A Tax Break for Insurance Stock

A long-awaited federal-court decision means the IRS may owe millions of dollars in refunds to life-insurance policyholders who were forced to pay taxes on the value of stock received from their insurer.

The setup: When a mutual insurance company (one owned by policyholders) becomes a stock company (owned by shareholders), the process is called demutualization. And when it occurs, policyholders are given shares of stock in the new company.

The IRS has long held that policyholders have no cost basis in the stock and, therefore, the full value of the shares is taxable income. But the U.S. Court of Federal Claims flatly rejected that idea in its decision in Fisher v. U.S. The court ruled in August that policyholders owe no tax on shares they receive in a demutualization.

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Don't break out the champagne just yet. The IRS is expected to appeal, and it's likely to be at least a year before the case is settled.

If before 2005 you paid tax on shares received in a demutualization, the relief comes too late; in most instances, you have just three years from the due date of a tax return to ask for a refund. There is an exception, however, if you file a protective refund claim.

Such a claim -- basically an amended return that directs the IRS not to process the refund claim until the Fisher case is resolved -- extends the statute of limitations. If you filed such a claim in the past, your claim will be held in abeyance while the IRS appeals the decision. (For more on protective refund claims, go to www.demutualization.biz.)

But what if you own stock received in a demutualization or you sold it earlier this year? William Raby, a CPA for the law firm that handled the case, recommends that you apply the Fisher decision and claim a basis in the shares equal to the value of the stock when it was distributed.

Raby says the Fisher case gives taxpayers "substantial authority" for taking such a position. That means that should the IRS challenge your return and reject the position, you won't be penalized.

McCormally retired in 2018 after more than 40 years at Kiplinger. He joined Kiplinger in 1977 as a reporter specializing in taxes, retirement, credit and other personal finance issues. He is the author and editor of many books, helped develop and improve popular tax-preparation software programs, and has written and appeared in several educational videos. In 2005, he was named Editorial Director of The Kiplinger Washington Editors, responsible for overseeing all of our publications and Web site. At the time, Editor in Chief Knight Kiplinger called McCormally "the watchdog of editorial quality, integrity and fairness in all that we do." In 2015, Kevin was named Chief Content Officer and Senior Vice President.