Calculation of capital gains and losses has become a little easier for Enrolled Agents now that financial institutions are required to report cost basis figures for sold securities. However, sale of an investment acquired long ago may still demand taxpayer knowledge of basis. Some individuals have lax information about their basis and a few cases are complicated basis determinations. Fortunately, Enrolled Agent training covers instances where basis is determined in ways other than cost.
One of the trickier situations occurs when stock is held in an insurance corporation that converted from a mutual insurance company. This conversion process is known as demutualization. It occurs when a mutual insurance company issues stock to its policyholders. Prior to demutualization, the policyholders are already owners of the insurance business. Converting their ownership to corporate stock allows issuing of more shares to investors.
The problem with demutualization is that policyholders don’t pay anything for their stock. According to the IRS, this means the shares have a zero basis. Like Enrolled Agent exam questions with zero basis, demutualized sales resulted in IRS determination of the entire sales proceeds as capital gain. However, Enrolled Agents have relied upon a successful court challenge to the IRS position by assigning cost basis to demutualized shares of insurance corporations.
In the Fisher case, the court ruled that insurance premiums paid by policyholders comprise their basis in shares issued upon demutualization. Following the Fisher decision, EA problems addressing sale of demutualized insurance company stock have considered insurance premiums as basis in the shares. This typically resulted in reported capital gain of zero.
In 2012, the IRS attained a small victory on its position in the Dorrance case. An Arizona court found that the approach under Fisher is not proper. Apparently, the Fisher decision rested upon accepting either zero basis for demutualized shares or the entire amount of all insurance premiums as allocable to basis. The court deciding Dorrance was not so limited and the judge was unconvinced that either concept is valid. Consequently, Enrolled Agent education about the basis of demutualized shares has recently become unsettled.
A trial is pending for determination of how to allocate past policy premiums between insurance coverage and ownership basis later converted to demutualized shares. Among the suggestions is comparing insurance premiums paid for a policy issued by a mutual insurer to the policies issued by non-mutual companies. Another suggestion is comparison of market values for the policy and the stock at the time of demutualization. That ratio is then applied to the premium payments for basis calculation.
In early 2013, the US District Court for the Central District of California ruled in favor of the IRS by finding that demutualized shares have a zero basis. This decision of the Reuben case throws the entire issue into the wind. The matter seems destined for the US Supreme Court to arrive at a final process, which will then yield instructions for an Enrolled Agent course.
Meanwhile, tax preparation that relies upon the Fisher ruling should disclose the disputed position on Form 8275. But, the IRS is certain to delay processing of refunds on these returns. The only safe taxpayers are those who relied on Fisher years ago when selling demutualized shares because those tax periods are now closed.
IRS Circular 230 Disclosure
Pursuant to the requirements of the Internal Revenue Service Circular 230, we inform you that, to the extent any advice relating to a Federal tax issue is contained in this communication, including in any attachments, it was not written or intended to be used, and cannot be used, for the purpose of (a) avoiding any tax related penalties that may be imposed on you or any other person under the Internal Revenue Code, or (b) promoting, marketing or recommending to another person any transaction or matter addressed in this communication.