In the last few years, many of NorthAmerica’s largest mutual life insurancecompanies have demutualized, distribut-

ing about $75 billion in stock and cash to theirpolicyholders. The demutualized companies in-clude Prudential, MetLife, Principal, JohnHancock, Sun Life, MONY, Manulife,Clarica, Canada Life, AmerUs, ProvidentMutual, and Phoenix Home Life.

When these companies distributed stock andcash to their policyholders, they generally ad-vised them that the tax basis of their distribu-tions was zero. Thus, the entire amount of thedistribution would be subject to taxes. Althoughthe IRS, the demutualized insurance compa-nies, and major law firms agreed that this wasthe correct tax treatment, a CPA in Minnesota,Charles D. Ulrich, did not. After a consider-able amount of work, he contacted JosephBelth, editor of The Insurance Forum andauthor of the following article.

Before we get to that article, however, we’dlike to say a few words about Joseph Belth.

Joseph M. Belth, Ph.D., is the editor of TheInsurance Forum, the author of LifeInsurance: A Consumer’s Handbook andother books, and professor emeritus of insur-ance in the Kelley School of Business at IndianaUniversity (Bloomington). He has received nu-merous awards for his work including a GeorgePolk Award in 1990 and the Huebner GoldMedal from The American College in 1999.Awards, of course, don’t really tell you much.Reading 30 years worth of The InsuranceForum will.

The Insurance Forum—an independentmonthly written by Joe—is a testament to thepower of thoughts, ideas, well-chosen words, anddedication. It would take many pages just to glossover all the important articles Joe has written.Some of his notable topics include the following:deceptive sales practices, First Executive’s rein-surance arrangements, A. L. Williams, policy

transfers, fractional premiums, viaticals and lifesettlements, the sale of insurance on militarybases, Unum Provident’s disability claims prac-tices, mutual holding companies, demutualiza-tions, and the compensation of insurance-com-pany executives.

Joe isn’t a household name, but deserves tobe, and The Insurance Forum should beread by everyone in any of the following cate-gories: (1) people interested in life insurance,(2) people interested in insurance, (3) peoplewho have purchased insurance, (4) people whowill purchase insurance, (5) people who are in-terested in good journalism, and (6) peoplewho read Schiff’s Insurance Observer.

Joe, who was a life insurance agent inSyracuse for five years in the 1950s, is one ofour heroes—and we don’t have a long list ofheroes. He’s a great insurance journalist, an-alyst, and historian, and we’re fortunate tohave gotten to know him well during the pastdecade.

The following article, “Income Taxation ofDistributions to Policyholders inDemutualizations,” was written by Joe and isadapted from an article that originally ap-peared in the June 2003 issue of TheInsurance Forum. You can contact TheInsurance Forum at P. O. Box 245,Ellettsville, Indiana 47429, (812) 876-6502(www.theinsuranceforum.com).

The Internal Revenue Service (IRS)and the mutual insurance compa-nies that demutualized in recent

years have told policyholders about the in-come tax treatment of the distributions thepolicyholders received in exchange fortheir ownership interests in the companies.Early this year, Charles D. Ulrich, a certi-fied public accountant who has studiedthe subject carefully, brought to my at-tention his belief that the treatment usedby the IRS and the insurance companiesis incorrect and is extracting billions of

dollars of unwarranted taxes from policy-holders. He recommends that policyhold-ers who have already paid taxes on distri-butions should file amended tax returnsand seek refunds.

When Mr. Ulrich contacted me, Ifound it difficult at first to believe theremight be no statutory authority for the taxtreatment used by the IRS and the insur-ance companies. After studying the mat-ter, however, I think the treatment usedby the IRS and the companies is open toserious question. This article has four pur-poses: (1) to describe the tax treatmentused by the IRS and the insurance com-panies, (2) to discuss the absence of statu-tory support for that treatment, (3) to de-scribe the tax treatment Mr. Ulrich sug-gests, and (4) to indicate what a policy-holder might do.

A Note on TerminologyA mutual insurance company is a cor-

poration that is engaged in the business ofinsurance, has no shareholders, has poli-cyholders who are customers with own-ership interests, and is operated exclu-sively for the benefit of the policyhold-ers. I say individual policyholders have“ownership interests”—rather than say-ing they are owners—because they havesome but not all the characteristics ofowners. A policyholder has the right tovote on certain matters and the right toshare in certain distributions, but thoserights terminate when his or her policyterminates. In short, a mutual insurancecompany’s policyholders—as a group—own the company, and individual policy-holders of the company have ownershipinterests.

Some mutual insurance companies, es-pecially those who downplay the rights ofthe policyholders, call the policyholders“members” and say they have “member-

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August 22, 2003Volume 15 • Number 14 I N S U R A N C E O B S E R V E R

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Taxation of Policyholders in Demutualization$10 Billion at Stake

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ship interests.” The IRS uses the phrases“equity interests” or “proprietary inter-ests.” In this article, except when quotingothers, I use the expression “ownershipinterests.”

The IRS/Company ApproachHere, in brief, is how the IRS and the

demutualizing insurance companies ex-plain the income tax treatment of demu-tualization distributions. For the policy-holder who receives shares of stock, thereis no immediate taxable income; however,when the shares are sold, the policy-holder’s basis in the shares is zero and thefull amount received in the sale is a capi-tal gain. For the policyholder who receivescash, the full amount received is taxed im-mediately as a capital gain.

Whether a policyholder’s capital gain islong term or short term depends on whenthe policyholder first acquired his owner-ship interest. Because the typical policy-holder purchased his or her first policy inthe company more than one year beforethe distribution, the amount received inmost instances is a long-term capital gain.In this article, I refer to the tax treatmentused by the IRS and the insurance com-panies as the zero-basis approach.

One Company’s ExplanationProvident Mutual Life Insurance

Company (“Provident”) demutualized in2002 and immediately became a sub-sidiary of Nationwide Financial Services,Inc. (“Nationwide”). In exchange for theirownership interests, eligible Providentpolicyholders received shares of stock inNationwide.

In an information brochure accompa-nying the stock distribution sent to eachpolicyholder, Nationwide said the valueof a policyholder’s ownership interest inProvident was $28.0146 per share—thevolume-weighted average price per shareduring the 15 trading days endedSeptember 24, 2002—multiplied by thenumber of shares allocated to the policy-holder. The Nationwide/Provident proxystatement/prospectus (“proxy”) sent topolicyholders in August 2002, in a sectionentitled “Material Federal Income TaxConsequences” on page 58, said that“your tax cost or ‘basis’ for any shares youreceive will be zero.” The law firm ofDebevoise & Plimpton provided a taxopinion dated August 2, 2002 toProvident’s board of directors. The opin-

ion was in the proxy and included thissentence:

The summary of federal tax consequencesto Eligible Members, the Company and itsAffiliates resulting from the consummation ofthe Plan and the Merger Agreement, set forthunder the heading “Material Federal IncomeTax Consequences” in the Joint ProxyStatement/Prospectus is correct and completein all material respects under the FederalIncome Tax Law in effect as of the date hereof.

My InquiryAs a Provident policyholder,

Nationwide shareholder, and journalist, Iwrote to Patricia R. Hatler, senior vicepresident, general counsel and secretaryof Nationwide. I said that I receivedshares of Nationwide in exchange for myownership interest in Provident, that Ihave not sold the shares, and that I maysell the shares soon. I quoted the abovestatement from the proxy and the abovestatement from the Debevoise tax opin-ion. I asked this question: “What is thespecific statutory authority for the state-ment that my basis is zero?” I emphasizedthe word “statutory” because the phrase“Federal Income Tax Law” was used inthe tax opinion. Kevin S. Crossett, vicepresident and associate general counsel ofNationwide, responded:

Debevoise & Plimpton has advised us thatthe statement in the Joint ProxyStatement/Prospectus was based upon RevenueRulings 71-233 and 74-277. These Rulings areadministrative interpretations of the InternalRevenue Code and Treasury Regulations, whichare within the defined term “Federal IncomeTax Law” that you quote in your letter. As notedin the Joint Proxy Statement/Prospectus, we urgeyou, as we do everyone else who received con-sideration, to consult your own tax advisor re-garding the tax consequences of the transaction.

As Mr. Crossett indicated, revenue rul-ings are administrative interpretations.They are not laws, which are subject tothe legislative process, and they are notregulations, which are issued after allow-ing a period for public comment. Rather,revenue rulings are mere expressions ofopinion by the IRS staff. By answering thequestion as he did, Mr. Crossett avoidedacknowledging the lack of statutory au-thority for the zero-basis approach.

The Old Revenue RulingsThe revenue rulings cited by Mr.

Crossett were issued in 1971 and 1974, re-spectively. They did not involve demutu-

alizations; indeed, they were issued yearsbefore the first demutualization occurred,and years before the word “demutualiza-tion” came into use. Also, the rulings donot provide a satisfactory explanation forthe zero-basis approach.

Revenue Ruling 71-233 involved themerger of a mutual life insurance com-pany [X] into a newly organized stock lifeinsurance company [Y]. Upon consum-mation of the merger, Y was to issuestock to policyholders of X in exchangefor their ownership interests in X. Thezero basis is mentioned in this paragraphof the ruling:

Payment by each policyholder of the pre-miums called for by the insurance contracts is-sued by X represents payment for the cost ofinsurance and an investment in his contract butnot an investment in the assets of X. His pro-prietary interest in the assets of X arises solelyby virtue of the fact that he is a policyholder ofX. Therefore, the basis of each policyholder’sproprietary interest in X is zero.

Revenue Ruling 74-277 involved thetransfer of the assets of a fraternal benefitsociety to a newly organized mutual lifeinsurance company. There was no distri-bution to policyholders in exchange fortheir ownership interests, but RevenueRuling 71-233 was cited and similar zero-basis language was used.

A Recent Revenue RulingEarly in 2003, the IRS issued

Revenue Ruling 2003-19. It discussesthe tax consequences of a mutual insur-ance company’s conversion to stock form,but the focus is on the consequences forthe company rather than the conse-quences for the policyholder. Also, theruling does not mention the zero-basisapproach.

The Schedule D InstructionsSchedule D is that portion of the in-

come tax return on which capital gains andlosses are shown. The IRS instructions forSchedule D include a discussion entitled“Demutualization of Life InsuranceCompanies.” The discussion was in-cluded for the first time in 2002, despitethe fact that the first demutualization oc-curred in 1986.

The discussion says “the basis of yourequity interest in the mutual company isconsidered to be zero,” and because ofthat “your basis in the stock received iszero.” The discussion does not explain

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why the basis of the policyholder’s own-ership interest “is considered to be zero.”

The discussion in the Schedule D in-structions also says the tax treatment de-scribed in the previous paragraph applieswhere the demutualization qualifies as atax-free reorganization, suggests that thetaxpayer can find out from the insurancecompany whether the demutualizationqualifies as a tax-free reorganization, anddescribes the tax treatment where the de-mutualization fails to qualify as a tax-freereorganization. The distinction mentionedin the discussion is not relevant becauseall demutualizations are tax-free reorgani-zations. For the insurance company, thetax implications of a demutualization thatdoes not qualify as a tax-free reorganiza-tion are draconian. For that reason, a de-

mutualization would not occur if it fails toqualify as a tax-free reorganization.

Correspondence with the IRSAn individual wrote the IRS inquiring

about the tax treatment of the distributionhe received. The response was similar tothe discussion in the Schedule D instruc-tions. The individual then asked why thebasis of his ownership interest is consid-ered to be zero. The response does notprovide an adequate explanation for thezero-basis approach. The IRS said:

Your cost or other basis in a demutualizationis zero because your policy is unaffected by this.The amount you paid in premiums remainswith the policy. In essence, the payment you re-ceive under a demutualization is paid to you sothat you give up your voting rights in the com-pany now that it has gone to the public market.As a shareholder you would have had some vot-ing power on decision making for the company.

An Alternative ApproachMr. Ulrich’s suggested alternative to

the zero-basis approach is to treat the dis-tribution in the same manner as a policydividend is treated for tax purposes. Inthis article, the alternative is referred to asthe dividend approach.

For tax purposes, a policy dividend isnot treated in the same manner as a divi-dend on a share of stock; instead, a policydividend is treated as a reduction in thecost of insurance. Thus a policy dividendis not treated as income at the time it is re-ceived; instead, it reduces the policy-holder’s cost and increases the policy-holder’s “profit” in the event he or shesurrenders the policy. The “profit” istaxed as ordinary income. (It is my beliefthat the reason for ordinary income ratherthan capital gain treatment is that the“profit” arises from the “inside interest,”which would have been taxed as ordinaryincome if its taxation had not been de-ferred.)

For example, suppose the total of thepremiums paid for a policy is $100,000,the total of the dividends is $60,000, andthe cash received on surrender is $75,000.The cost of the insurance for tax purposesis $40,000 ($100,000 minus $60,000), andthe “profit” on surrender is $35,000($75,000 minus $40,000).

Now suppose the distribution to thepolicyholder in connection with a demu-tualization is $10,000 in cash or stock.Under the dividend approach, the cost ofinsurance for tax purposes would be

$30,000 ($100,000 minus $70,000), andthe “profit” on surrender would be$45,000 ($75,000 minus $30,000). In otherwords, the cost would be reduced and the“profit” on surrender would be increasedby the amount of the distribution.

Under the dividend approach, if thedistribution is in shares of stock, the poli-cyholder’s basis in the shares—if the pol-icyholder sells the shares later—would bethe value of the shares at the time of thedistribution ($10,000 in the illustration).Also, whether the sale results in a long-term or short-term capital gain or losswould depend on the length of the periodbetween the distribution and the sale.

Multiple PoliciesIf a policyholder owns more than one

policy, the dividend approach would in-volve a technical problem. Because a de-mutualization distribution consists offixed shares (to compensate the policy-holder for giving up his or her voting rightsin the mutual company) and variableshares (representing the policyholder’sproportionate contribution to the value ofthe mutual company), the fixed shareswould have to be allocated among a poli-cyholder’s policies in each instance wherea policyholder owns more than one policy.The problem would not present seriousdifficulties; the number of variable sharesfor each policy is known to the insurancecompany, and it would be a simple matterto allocate the fixed shares among thepolicies in the same proportion.

For example, suppose a person ownstwo policies. He or she receives a total of240 shares, consisting of 40 fixed sharesand 200 variable shares. If 120 variableshares are for Policy A and 80 variableshares are for Policy B, then 24 of the fixedshares should be allocated to Policy A andthe other 16 fixed shares should be allo-cated to Policy B.

The ImplicationsFor the policyholder who receives his

or her distribution in cash, the zero-basisapproach means a substantial capital gainstax is imposed immediately. For the poli-cyholder who receives his or her distribu-tion in shares of stock, the zero-basis ap-proach means a substantial capital gainstax is imposed when the shares are sold.

There are two methods by which thepolicyholder who receives shares of stockcan escape the tax effect of the zero-basis

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approach. One method is to hold theshares until death, in which case the pol-icyholder’s heirs would take as their basisthe value of the shares on the date of thepolicyholder’s death. Another method isto give the shares to a 501(c)(3) charitableorganization, in which case the value ofthe shares on the date of the gift would bedeductible as a charitable contribution(provided the policyholder itemizes his orher deductions).

The policyholder cannot escape thetax effect of the zero-basis approach bygiving the shares to an individual. The re-cipient’s basis in the shares would be thesame as the policyholder’s basis.

Under the dividend approach, neitherthe policyholder who receives cash northe policyholder who receives shares ofstock would have any immediate tax con-sequences. If the policyholder keeps thepolicy in force until death, the distribu-tion would escape income taxation. If thepolicyholder surrenders the policy, the re-sult would be ordinary income taxation ofall, part, or none of the distribution; theresult in any particular case would dependupon the relationship between the cost ofthe policy and the amount received onsurrender of the policy.

ConclusionOn balance, I think the dividend ap-

proach is superior to the zero-basis ap-proach for at least two reasons. First, thedividend approach probably would bepreferred by most policyholders from anincome tax standpoint. That is, most pol-icyholders receiving cash would prefer toavoid immediate capital gains taxation ofthe distribution, and most policyholdersreceiving shares of stock would prefer tohave a substantial basis in their shares,even though some or all of the distribu-tion they receive might be subject to or-dinary income taxation at a later date.

Second, the dividend approach makeseconomic sense. One of the policyholder’sownership rights is the right to share incertain distributions, and that right has aneconomic value even though no part ofthe premiums was earmarked as paymentfor that right. Moreover, it would be logi-cal to treat demutualization distributionsas a reduction in the policyholder’s cost,just as dividend distributions are treated.

I am not aware of any effort by the in-surance companies or their tax attorneysto persuade the IRS to use the dividend

approach rather than the zero-basis ap-proach. I think the effort should havebeen made.

What a Policyholder Might DoMr. Ulrich’s opinion—that the divi-

dend approach is correct and that the zero-basis approach is incorrect—is based onwhat he describes as two years of uncom-pensated research into the issue. He citesstatutes, regulations, and case law to but-tress his opinion. He thinks policyholderswho have paid capital gains taxes—be-cause they received cash in lieu of sharesor because they sold their shares—shouldfile amended tax returns and seek re-funds. He has offered, for a small fee, toassist any interested policyholder inpreparing an amended return.Alternatively, he will work with the poli-cyholder’s tax adviser in preparing anamended return.

See www.demutualization.org for furtherdetails, or contact Charles D. Ulrich, CPA, atP. O. Box 2568, Baxter, MN 56425. Phone:(218) 828-4289. E-mail: cdu@charter.net.

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