s precisely what this case is. 

This case arises from several different insurance-company demutualizations. A mutual insurance company is owned by its policyholders, who receive the surplus that the company earns. When a mutual insurance company demutualizes, it transforms from a company owned by its policyholders to one owned by its stockholders. The policyholders receive an amount of stock that is typically calculated based on the value of their previous voting rights, the value of their policy, and the amount of their premiums. 

Now, if the policyholders sell their stock and have to pay income tax on the sale, how is their income calculated? Specifically, what’s the tax basis of the stock? That’s the issue here. 

As the panel majority sees it, the tax basis of the stock is zero. Policyholders received stock based in part on their “membership rights” as policyholders: the right to vote and the right to receive surplus. But those rights weren’t separable from their rights as policyholders, and when a policy terminates, those membership rights terminate. The membership rights had no independent value. Plus, policyholders’ premiums weren’t calculated based on membership rights. So, according to the majority, the policyholders didn’t pay extra for the membership rights, and when the membership rights were converted into stock, the policyholders were getting something for free. That analysis does prompt a question: what motivated presumably rational economic actors to give away free stock? According to the majority, it was “outside influences, such as tax policy, economic conditions, or competitive pressures.”

Judge Milan Smith dissents, saying the majority has created “nothing out of something.” That “something,” according to Judge Smith, was the mutual insurance company’s surplus, to which the policyholders had contributed and for which the policyholders were given stock. The stock’s basis was not zero.