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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 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 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 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 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 * *
*
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 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 • E-mail me at taxreport@wsj.com4.
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