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demutualization
reprinted with permission from Fairmark.com
Billions in Overpaid Taxes
It's critical to act by April 15
By Kaye A. Thomas
Posted December 8, 2006
A ruling on demutualization will come too late for millions of taxpayers.
Kaye ThomasThis year, thousands of tax preparers will commit malpractice, and millions of taxpayers will permanently forgo their right to receive a refund of taxes they overpaid in 2003. The total amount of tax involved could be billions.
    The issue is how much tax you have to pay when you cash out after a mutual insurance company converts to a stock company. These companies either paid cash to their policy holders or sent them shares of stock they subsequently sold. In either case, if you followed instructions from the IRS, or from the insurance company (which blandly, blindly, followed the IRS approach), you almost surely overpaid your taxes.

IRS to lose case
When I first wrote about this issue in 2004 I said I didn't know how a pending challenge to the IRS treatment would come out. The issues are complicated enough so different people can reach different conclusions. The court still hasn't issued a decision in the case, and won't do so until after a trial. But a recent ruling on the case sends a strong signal the IRS is going to lose. The IRS has been saying all along that shares received in connection with a demutualization have zero basis. The court recently rejected an IRS request for summary judgment, saying the case must go to trial to determine the basis of the shares. If the court agreed with the IRS position, it should have granted summary judgment instead of ordering a trial.

Still unknown

There's a lot we still don't know about how this case is going to come out. Here are some of the variables:

  • We don't know when the decision will come down. All we know for sure is it will be after April 15, 2007, which is now a critical date. It may even end up being after April 15, 2008.
  • We don't know the precise theory the court will end up using to determine the basis of shares received in demutualizations.
  • We don't know if the government will appeal, how long the appeal will take, or whether the appeals court will agree with the trial court.

Why malpractice
Prior to this ruling, we had no clear indication the IRS would lose the case. It was simply one expert's opinion against another as to the proper interpretation of the tax law in connection with these transactions. While a majority seemed to think the IRS was wrong, it wasn't necessarily malpractice to proceed on the assumption that the IRS might well prevail.
    This new development puts us on notice that the IRS is going to lose this case. Tax professionals should be checking 2003 tax returns for all their clients that might have filed using the IRS' zero basis position. For millions of taxpayers, April 15, 2007 is the day the clock runs out on 2003 tax refunds. Failure to act means you'll never be able to recover taxes you overpaid that year.

What to do
Check your past tax returns for demutualization amounts and determine whether the dollar amount is large enough to be worth the bother. If it is, take action to protect your right to receive a refund in the event the courts eventually rule against the IRS.
    One way to do this is to file for a refund. You can do this on your own or with the help of a tax professional. In either case you should review the information available at this link to gain an understanding of the legal issues. I am not endorsing the services offered at that web site, but I applaud them for pursuing this issue and have high respect for the lawyers handling the case for the taxpayers.
    Another approach is to file a protective claim. You prepare a claim as if you were filing for a refund, but write at the top in bold letters, "Protective Claim — Do Not Process." Attach an explanation that this claim is filed to protect your right to a refund in the event of a court ruling determining that demutualization payments are not taxable. There's no way to be certain you will obtain the same rights by filing a protective claim, but this may be simpler and less costly than actually seeking a refund at this time.