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Life Insurance Demutualization and Tax Impact

In the last twenty or so years, several major life insurance companies, owned by their policy holders as a group, determined to change the format to become a shareholder owned business. This process is called a demutualization. Members receive either a cash payment or shares in the company in exchange for their voting and liquidation rights, while retaining their life insurance policies.  

The receipt of cash or shares will be considered taxable income to the extent the value received exceeds the former member’s cost basis in the property – rights – exchanged for the cash or shares. The receipt of cash would be income at the time received. When a member received shares, that in and of itself was not a taxable event until the member decided to sell the shares and thereby realize the income. That is all basic tax law and seems straightforward enough.  

The problem, of course, is determining the value of those rights given up by the member in return for those shares or cash. Not surprisingly, the IRS has taken the position that the member has a zero tax basis in the cash or shares received. This disregards the fact that some portion of premiums paid by a member for insurance was in return for the rights the member held and over and above the actual cost of insurance itself. Of course, the premium payments themselves were not broken out into specific aspects reflecting the cost of insurance, the amount allocated to voting and other rights and any other item. This makes it more difficult for the member, as taxpayer, to establish a cost basis.

In litigation with the IRS, the courts have taken a variety of viewpoints and results on the cost basis issue. If you, like many other folks, have been holding onto shares received in a demutualization, it may be helpful to consult not only with the insurance company itself regarding the issue but also with a tax professional who may shed light on what your courts are likely to decide. For some of us, this issue can result in either a large tax saving or a large tax bill. It is worth looking into to understand the possible outcome. 

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