Dorrance v. United States

Taxpayers who obtain stock through demutualization and subsequently sell the stock cannot claim a basis in that stock for tax purposes because their basis in the mutual rights that were terminated during the demutualization was zero.

Bennett and Jacquelyn Dorrance purchased life insurance policies. They received stock when the company was demutualized and later sold the stock. They originally asserted a zero cost basis for the stock sold and paid tax on the gain from the sale. A few years later they filed a tax refund claim with the IRS, arguing they did not owe taxes on the sale of the stock because the sale was a return on formerly paid insurance policy premiums. The district court calculated the basis of the stock using a formula, which took into consideration the initial public offering (IPO) value of the shares given to the Dorrances upon demutualization and 60% of the IPO value of the shares, giving them a partial refund from the Internal Revenue Service (IRS). Both parties appealed. On appeal, the Ninth Circuit determined how to calculate the basis of stock obtained through demutualization. The panel held that since the Dorrances did not establish that they had a basis for their membership rights the IRS properly rejected their refund claim. Since basis is a taxpayer’s capital stake in an asset for tax purposes, the taxpayer must prove what he was required to pay for that asset, not what he would have been willing to pay or what the market value was. The value of the stock, when demutualization occurred, did not come from something paid for by the Dorrances. This was evidenced by the fact that the they paid nothing for the stock exchange and the demutualization itself was structured as tax-free, meaning when the Dorrances initially received the stock no taxable gain was generated. Therefore, the basis in the stock the Plaintiffs received upon demutualization was the same as the basis as what was being exchanged, which was the membership rights. REVERSED.