The Wall Street Journal


August 28, 2003










How to Tax Some Insurers' Shares

Did the IRS get it wrong?

Americans have received billions of dollars of stock as mutually owned insurers converted into publicly traded companies. The Internal Revenue Service says when these shareholders sell those shares, they must pay capital-gains taxes on the full amount.

Now, a few tax professionals and academics are saying the IRS is being overly harsh. The debate has heated up following a recent article in Tax Notes, a respected tax publication, by an Arizona lawyer and a certified public accountant. The authors of that article thanked C.D. Ulrich, a Baxter, Minn., CPA, for drawing their attention to the situation. Mr. Ulrich says he has filed papers seeking refunds for a handful of clients using an alternative tax treatment. He and his clients will fight the IRS in court if it rejects the approach, he says.

The issue might seem arcane, but if Mr. Ulrich and his supporters prevail, it could save taxpayers large amounts of money. More than a dozen big insurers -- including MetLife Inc., Prudential Financial Inc., John Hancock Financial Services Inc. and Principal Financial Group Inc. -- have converted from mutual ownership, where policyholders own the companies, to stockholder ownership. Some policyholders got stock while others got cash. In the MetLife demutualization alone, policyholders received stock valued at $7.6 billion.

Policyholders who received shares instead of cash owed nothing in taxes initially. But when they sold the shares, they were required to pay capital-gains taxes on the entire proceeds. Those who received cash were supposed to pay capital-gains taxes on the entire amount in that tax year. Under the law enacted in May, the top long-term capital-gains rate fell to 15% from 20%.

At issue is the so-called cost basis of the stock -- what it cost the shareholder to acquire the stock -- for tax purposes. The IRS instructions for Schedule D, the form for reporting capital gains and losses, are clear: "The basis of your equity interest in the mutual company is considered to be zero." In other words, the IRS's view is that policyholders paid nothing for the stock and that they should ultimately pay taxes on the entire amount.

Mr. Ulrich disagrees. He received shares from the demutualizations of Indianapolis Life, a subsidiary of AmerUs Group Co., and Prudential and began researching the question two years ago. "Common sense told me it was wrong," says Mr. Ulrich, who has spent 44 years as a tax professional, including a stint with the Minnesota Department of Revenue in the 1950s.

Mr. Ulrich concluded that policyholders didn't get something for nothing when they received shares. Instead, he says, they got their ownership positions by paying premiums, and the shares represent a return of the premiums -- not a gain.

What would that mean at tax time? By Mr. Ulrich's reasoning, most policyholders should pay taxes only on stock-price gains that occur after the shares were distributed.

The Treasury says the IRS is right. "The Schedule D instructions represent longstanding IRS interpretation of the consequences of a mutual insurance company becoming a stock company, whether by merger or demutualization," says Tara Bradshaw, a Treasury spokeswoman. "We believe that the interpretation is correct. Taxpayers should exercise considerable caution in taking a reporting position that is contrary to the instructions."

Some big insurers, such as Prudential and MetLife, told clients to stick with the IRS approach. "That was a ruling the IRS gave us," a Prudential spokesman says.

Convincing the IRS that it got the law wrong is likely to be an uphill battle. But Mr. Ulrich's argument has caught the attention of several well-known tax and insurance professionals, including Joseph Belth, professor emeritus for insurance at Indiana University in Bloomington and editor of a widely read insurance newsletter, and David Schiff, editor of Schiff's Insurance Observer. Both say Mr. Ulrich has raised enough questions to leave the proper tax treatment of demutualization shares in doubt. (For more on this subject, see www.demutualization.org1).

The difference between the approach advocated by Mr. Ulrich and the IRS's instructions could be huge for taxpayers. Mr. Belth, for example, once received shares in a demutualized insurer, Nationwide Financial Services Inc., valued at $28.01 apiece; today, they trade for $29.03 each. Under the zero-basis treatment, selling a share today would mean taxable income of $29.03. Under the other scenario, it would mean a taxable gain of about $1 a share, he says.

An article on the subject by tax attorney Burgess J.W. Raby and William L. Raby, a CPA, appeared in the Aug. 4 issue of Tax Notes, a weekly publication of Tax Analysts in Arlington, Va. "If we are right, there are millions or billions of dollars of tax-refund opportunities potentially available," the Rabys wrote.

The Tax Notes article by the Rabys has attracted other admirers. "I was persuaded by their reasoning," says Robert Willens, tax and accounting analyst at Lehman Brothers in New York. "I felt they made a good case."

What should policyholders do? If you are inclined not to follow the IRS's instructions, don't make a move without consulting a professional tax adviser. If you try claiming the higher basis, be prepared for a tough fight with the IRS. For many people, it probably isn't worth the time and trouble to do that.

Given the cost of fighting the government, "what is needed here is somebody who has a huge distribution of shares -- I mean huge, millions of dollars -- who will take on the IRS," Mr. Belth says.

One New York lawyer and CPA got around the issue by donating his stock to charity. That allowed him to deduct the fair-market value of the stock -- and meant he didn't have to worry about calculating his basis in those shares.

* * *

The IRS will impose a fee on many people seeking a compromise on their tax debts.

Beginning Nov. 1, the IRS will charge a $150 application fee for those participating in the agency's offer-in-compromise program.

The fee will "provide funding to recover some of the costs associated with the offer-in-compromise program and reduce the number of inappropriate filings," says Dale Hart, commissioner of the IRS's small-business/self-employed division.

Not everyone will have to pay the fee. "All taxpayers who file an OIC will have to pay the application fee with their submission unless the offer is based solely on doubt as to liability, or the taxpayer's total monthly income falls at or below income levels based on the Department of Health and Human Services poverty guidelines," the IRS says.

For more information, see the IRS Web site (www.irs.gov2).

The offer-in-compromise program has drawn heavy fire from tax specialists, including members of the IRS Oversight Board, for being overly confusing and subject to abuse.

* * *

The millionaire's club expanded rapidly in 1995 to 1998.

The number of millionaires -- those with a net worth of $1 million or more -- in the U.S. rose to more than 2.7 million in 1998, according to an article by Barry W. Johnson and Lisa M. Schreiber in the IRS's Statistics of Income Bulletin. That was up from nearly 1.6 million millionaires three years earlier, Mr. Johnson says.

California had the largest number of millionaires: 412,000, up from 228,000 in 1995. New York came in second, followed by Florida, Texas, Illinois, Pennsylvania and New Jersey.

Connecticut ranked 12th in the number of millionaires, with 65,000. But it had the greatest per-capita concentration of millionaires, with more than 2.6% of its residents qualifying for the elite club, the article says. Colorado had the second-highest density of millionaires, at 1.9%.

Mr. Johnson and Ms. Schreiber are economists in the IRS's Statistics of Income division.

* * *

BRIEFS: Richard A. Shaw, a tax partner at Higgs, Fletcher & Mack in San Diego, takes over as head of the American Bar Association's tax section. He succeeds Herbert Beller of Sutherland, Asbill & Brennan. Kenneth W. Gideon of Skadden, Arps, Slate, Meagher & Flom was named "chair-elect" and is scheduled to take over next summer. ... The Federation of Tax Administrators (www.taxadmin.org3) posts a summary of states offering sales-tax holidays.

 E-mail me at taxreport@wsj.com4.


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Updated August 28, 2003


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