Jacquelynn Dorrance v. United States

FOR PUBLICATION
UNITED STATES COURT OF APPEALS
FOR THE NINTH CIRCUIT
BENNETT DORRANCE; JACQUELYNN Nos. 13-16548
DORRANCE, 13-16635
Plaintiffs-Appellees/
Cross-Appellants, D.C. No.
2:09-cv-01284-
v. GMS
UNITED STATES OF AMERICA,
Defendant-Appellant/ OPINION
Cross-Appellee.
Appeal from the United States District Court
for the District of Arizona
G. Murray Snow, District Judge, Presiding
Argued and Submitted
April 9, 2015—Pasadena, California
Filed December 9, 2015
Before: Stephen Reinhardt, M. Margaret McKeown,
and Milan D. Smith, Jr. Circuit Judges.
Opinion by Judge McKeown
Dissent by Judge Milan D. Smith, Jr.
2 DORRANCE V. UNITED STATES
SUMMARY*
Tax
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
*
This summary constitutes no part of the opinion of the court. It has
been prepared by court staff for the convenience of the reader.
DORRANCE V. UNITED STATES 3
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.
COUNSEL
M. Todd Welty (argued) and Laura L. Gavioli, Dentons US,
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.
OPINION
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.
4 DORRANCE V. UNITED STATES
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.
DORRANCE V. UNITED STATES 5
BACKGROUND
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.1 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
1
Even earlier, in 1752, Benjamin Franklin, who had likely become
aware of similar innovations in England, formed the Philadelphia
Contribution for the Insurance of Houses From Loss by Fire,
often characterized as the first mutual insurance company. See
The Philadelphia Contributionship, Company History (2015),
http://www.contributionship.com/history/index.html.
6 DORRANCE V. UNITED STATES
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.
 DORRANCE V. UNITED STATES 7
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
companies2 in 19963, 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
2
The companies are: Prudential Insurance Company; Sun Life
Assurance Company; Phoenix Home Life Mutual Insurance Company;
Principal Life Insurance Company; and Metropolitan Life Insurance
Company (“MetLife”).
3
By 1996, many states already allowed demutualization or were in the
process of changing their laws. Demutualization was permitted under
New York and Iowa law (governing MetLife, Phoenix, and Principal).
See NY Ins. Law § 7312 (McKinney 2011); Iowa Code § 508B.1 et seq.
The New Jersey demutualization statute (governing Prudential) became
effective in July 1998. N.J. Stat. Ann. 17:17C-1. In 1999, Canadian
regulations (governing Sun Life) were revised to allow for
demutualization. Mutual Company (Life Insurance) Conversion
Regulations SOR/99-128 s.14 (Can.).
8 DORRANCE V. UNITED STATES
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
DORRANCE V. UNITED STATES 9
“general target.” Sun Life did not consider policyholders’
contribution to surplus in its allocation calculation, but rather
looked at the cash value and annual premiums of eligible
policies.
Prior to demutualization, the insurance companies each
obtained a ruling from the IRS that the stock ownership
company resulting from the demutualization qualified as a
tax-free organization under Internal Revenue Code, I.R.C.
§ 368.
Upon demutualization, the Dorrances received 58,455
shares in Prudential, 3,209 shares in Sun Life, 1,601 shares in
Phoenix, 5,039 shares in Principal, and 2,721 shares in
MetLife. At the time of receipt, the market value of the stock
derived from these policies totaled $1,794,771. As the
government’s expert report explained: “Some may think that
the cash paid out in demutualization comes from the
distribution of positive surplus of the mutual company;
however, such is not the case. The cash actually comes from
new stockholders which subscribe to the IPO [initial public
offering] . . . .”
In 2003, the Dorrances sold all of the stock for
$2,248,806. On their 2003 tax return, in compliance with IRS
policy, the Dorrances listed their basis in the stock as zero,
reported the $2,248,806 as capital gain, and paid the tax due
on that gain. See Rev. Rul. 71-233, 1971-1 C.B. 113; Rev.
Rul. 74-277, 1974-1 C.B. 88.
C. PRIOR PROCEEDINGS
By 2007, the Dorrances had a change of heart. They filed
a tax refund claim with the IRS, in which they argued that
10 DORRANCE V. UNITED STATES
they owed no taxes on the stock sale because it represented a
return on previously-paid insurance policy premiums. The
IRS did not issue a final determination on the 2007 claim, so
the Dorrances filed a complaint in district court. The IRS
argued that the Dorrances had a zero basis in their stock
because the life insurance premiums that they paid were not
in exchange for membership rights in the life insurance
policies. The district court denied the cross-motions for
summary judgment, ruling that there was a calculable basis in
the stock, and set the case for trial to determine how the basis
should be calculated.
The district court held a two-day bench trial, which
featured expert testimony from both sides regarding the basis
calculation. The court rejected the Dorrances’ argument that
the “open transaction” doctrine, espoused by the Court of
Federal Claims, applied to their refund request.4 It also
rejected the government’s zero basis argument. Instead, the
district court ruled that the Dorrances had “paid something
for the [membership] rights because they paid premiums for
policies that included both policy rights and mutual rights”
and that their basis was calculable.
The district court calculated the Dorrances’ basis in the
stock using the following formula: (1) the initial public
offering (“IPO”) value of the fixed shares allocated to the
Dorrances in 2003, plus (2) 60% of the IPO value of the
4
The district court declined to follow the Court of Federal Claims’
approach that “the value of the ownership rights [in mutual rights are] not
discernible” and that, therefore, the full basis of the policy should apply
under the rarely-used “open transaction” doctrine. Fisher v. United States,
82 Fed. Cl. 780, 799 (2008) aff’d, 333 F. App’x 572 (Fed. Cir. 2009). In
light of our decision, it is unnecessary to address whether the “open
transaction” doctrine is applicable to this situation.
DORRANCE V. UNITED STATES 11
variable shares. Applying this formula, the court found that
the Dorrances were required to pay taxes on $1,170,678,
rather than on the full $2,248,806 value of the stock. Because
in 2003 the Dorrances had paid taxes based on a zero basis
calculation in the stock, the district court found that they were
entitled to a refund.
Both parties appeal the adverse portions of the judgment.
ANALYSIS
The crux of this case is how to calculate the basis of stock
received through demutualization. The question of basis in
the stock is a mixed question of law and fact that “require[s]
consideration of legal concepts and involve[s] the exercise
about the values underlying legal principles [and is]
reviewable de novo.” Smith v. Comm’r, 300 F.3d 1023, 1028
(9th Cir. 2002) (citing Mayors v. Comm’r, 785 F.2d 757, 759
(9th Cir. 1986)). The parties do not dispute the district
court’s factual findings. Instead, their divergence of views
stems from the legal conclusions that follow.
As the taxpayers, the Dorrances bear the burden of
establishing basis, and “[t]he fact that basis may be difficult
to establish does not relieve [them] from [t]his burden.”
Coloman v. Comm’r, 540 F.2d 427, 430 (9th Cir. 1976).
Because they failed to establish that they had a basis in the
membership rights, we afford the basis utilized by the IRS a
presumption of correctness—even where, as here, that figure
is zero. Id. The Supreme Court explained long ago in a
similar context that “[t]he impossibility of proving a material
fact upon which the right to relief depends simply leaves the
claimant upon whom the burden rests with an unenforceable
claim, a misfortune to be borne by him, as it must be borne in
12 DORRANCE V. UNITED STATES
other cases, as the result of a failure of proof.” Burnet v.
Houston, 283 U.S. 223, 228 (1931).
A. THE STRUCTURE OF MUTUAL INSURANCE POLICIES
In analyzing the insurance policies, it pays to bear in mind
that, “[a]s an overarching principle, absent specific
provisions, the tax consequences of any particular transaction
must reflect the economic reality.” Washington Mut. Inc.,
636 F.3d at 1217 (citing Kraft, Inc. v. United States, 30 Fed.
Cl. 739, 766 (Fed. Cl. 1994); United States v. Winstar Corp.,
518 U.S. 839, 863 (1996)). The reality here is that the
Dorrances acquired the membership rights at no cost, but
rather as an incident of the structure of mutual insurance
policies.
The logic of this conclusion is simple—when the
Dorrances purchased their mutual insurance policies in 1996,
the premiums they paid related to their rights under the
insurance contracts, not to collateral membership benefits
such as voting. Under the insurance contract, policyholders
paid premiums for the following “contract rights”: (1) a death
benefit; (2) the right to surrender the policy for a “cash
value”; and (3) annual policyholder dividends representing
the policyholder’s portion of the company’s “divisible
surplus.”
Separate from the contract rights, through operation of
law and the company charter, each policyholder had a right
to vote on certain matters, such as the election of the board of
directors. That vote was restricted to one vote per
policyholder, regardless of the size or face value of the
policy. In addition, in the very unlikely event of a
liquidation, the policyholder was entitled to any surplus from
DORRANCE V. UNITED STATES 13
that liquidation.5 At trial, the government expert stated that
he did not know of a single mutual insurance company that
had ever had a solvent liquidation, a point echoed by the
MetLife representative. This bundle of rights—derived from
operation of law—is referred to as “mutual rights” or
“membership rights.”6 These rights are not transferable and
upon termination of a policy, the policyholder receives
nothing for any membership rights.
The difference between contract rights and membership
rights is critical to resolution of this case. The premiums paid
covered the rights under the insurance contract, not any
membership rights. Notably, the policies themselves
generally make no reference to any such membership rights.
In other words, premium payments go toward the actual cost
of the life insurance benefits provided. The mutual
companies did not count membership rights as having a cost
(apart from minimal administrative costs, if there is a
policyholder vote), so they did not charge policyholders for
such rights.
The government’s expert, American Academy of
Actuaries member Ralph Sayre, testified that mutual
companies calculate premiums based solely on the expected
cost of providing contractual insurance benefits. This
calculation process is “very precise in actuarial circles” and
5
Prior to demutualization, solvent liquidation in a mutual insurance
company was unlikely because mutual insurance companies are highly
regulated entities that operate conservatively to remain as a “going
concern” for their policyholders.
6
The moniker “mutual rights” more accurately describes what is at
issue, though we adopt the term “membership rights” as used by the
parties.
14 DORRANCE V. UNITED STATES
“there just is no portion of the premium or charge for
membership rights.” He linked this analysis to the obvious:
“[U]sually you don’t pay [for] something if . . . you aren’t
charged for it.” This explanation is consistent with the
Supreme Court’s description of what the premium pays for:
“It is of the essence of mutual insurance that the excess in the
premium over the actual cost as later ascertained shall be
returned to the policy holder.” Penn Mut. Life Ins. Co. v.
Lederer, 252 U.S. 523, 525 (1920).
In referencing “ownership rights,” by which he meant
membership rights, the description by the Dorrances’ expert
was essentially in line with Sayre’s conclusion: “The
ownership rights were not separate from the policy rights and
could not be sold. The cost associated with acquiring
ownership rights cannot be established exclusively through
premium payments.”
Consistent with the general practice for mutual insurances
companies, the companies involved in this case did not
charge the Dorrances for their membership rights. This point
was underscored by Mr. Dorrance’s testimony that, at the
time he bought the policies, he actually understood that he
would pay less for a policy from a mutual insurance company
than he would for one from a stock company. See S.
Bancorporation, Inc. v. United States, 732 F.2d 374, 377 (4th
Cir. 1984) (rejecting refund claim where the taxpayer
“introduced no evidence to prove that it intended to pay an
enhanced value for the [asset] at the time of sale”) (emphasis
in original). It was no surprise then, that in 2003, when the
Dorrances filed their tax returns following the sale of the
stock derived from demutualization, they listed their basis as
zero.
DORRANCE V. UNITED STATES 15
B. THE EFFECT OF DEMUTUALIZATION
The membership rights were assigned a monetary value
at the time of the exchange only as a consequence of the
demutualization process. The error of the Dorrances and the
district court was to assume that the value received upon
demutualization was linked with some premium value paid by
the policyholders in the past. But the stock the Dorrances
received in exchange for the membership rights cannot be
understood as a partial return on their past premium payments
and it is well understood that policyholders do not contribute
capital to the companies.
By the time of the demutualization, the lion’s share of the
surplus that fed valuation of the newly issued stock could not
be traced to payments made by current policyholders. Nearly
all of the surplus held by the companies at that time was
attributable to former policyholders, not current policyholders
like the Dorrances. For example, at the time of
demutualization, less than 10% of the Sun Life surplus was
attributable to current policyholders; premiums paid by
former policyholders accounted for over 90% of the surplus.
Thus, the value at demutualization was not derived from
something paid for by the Dorrances.
Sayre explained the situation as follows:
The demutualization is not a result of []
current policyholders having done something
different from the other previous millions of
policyholders, but is a result of outside
influences, such as tax policy, economic
conditions or competitive pressures. The
current policyholders are fortunate to be
16 DORRANCE V. UNITED STATES
policyholders at the time of demutualization
but their value received is a result of the new
stockholders who are willing to pay them in
order to receive their membership benefits for
the purpose of what they can do with them in
the future.
This anomaly prompted one insurance company official
involved in this case to refer to the receipt of stock as a
“windfall” for current policyholders. This characterization
was echoed by the Sixth Circuit, which referred to
demutualization proceeds as “a pot of money that no one
expected or even envisioned.” Bank of New York v.
Janowick, 470 F.3d 264, 266 (6th Cir. 2006); see also
Douglas P. Faucette & Timothy S. Farber, National
Insurance Act of 2007 & Demutualization of Insurers: The
Devil is in the Details, 58 Fed’n Def. & Corp. Couns. Q. 109,
127 (2007) (noting that policyholders “receive payouts that
they had not expected, consciously bargained for, or
purchased. Simply put, distribution of the surplus amounts to
‘a windfall resulting from the increase in the value of that
policy arising from its unforseen restructuring.’” (citation
omitted)).
Following the transfer of stock, it was business as usual
in terms of the contract rights. After demutualization, the
Dorrances’ insurance premiums remained level—reinforcing
the fact that they had not been paying a “premium” for any
membership rights in the first place. For example, the
premium history for Principal Financial Group shows that the
Dorrances’ premium was $124,450 both before and after the
1999 demutualization. This transition occurred under the
oversight of regulators who were charged with ensuring that
policyholders were treated fairly during the demutualization
DORRANCE V. UNITED STATES 17
process and who did not require a reduction in the premiums
to sync with the loss of the now-claimed rights. The
Dorrances continued to pay the same premiums and receive
the same coverage. The stock exchange, for which they paid
nothing, was the only aspect of the transaction related to
membership rights.
The demutualizations themselves were structured as tax-
free, meaning that the initial transaction by which the
Dorrances received the stock did not trigger any taxable gain
for the policyholders. As an exchange under I.R.C. § 3547,
the deal would not have been tax free if there was a gain upon
the exchange. I.R.C. § 358(a)(1) (providing that the basis of
property received under a § 354 exchange “shall be the same
as that of the property exchanged”). In other words, the stock
was a direct exchange for the lost membership rights.
Put another way, the basis in the new stock was the same
as the basis in what was being exchanged—the membership
rights. Hence, the companies told policyholders that the tax
basis on the stock was “zero.” For example, with regard to
the receipt of stock, Phoenix explained in its Q&A document:
If you receive common stock, you will not be
taxed when you receive it. However, if you
sell or otherwise dispose of your common
stock, you will be taxed on the full amount of
7
I.R.C. § 354(a)(1) provides:
No gain or loss shall be recognized if stock or securities
in a corporation a party to a reorganization are, in
pursuance of the plan of reorganization, exchanged
solely for stock or securities in such corporation or in
another corporation a party to the reorganization.
18 DORRANCE V. UNITED STATES
the proceeds you receive for the common
stock. (Your tax basis in the common stock
will be zero.)
The other companies alerted policyholders to the same thing:
Sun Life advised that the “cost basis of these shares for tax
purposes will be zero” and, after saying that the tax cost
would be “zero,” Principal Mutual stated that “if you later
sell or otherwise dispose of your Common Stock, you will
generally be taxed on the full amount of the proceeds of that
sale or other disposition.”
The insurance companies’ advice to their policyholders
comports with IRS rulings dating back to the 1970s. Those
rulings stated that the policyholder’s basis in mutual rights is
zero. See Rev. Rul. 71-233, 1971-1 C.B. 113; Rev. Rul. 74-
277, 1974-1 C.B. 88. Revenue Ruling 71-233 addresses the
tax consequences to policyholders when they exchange their
proprietary interests for preferred stock. Consistent with our
explanation above—distinguishing between contract rights
and membership rights (which are also referred to as
proprietary rights), the IRS advised:
Payment by each policyholder of the
premiums called for by the insurance
contracts issued by X represents payment for
the cost of insurance and an investment in his
contract but not an investment in the assets of
X. His proprietary interest in the assets of X
arises solely by virtue of the fact that he is a
policyholder of X. Therefore, the basis of
DORRANCE V. UNITED STATES 19
each policyholder’s proprietary interest in X
is zero.
Id.
Within the tax code, the transaction exchanging mutual
rights for stock does not operate in a vacuum. Treating the
premiums as payment for membership rights would be
inconsistent with the Code’s provisions related to insurance
premiums. For example, gross premiums paid to purchase a
policy are allocated as income to the insurance company; no
portion is carved out as a capital contribution. See I.R.C.
§§ 803(a)(1), 118. On the flip side, the policyholder is
allowed to deduct the “aggregate amount of premiums” paid
upon receipt of a dividend or cash-surrender value. I.R.C.
§ 72(e). No amount is carved out as an investment in
membership rights. The taxpayer can’t have it both ways—a
tax-free exchange with zero basis and then an increased basis
upon sale of the stock.
The district court skipped a critical step by examining the
value of the mutual rights without evidence of whether the
Dorrances paid anything to first acquire them. The basis
inquiry is concerned with the latter question. The district
court also erred when it estimated basis by using the stock
price at the time of demutualization rather than calculating
basis at the time the policies were acquired. The stock value
post-demutualization is not the same as the cost at purchase.
20 DORRANCE V. UNITED STATES
We have previously explained that basis8 “refers to a
taxpayer’s capital stake in an asset for tax purposes.”
Washington Mut. Inc., 636 F.3d at 1217 (citing In re Lilly, 76
F.3d 568, 572 (4th Cir. 1996)). “The taxpayer must prove
what, if anything, he actually was required to pay . . . not
what he would have been willing to pay or even what the
market value . . . was.” Better Beverages, Inc. v. United
States, 619 F.2d 424, 428 (5th Cir. 1980). Here the
Dorrances failed to do so.
CONCLUSION
This analysis brings us back to the Dorrances’ burden and
the economic realities of this case. Because the Dorrances
offer nothing to show payment for their stake in the
membership rights, as opposed to premium payments for the
underlying insurance coverage, the IRS properly rejected
their refund claim. The district court erred when it held that
there was a calculable cost basis in the Dorrances’
membership rights. The government’s motion for summary
judgment should have been granted and the Dorrances’ cross-
motion should have been denied.
REVERSED.
8
The Code provides that “[t]he basis of property shall be the cost of
such property, except as otherwise provided in this subchapter and
subchapters C (relating to corporate distributions and adjustments), K
(relating to partners and partnerships), and P (relating to capital gains and
losses).” I.R.C. § 1012(a). None of these exceptions apply here.
DORRANCE V. UNITED STATES 21
M. SMITH, Circuit Judge, dissenting:
For thousands of years, philosophers, theologians, and
now physicists, have debated whether the earth was created
ex nihilo, i.e., out of nothing. Whatever the answer to that
question, there is little doubt that my colleagues in the
majority have performed a notable miracle of their own in
this case, by creating nothing out of something, i.e., nihil ex
aliquo. Let us consider how this miracle was wrought by
endeavoring to follow the money.
I. The Government’s Conditions to Demutualization
For what precisely did the Dorrances pay when they
purchased policies from the mutual life insurance companies
involved in this case? The majority contends that they paid
only for a death benefit, the right to surrender the policy for
a “cash value,” and annual policyholder dividends
representing their share of the company’s “divisible surplus.”
But if, as the majority contends, the Dorrances paid
nothing for their membership rights, and did not contribute
capital, then why did the several governmental regulators
involved require, as a condition of demutualization of each of
those insurance companies, that they issue stock to their
policyholders to compensate them for the loss of those rights?
Since those who acquired shares in the newly publicly
traded insurance companies during the IPO process paid cash
for their interests, if the policyholders when the insurance
companies were structured as mutual insurance companies
had not paid for the surplus they later received in stock, then
the value of the distributed shares ought to have remained as
the insurance companies’ working capital, and not been
22 DORRANCE V. UNITED STATES
gratuitously gifted to policyholders. Neither the regulators
nor the IPO investors would have tolerated such a gratuity.
But the stock distribution to the Dorrances, even if not
specifically contemplated at the time they purchased the
policies, was no gift. While insurance companies may be
powerful, they do not have the power of creation ex nihilo. To
the contrary, by the very nature of a mutual insurance
company, all of its accumulated value comes from premiums
paid by its owners, and the investment of those premiums.
That is why, when allocating shares during the
demutualization process, the insurance companies relied on
a calculation of a fixed component based on the loss of voting
rights and a variable component related to past and projected
future contributions to surplus.
The majority relies on a statement by a government’s
expert: “Some may think that the cash paid out in
demutualization comes from the distribution of positive
surplus of the mutual company; however, such is not the case.
The cash actually comes from new stockholders which
subscribe to the IPO . . . .” Here, the Dorrances received
stock, not cash. Of course, when they sold the stock, the cash
that they obtained from the sale came from the buyers of the
stock, and not from the insurance companies’ bank accounts.
But that is always true in a stock sale. Of course, that does not
mean that all stock sales have a zero basis. Thus, the cited
government expert’s testimony is merely a truism. It provides
no support for the majority’s conclusion.
II. Accrued Surplus or Not?
Some context is in order. The majority mentions the IPO
value of the Dorrances’ stock: $1,794,771. The majority also
DORRANCE V. UNITED STATES 23
unworthily mentions the Dorrances’ net worth, which is not
relevant to any issue before us. While the majority concedes
that the premiums the Dorrances had paid to the insurance
companies, which totaled $15,265,608, were “substantial,”
the majority is unimpressed by that figure because the face
value of the policies was substantially larger than the
premium. Of course, that is always the case in insurance. The
relevance of the premiums paid to the question before us is
that the distributed stock represents only 11.7% of the money
the Dorrances had paid the insurance companies. That may
not be far from the usual dividends paid on mutual insurance
policies.1
However, the majority is quick to call that return of a
small proportion of funds expended a “windfall.” But while
the majority asserts that one insurance company official so
characterized the stock distribution, he actually took care to
state that “windfall” was the company’s characterization, not
his. Moreover, the majority ignores the fact that every other
insurance company representative deposed in this case either
expressly rejected that characterization, or in one instance,
did not know how to answer the question.
The majority credits testimony by the government’s
expert that the insurance companies charged the Dorrances
premiums that were based solely on the expected costs of
1
The parties did not identify the dividend rates the policies at issue
provided. Data for the Massachusetts Mutual Life Insurance Company, not
one of the companies at issue, is publicly available. See Historical
Dividend Studies from Massachusetts Mutual Life Insurance Company
(2015), available at https://fieldnet.massmutual.com/public/life/
pdfs/li7954.pdf (last visited Nov. 18, 2015). That data shows that a policy
purchased after March of 1996 yielded a yearly dividend interest rate of
between 8.4% and 7.9% between 1996 and 2003.
24 DORRANCE V. UNITED STATES
providing insurance benefits, using calculations that were
“very precise in actuarial circles,” such that “there is just no
portion of the premium or charge for membership rights.”
That asserted precision is disproved by the existence of a
surplus accrued within the insurance company. In fact, the
majority elsewhere relies on testimony that, at the time of
demutualization, “less than 10% of the SunLife surplus was
attributable to current policyholders; premiums paid by
former policyholders accounted for over 90% of the surplus.”
In other words, despite their asserted actuarial precision,
the insurance companies had not been returning via dividend
all of the premium surplus. Instead, the surplus accumulated
within the companies, where it served the role that any
accumulation of capital does. Therefore, the majority errs by
stating that “it is well understood that policyholders do not
contribute capital to the companies.”2 If not from the
policyholders, from whence did that accumulated capital
come?
Certainly, the cited testimony raises the question of how
much the Dorrances contributed to the surplus. That question
2
The majority misconstrues government witness Ralph Sayre’s
testimony in this regard. Sayre testified that, from the view of a mutual
insurance company, “because we don’t have shareholders who have
contributed to surplus or contributed capital to withstand [the demand for
benefit payments], we’re going to have to charge [the policyholder] a little
bit more of that up front. But keep in mind that we will also give it back
to you. As our experience unfolds and we realize earnings from that extra
charge, or from the use of that extra money, we will return it back to you.”
Thus, policyholders do contribute capital—but they are eventually
supposed to get it back. The majority believes that it comes back with a
basis of zero, which complements the majority’s belief that the insurance
companies created something out of nothing.
DORRANCE V. UNITED STATES 25
was addressed during the demutualization. To determine the
number of shares of stock to issue to each member, the
insurance companies applied a formula approved by the
government regulators, which included a fixed component
and a variable component. According to that formula, 14-25%
of each company’s shares were allocated on a fixed basis to
shareholders. The variable shares were allocated based on the
“contribution-to-surplus” method, which allocated the total
shares based on a policyholder’s contribution.
Thus, even if we were to accept the majority’s conclusion
that the Dorrances had no basis in the voting aspect of the
membership rights—remembering that the fixed shares
granted solely on that basis were worth $3,164, a minuscule
portion of the $1,794,771 of IPO stock at issue—the
calculations expressly accounted for their actual contribution
to the surplus.
III. “Tax Free Exchange” Is Not a Synonym for “Zero
Basis”
The majority also misapplies the concept of a tax-free
exchange in stating that “[t]he taxpayer can’t have it both
ways—a tax-free exchange with zero basis and then an
increased basis upon sale of the stock.”
It is unclear how the Dorrances are trying to “have it both
ways.” All that is required for the exchange to be tax-free is
for the value received in stock to be the same as the value of
the property exchanged. See 26 U.S.C. § 358(a)(1). In this
case, the IRS, citing its own interpretations, opined that the
basis should be zero. Whether that interpretation squares with
the facts is the very question at issue in this case. By relying
26 DORRANCE V. UNITED STATES
in part on the IRS’s interpretation to answer the question, the
majority assumes the conclusion.
IV. The District Court’s Sound Calculations
After hearing all of the evidence at trial, the district court
determined the Dorrances’ cost basis by deducting the
expected future premium contribution from the IPO value of
the stock, yielding a cost basis of $1,078,128. This was the
sum of: (1) the IPO value of the fixed shares allocated to the
Dorrances ($3,164) and (2) 60% of the IPO value of the
variable shares ($1,074,964). The 60% proportion reflected
an expert estimate of past contributions by the Dorrances to
the life insurance policies; the remaining 40% was an
estimate of the policyholders’ future contributions to the
policies. Applying this formula, the court found that the
Dorrances were required to pay taxes on $1,170,678, which
was their sale proceeds of $2,248,806 less their basis of
$1,078,128.
Thus, the district court quite sensibly reduced the basis by
an expert’s estimate of the future contribution component of
the IPO value, ensuring that the Dorrances would not
underpay the taxes owed. This was a careful analysis using
reasonable methodology based on the evidence presented at
trial. By contrast, the majority’s contrary conclusions do not
follow from the facts. A portion of the assets of the insurance
companies clearly came from the premiums paid by the
Dorrances, and they had a substantial basis in the stock
distributed to them. By contending to the contrary, my
colleagues in the majority have created nothing out of
something. It’s a miracle!
I respectfully dissent.