Document ID: s3://data.kl3m.ai/documents/govinfo/USCOURTS/USCOURTS-ca9-13-16548/USCOURTS-ca9-13-16548-1/pdf.json

Parties Involved:
Bennett Dorrance
Appellee
Jacquelynn Dorrance
Appellee
United States of America
Appellant

Document Text:

FOR PUBLICATION

UNITED STATES COURT OF APPEALS

FOR THE NINTH CIRCUIT

BENNETT DORRANCE; JACQUELYNN

DORRANCE,

Plaintiffs-Appellees/

Cross-Appellants,

v.

UNITED STATES OF AMERICA,

Defendant-Appellant/

Cross-Appellee.

Nos. 13-16548

13-16635

D.C. No.

2:09-cv-01284-

GMS

AMENDED

OPINION

Appeal from the United States District Court

for the District of Arizona

G. Murray Snow, District Judge, Presiding

Argued and Submitted

April 9, 2015—Pasadena, California

Filed December 9, 2015

Amended December 30, 2015

Before: Stephen Reinhardt, M. Margaret McKeown,

and Milan D. Smith, Jr. Circuit Judges.

Opinion by Judge McKeown

Dissent by Judge Milan D. Smith, Jr. 

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2 DORRANCE V. UNITED STATES

SUMMARY*

Tax

The panel reversed the district court’s denial of the

government’s motion for summary judgment in a tax refund

action involving the calculation of the cost basis of stock

received through demutualization.

Taxpayers received and then sold stock derived from the

demutualization of five mutual insurance companies from

which they had purchased life insurance policies. Taxpayers

initially asserted a zero cost basis in the stock and paid tax on

the gain, but later claimed a full refund. The district court

held that taxpayers had a calculable basis in the stock and

were therefore entitled to a partial refund.

The panel held that the Internal Revenue Service properly

denied the refund claim and that the district court had erred

in its cost basis calculation because taxpayers had not met

their burden of showing that they had in some way paid for

the stock.

The panel explained that under the life insurance policies,

taxpayers were entitled to certain contractual rights such as a

death benefit, the right to surrender the policy for cash value,

and annual dividends. After demutualization, taxpayers

retained their contractual interests and continued to pay the

same premiums. Taxpayers as policyholders also had certain

membership rights for which they received nothing upon

* This summary constitutes no part of the opinion of the court. It has

been prepared by court staff for the convenience of the reader.

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DORRANCE V. UNITED STATES 3

demutualization. The stock they received was due to the legal

requirement that the insurance companies produce a “fair and

equitable” allocation of each company’s surplus at the time

of demutualization, but evidence showed that this was not

based on some premium value that taxpayers had paid in the

past.

Judge M. Smith dissented. He agreed with the district

court’s cost basis calculation, and disagreed with the

majority’s view that taxpayers paid nothing for their

membership rights.

COUNSEL

M. Todd Welty (argued) and Laura L. Gavioli, McDermott

Will & Emery LLP, Dallas, Texas, for PlaintiffsAppellees/Cross-Appellants.

Kathryn Keneally, Assistant Attorney General; Tamara W.

Ashford, Principal Deputy Assistant Attorney General;

Gilbert S. Rothenberg, Jonathan S. Cohen, and Judith A.

Hagley (argued), Attorneys, United States Department of

Justice, Tax Division, Washington, D.C., for DefendantAppellant/Cross-Appellee.

OPINION

McKEOWN, Circuit Judge:

This appeal requires us to “return to the very basics of tax

law” and consider whether taxpayers had a cost basis in assets

that they later sold, but for which they paid nothing. 

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4 DORRANCE V. UNITED STATES

Washington Mut. Inc. v. United States, 636 F.3d 1207, 1217

(9th Cir. 2011). The specific question we address is whether

a life insurance policyholder has any basis in a mutual life

insurance company’s membership rights. This issue, one of

first impression in our circuit, arises out of a trend in the late

1990s and early 2000s towards the “demutualization” of

mutual life insurance companies. As many mutual insurance

companies transformed into stock companies, the surplus

resulting from the sale of shares in the company was divided

among current policy holders, often in the form of stock.

Bennett and Jacquelyn Dorrance received and then sold

stock derived from the demutualization of five mutual life

insurance companies from which theyhad purchased policies. 

The Dorrances initially asserted a zero cost basis in the stock

and paid tax on the gain. They later claimed a full refund on

the taxes they paid upon on the sale of the stock, either

because the stock represented a return of previously paid

policy premiums or because their mutual rights were not

capable of valuation and, therefore, the entire cost of their

insurance premiums should have been counted toward their

basis in the stock. The government takes the position that the

Dorrances are not entitled to any refund; since they paid

nothing for their membership rights, their basis was zero. 

The district court held that the Dorrances had a calculable

basis in the stock, albeit not at the level the taxpayers

claimed, and thus they were entitled to a partial refund from

the Internal Revenue Service (“IRS”). We disagree. 

Taxpayers who sold stock obtained through demutualization

cannot claim a basis in that stock for tax purposes because

they had a zero basis in the mutual rights that were

extinguished during the demutualization.

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DORRANCE V. UNITED STATES 5

BACKGROUND

A. MUTUAL INSURANCE COMPANIES

The first life insurance company in America was a mutual

company called the Presbyterian Minister’s Fund, organized

in 1759 in Philadelphia.1 For centuries, mutual insurance

companies have provided a structure for collecting

policyholder premiums and spreading risk and surplus among

policyholders, while maintaining policyholder ownership of

the company. Mutual insurance companies are distinct from

stock companies in that they are owned by the policyholders,

not by stockholders. See Edward X. Clinton, The Rights of

Policyholders in an Insurance Demutualization, 41 Drake L.

Rev. 657, 659 (1992). To ensure that they can pay all of the

contractual benefits, these mutual insurance companies

generallycharge slightly higher rates than other life insurance

providers. Surplus is returned to the policyholders in

dividends. For decades (and even more than a century for

some mutual companies) policyholders joined, became

members, and terminated their policies without getting

anything back for membership rights. 

Starting in the middle of the twentieth century and

increasing through the 1980s, the mutual model became less

economically advantageous when compared to stock

companies. Id. See also Paul Galindo, Revisiting the ‘Open

1 Even earlier, in 1752, Benjamin Franklin, who had likely become

aware of similar innovations in England, formed the Philadelphia

Contribution for the Insurance of Houses From Loss by Fire,

often characterized as the first mutual insurance company. See

The Philadelphia Contributionship, Company History (2015),

http://www.contributionship.com/history/index.html. 

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6 DORRANCE V. UNITED STATES

Transaction’ Doctrine: Exploring Gain Potential and the

Importance of Categorizing Amounts Realized, 63 Tax L.

221, 226 (2009). The economic advantage of stock

companies comes, in large part, from the fact that they can

raise capital by selling shares, whereas mutual companies are

able to raise capital only by increasing the number of policies

sold or by reducing costs. Additionally, stock companies

have a greater capacity to diversify, which provides an

additional layer of financial stability. See Clinton, supra, at

667. 

In response to the challenges faced by mutual insurance

companies, in the mid-to-late 1990s many states changed

their insurance laws to permit “demutualization” of mutual

insurance companies. Demutualization entails the legal

transformation of a mutual company into a stock company. 

See Jeffrey A. Koeppel, The State of Demutualization, at v

(2d ed. 1996). As a consequence, by the late 1990s and early

2000s, many mutual insurance companies had transformed

into stock companies. 

The rapid shift toward demutualization was made possible

only by this widespread change in state insurance law.

Clinton, supra, at 674. Although state laws vary, including

in the scope of regulatory oversight, the demutualization

process occurred under operation of law and was monitored

by external insurance regulators. Id. at 665. Because

policyholders exert only weak influence over the mutual

company’s governance (each policyholder has only one vote,

out of possible thousands, regardless of the size of the

policy), external regulators focused on ensuring a fair and

equitable legal transformation of the insurance companies. Id.

at 678. 

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DORRANCE V. UNITED STATES 7

B. THE DORRANCES’ MUTUAL LIFE INSURANCE

POLICIES

Bennett Dorrance is the grandson of the founder of the

Campbell Soup Company. At the time the Dorrances

purchased life insurance policies from five mutual insurance

companies2

in 19963

, their net worth was approximately $1.5

billion. They bought the policies to cover estate tax for their

heirs. Over time, the Dorrances paid premiums totaling

$15,265,608. While that sum is definitely substantial, the

face value of the policies totaled just under $88 million, such

that theywould have received a huge contractual payout upon

death. 

The Dorrances’ contractual rights under the policies

entitled them to (1) a death benefit; (2) the right to surrender

the policy for “cash value”; and (3) annual policyholder

dividends representing the policyholder’s portion of the

company’s “divisible surplus.” As policyholders, they also

had certain membership rights. Specifically, they were

entitled to a portion of any surplus in the event of a solvent

2 The companies are: Prudential Insurance Company; Sun Life

Assurance Company; Phoenix Home Life Mutual Insurance Company;

Principal Life Insurance Company; and Metropolitan Life Insurance

Company (“MetLife”). 

3 By 1996, many states already allowed demutualization or were in the

process of changing their laws. Demutualization was permitted under

New York and Iowa law (governing MetLife, Phoenix, and Principal). 

See NY Ins. Law § 7312 (McKinney 2011); Iowa Code § 508B.1 et seq.

The New Jersey demutualization statute (governing Prudential) became

effective in July 1998. N.J. Stat. Ann. 17:17C-1. In 1999, Canadian

regulations (governing Sun Life) were revised to allow for

demutualization. Mutual Company (Life Insurance) Conversion

Regulations SOR/99-128 s.14 (Can.). 

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8 DORRANCE V. UNITED STATES

liquidation and to certain voting rights. The Dorrances’

membership rights in the mutual insurance companies were

not transferable or separable from the insurance policy. If the

policies terminated, so too would the membership rights,

without any rebate or additional compensation. Voting and

other membership rights were governed by state law and

company charter. 

In 2000 and 2001, each of the insurance companies from

which the Dorrances bought policies demutualized. Postdemutualization, the Dorrances no longer held any mutual

membership rights, but they retained their contractual

interests under the insurance policies and continued to pay the

same premiums. 

Government regulators (both in the United States and

Canada) required the insurance companies to produce a “fair

and equitable” allocation of the company’s surplus at the time

of demutualization. Mutual insurance companies complied

with this requirement in a variety of ways, but the companies

in question here opted to issue stock to their policyholders. 

When determining how many shares of stock to distribute

to each policyholder, the insurance companies calculated

(1) a fixed component for the loss of voting rights, as every

policyholder was entitled to a single vote regardless of policy

size, and (2) a variable component for the loss of other

membership rights, which was calculated based on the

policyholder’s past and projected future contributions to the

company’s surplus. As the government’s expert report

explained, each company used a different allocation

calculation to arrive at a distribution that was “fair and

equitable” to policyholders. MetLife, for example, “aimed

for around 20%” for the fixed portion, but stated this was a

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DORRANCE V. UNITED STATES 9

“general target.” Sun Life did not consider policyholders’

contribution to surplus in its allocation calculation, but rather

looked at the cash value and annual premiums of eligible

policies. 

Prior to demutualization, the insurance companies each

obtained a ruling from the IRS that the stock ownership

company resulting from the demutualization qualified as a

tax-free organization under Internal Revenue Code, I.R.C.

§ 368.

Upon demutualization, the Dorrances received 58,455

shares in Prudential, 3,209 shares in Sun Life, 1,601 shares in

Phoenix, 5,039 shares in Principal, and 2,721 shares in

MetLife. At the time of receipt, the market value of the stock

derived from these policies totaled $1,794,771. As the

government’s expert report explained: “Some may think that

the cash paid out in demutualization comes from the

distribution of positive surplus of the mutual company;

however, such is not the case. The cash actually comes from

new stockholders which subscribe to the IPO [initial public

offering] . . . .”

In 2003, the Dorrances sold all of the stock for

$2,248,806. On their 2003 tax return, in compliance with IRS

policy, the Dorrances listed their basis in the stock as zero,

reported the $2,248,806 as capital gain, and paid the tax due

on that gain. See Rev. Rul. 71-233, 1971-1 C.B. 113; Rev.

Rul. 74-277, 1974-1 C.B. 88.

C. PRIOR PROCEEDINGS

By 2007, the Dorrances had a change of heart. They filed

a tax refund claim with the IRS, in which they argued that

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10 DORRANCE V. UNITED STATES

they owed no taxes on the stock sale because it represented a

return on previously-paid insurance policy premiums. The

IRS did not issue a final determination on the 2007 claim, so

the Dorrances filed a complaint in district court. The IRS

argued that the Dorrances had a zero basis in their stock

because the life insurance premiums that they paid were not

in exchange for membership rights in the life insurance

policies. The district court denied the cross-motions for

summary judgment, ruling that there was a calculable basis in

the stock, and set the case for trial to determine how the basis

should be calculated. 

The district court held a two-day bench trial, which

featured expert testimony from both sides regarding the basis

calculation. The court rejected the Dorrances’ argument that

the “open transaction” doctrine, espoused by the Court of

Federal Claims, applied to their refund request.4It also

rejected the government’s zero basis argument. Instead, the

district court ruled that the Dorrances had “paid something

for the [membership] rights because they paid premiums for

policies that included both policy rights and mutual rights”

and that their basis was calculable. 

The district court calculated the Dorrances’ basis in the

stock using the following formula: (1) the initial public

offering (“IPO”) value of the fixed shares allocated to the

Dorrances in 2003, plus (2) 60% of the IPO value of the

4 The district court declined to follow the Court of Federal Claims’

approach that “the value of the ownership rights [in mutual rights are] not

discernible” and that, therefore, the full basis of the policy should apply

under the rarely-used “open transaction” doctrine. Fisher v. United States,

82 Fed. Cl. 780, 799 (2008) aff’d, 333 F. App’x 572 (Fed. Cir. 2009). In

light of our decision, it is unnecessary to address whether the “open

transaction” doctrine is applicable to this situation. 

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DORRANCE V. UNITED STATES 11

variable shares. Applying this formula, the court found that

the Dorrances were required to pay taxes on $1,170,678,

rather than on the full $2,248,806 value of the stock. Because

in 2003 the Dorrances had paid taxes based on a zero basis

calculation in the stock, the district court found that theywere

entitled to a refund. 

Both parties appeal the adverse portions of the judgment.

ANALYSIS

The crux of this case is how to calculate the basis of stock

received through demutualization. The question of basis in

the stock is a mixed question of law and fact that “require[s]

consideration of legal concepts and involve[s] the exercise

about the values underlying legal principles [and is]

reviewable de novo.” Smith v. Comm’r, 300 F.3d 1023, 1028

(9th Cir. 2002) (citing Mayors v. Comm’r, 785 F.2d 757, 759

(9th Cir. 1986)). The parties do not dispute the district

court’s factual findings. Instead, their divergence of views

stems from the legal conclusions that follow. 

As the taxpayers, the Dorrances bear the burden of

establishing basis, and “[t]he fact that basis may be difficult

to establish does not relieve [them] from [t]his burden.” 

Coloman v. Comm’r, 540 F.2d 427, 430 (9th Cir. 1976). 

Because they failed to establish that they had a basis in the

membership rights, we afford the basis utilized by the IRS a

presumption of correctness—even where, as here, that figure

is zero. Id. The Supreme Court explained long ago in a

similar context that “[t]he impossibility of proving a material

fact upon which the right to relief depends simply leaves the

claimant upon whom the burden rests with an unenforceable

claim, a misfortune to be borne by him, as it must be borne in

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12 DORRANCE V. UNITED STATES

other cases, as the result of a failure of proof.” Burnet v.

Houston, 283 U.S. 223, 228 (1931).

A. THESTRUCTUREOFMUTUALINSURANCEPOLICIES

In analyzing the insurance policies, it pays to bear in mind

that, “[a]s an overarching principle, absent specific

provisions, the tax consequences of any particular transaction

must reflect the economic reality.” Washington Mut. Inc.,

636 F.3d at 1217 (citing Kraft, Inc. v. United States, 30 Fed.

Cl. 739, 766 (Fed. Cl. 1994); United States v. Winstar Corp.,

518 U.S. 839, 863 (1996)). The reality here is that the

Dorrances acquired the membership rights at no cost, but

rather as an incident of the structure of mutual insurance

policies. 

The logic of this conclusion is simple—when the

Dorrances purchased their mutual insurance policies in 1996,

the premiums they paid related to their rights under the

insurance contracts, not to collateral membership benefits

such as voting. Under the insurance contract, policyholders

paid premiums for the following “contract rights”: (1) a death

benefit; (2) the right to surrender the policy for a “cash

value”; and (3) annual policyholder dividends representing

the policyholder’s portion of the company’s “divisible

surplus.” 

Separate from the contract rights, through operation of

law and the company charter, each policyholder had a right

to vote on certain matters, such as the election of the board of

directors. That vote was restricted to one vote per

policyholder, regardless of the size or face value of the

policy. In addition, in the very unlikely event of a

liquidation, the policyholder was entitled to any surplus from

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DORRANCE V. UNITED STATES 13

that liquidation.5 At trial, the government expert stated that

he did not know of a single mutual insurance company that

had ever had a solvent liquidation, a point echoed by the

MetLife representative. This bundle of rights—derived from

operation of law—is referred to as “mutual rights” or

“membership rights.”6 These rights are not transferable and

upon termination of a policy, the policyholder receives

nothing for any membership rights.

The difference between contract rights and membership

rights is critical to resolution of this case. The premiums paid

covered the rights under the insurance contract, not any

membership rights. Notably, the policies themselves

generally make no reference to any such membership rights. 

In other words, premium payments go toward the actual cost

of the life insurance benefits provided. The mutual

companies did not count membership rights as having a cost

(apart from minimal administrative costs, if there is a

policyholder vote), so they did not charge policyholders for

such rights. 

The government’s expert, American Academy of

Actuaries member Ralph Sayre, testified that mutual

companies calculate premiums based solely on the expected

cost of providing contractual insurance benefits. This

calculation process is “very precise in actuarial circles” and

5 Prior to demutualization, solvent liquidation in a mutual insurance

company was unlikely because mutual insurance companies are highly

regulated entities that operate conservatively to remain as a “going

concern” for their policyholders.

6 The moniker “mutual rights” more accurately describes what is at

issue, though we adopt the term “membership rights” as used by the

parties.

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14 DORRANCE V. UNITED STATES

“there just is no portion of the premium or charge for

membership rights.” He linked this analysis to the obvious: 

“[U]sually you don’t pay [for] something if . . . you aren’t

charged for it.” This explanation is consistent with the

Supreme Court’s description of what the premium pays for: 

“It is of the essence of mutual insurance that the excess in the

premium over the actual cost as later ascertained shall be

returned to the policy holder.” Penn Mut. Life Ins. Co. v.

Lederer, 252 U.S. 523, 525 (1920). 

In referencing “ownership rights,” by which he meant

membership rights, the description by the Dorrances’ expert

was essentially in line with Sayre’s conclusion: “The

ownership rights were not separate from the policy rights and

could not be sold. The cost associated with acquiring

ownership rights cannot be established exclusively through

premium payments.” 

Consistent with the general practice for mutual insurances

companies, the companies involved in this case did not

charge the Dorrances for their membership rights. This point

was underscored by Mr. Dorrance’s testimony that, at the

time he bought the policies, he actually understood that he

would pay less for a policy from a mutual insurance company

than he would for one from a stock company. See S.

Bancorporation, Inc. v. United States, 732 F.2d 374, 377 (4th

Cir. 1984) (rejecting refund claim where the taxpayer

“introduced no evidence to prove that it intended to pay an

enhanced value for the [asset] at the time of sale”) (emphasis

in original). It was no surprise then, that in 2003, when the

Dorrances filed their tax returns following the sale of the

stock derived from demutualization, they listed their basis as

zero. 

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DORRANCE V. UNITED STATES 15

B. THE EFFECT OF DEMUTUALIZATION

The membership rights were assigned a monetary value

at the time of the exchange only as a consequence of the

demutualization process. The error of the Dorrances and the

district court was to assume that the value received upon

demutualization was linked with some premium value paid by

the policyholders in the past. But the stock the Dorrances

received in exchange for the membership rights cannot be

understood as a partial return on their past premium payments

and it is well understood that policyholders do not contribute

capital to the companies.

By the time of the demutualization, the lion’s share of the

surplus that fed valuation of the newly issued stock could not

be traced to payments made by current policyholders. Nearly

all of the surplus held by the companies at that time was

attributable to former policyholders, not current policyholders

like the Dorrances. For example, at the time of

demutualization, less than 10% of the Sun Life surplus was

attributable to current policyholders; premiums paid by

former policyholders accounted for over 90% of the surplus. 

Thus, the value at demutualization was not derived from

something paid for by the Dorrances. 

Sayre explained the situation as follows: 

The demutualization is not a result of []

current policyholders having done something

different from the other previous millions of

policyholders, but is a result of outside

influences, such as tax policy, economic

conditions or competitive pressures. The

current policyholders are fortunate to be

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16 DORRANCE V. UNITED STATES

policyholders at the time of demutualization

but their value received is a result of the new

stockholders who are willing to pay them in

order to receive their membership benefits for

the purpose of what they can do with them in

the future. 

This anomaly prompted one insurance company official

involved in this case to refer to the receipt of stock as a

“windfall” for current policyholders. This characterization

was echoed by the Sixth Circuit, which referred to

demutualization proceeds as “a pot of money that no one

expected or even envisioned.” Bank of New York v.

Janowick, 470 F.3d 264, 266 (6th Cir. 2006); see also

Douglas P. Faucette & Timothy S. Farber, National

Insurance Act of 2007 & Demutualization of Insurers: The

Devil is in the Details, 58 Fed’n Def. & Corp. Couns. Q. 109,

127 (2007) (noting that policyholders “receive payouts that

they had not expected, consciously bargained for, or

purchased. Simply put, distribution of the surplus amounts to

‘a windfall resulting from the increase in the value of that

policy arising from its unforseen restructuring.’” (citation

omitted)).

Following the transfer of stock, it was business as usual

in terms of the contract rights. After demutualization, the

Dorrances’ insurance premiums remained level—reinforcing

the fact that they had not been paying a “premium” for any

membership rights in the first place. For example, the

premium history for Principal Financial Group shows that the

Dorrances’ premium was $124,450 both before and after the

1999 demutualization. This transition occurred under the

oversight of regulators who were charged with ensuring that

policyholders were treated fairly during the demutualization

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DORRANCE V. UNITED STATES 17

process and who did not require a reduction in the premiums

to sync with the loss of the now-claimed rights. The

Dorrances continued to pay the same premiums and receive

the same coverage. The stock exchange, for which they paid

nothing, was the only aspect of the transaction related to

membership rights. 

The demutualizations themselves were structured as taxfree, meaning that the initial transaction by which the

Dorrances received the stock did not trigger any taxable gain

for the policyholders. As an exchange under I.R.C. § 3547

,

the deal would not have been tax free if there was a gain upon

the exchange. I.R.C. § 358(a)(1) (providing that the basis of

property received under a § 354 exchange “shall be the same

as that of the property exchanged”). In other words, the stock

was a direct exchange for the lost membership rights. 

Put another way, the basis in the new stock was the same

as the basis in what was being exchanged—the membership

rights. Hence, the companies told policyholders that the tax

basis on the stock was “zero.” For example, with regard to

the receipt of stock, Phoenix explained in its Q&A document:

If you receive common stock, you will not be

taxed when you receive it. However, if you

sell or otherwise dispose of your common

stock, you will be taxed on the full amount of

 

7

 I.R.C. § 354(a)(1) provides:

No gain or loss shall be recognized ifstock or securities

in a corporation a party to a reorganization are, in

pursuance of the plan of reorganization, exchanged

solely for stock or securities in such corporation or in

another corporation a party to the reorganization.

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18 DORRANCE V. UNITED STATES

the proceeds you receive for the common

stock. (Your tax basis in the common stock

will be zero.)

The other companies alerted policyholders to the same thing: 

Sun Life advised that the “cost basis of these shares for tax

purposes will be zero” and, after saying that the tax cost

would be “zero,” Principal Mutual stated that “if you later

sell or otherwise dispose of your Common Stock, you will

generally be taxed on the full amount of the proceeds of that

sale or other disposition.”

The insurance companies’ advice to their policyholders

comports with IRS rulings dating back to the 1970s. Those

rulings stated that the policyholder’s basis in mutual rights is

zero. See Rev. Rul. 71-233, 1971-1 C.B. 113; Rev. Rul. 74-

277, 1974-1 C.B. 88. Revenue Ruling 71-233 addresses the

tax consequences to policyholders when they exchange their

proprietary interests for preferred stock. Consistent with our

explanation above—distinguishing between contract rights

and membership rights (which are also referred to as

proprietary rights), the IRS advised: 

Payment by each policyholder of the

premiums called for by the insurance

contracts issued by X represents payment for

the cost of insurance and an investment in his

contract but not an investment in the assets of

X. His proprietary interest in the assets of X

arises solely by virtue of the fact that he is a

policyholder of X. Therefore, the basis of

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DORRANCE V. UNITED STATES 19

each policyholder’s proprietary interest in X

is zero. 

Id. 

Within the tax code, the transaction exchanging mutual

rights for stock does not operate in a vacuum. Treating the

premiums as payment for membership rights would be

inconsistent with the Code’s provisions related to insurance

premiums. For example, gross premiums paid to purchase a

policy are allocated as income to the insurance company; no

portion is carved out as a capital contribution. See I.R.C.

§§ 803(a)(1), 118. On the flip side, the policyholder is

allowed to deduct the “aggregate amount of premiums” paid

upon receipt of a dividend or cash-surrender value. I.R.C.

§ 72(e). No amount is carved out as an investment in

membership rights. The taxpayer can’t have it both ways—a

tax-free exchange with zero basis and then an increased basis

upon sale of the stock.

The district court skipped a critical step by examining the

value of the mutual rights without evidence of whether the

Dorrances paid anything to first acquire them. The basis

inquiry is concerned with the latter question. The district

court also erred when it estimated basis by using the stock

price at the time of demutualization rather than calculating

basis at the time the policies were acquired. The stock value

post-demutualization is not the same as the cost at purchase. 

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20 DORRANCE V. UNITED STATES

We have previously explained that basis8“refers to a

taxpayer’s capital stake in an asset for tax purposes.” 

Washington Mut. Inc., 636 F.3d at 1217 (citing In re Lilly, 76

F.3d 568, 572 (4th Cir. 1996)). “The taxpayer must prove

what, if anything, he actually was required to pay . . . not

what he would have been willing to pay or even what the

market value . . . was.” Better Beverages, Inc. v. United

States, 619 F.2d 424, 428 (5th Cir. 1980). Here the

Dorrances failed to do so.

CONCLUSION

This analysis brings us back to the Dorrances’ burden and

the economic realities of this case. Because the Dorrances

offer nothing to show payment for their stake in the

membership rights, as opposed to premium payments for the

underlying insurance coverage, the IRS properly rejected

their refund claim. The district court erred when it found

after the bench trial that the Dorrances had shown they paid

something for the membership rights. It should have found

their basis to be zero.

REVERSED.

8 The Code provides that “[t]he basis of property shall be the cost of

such property, except as otherwise provided in this subchapter and

subchapters C (relating to corporate distributions and adjustments), K

(relating to partners and partnerships), and P (relating to capital gains and

losses).” I.R.C. § 1012(a). None of these exceptions apply here.

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DORRANCE V. UNITED STATES 21

M. SMITH, Circuit Judge, dissenting:

For thousands of years, philosophers, theologians, and

now physicists, have debated whether the earth was created

ex nihilo, i.e., out of nothing. Whatever the answer to that

question, there is little doubt that my colleagues in the

majority have performed a notable miracle of their own in

this case, by creating nothing out of something, i.e., nihil ex

aliquo. Let us consider how this miracle was wrought by

endeavoring to follow the money.

I. The Government’s Conditions to Demutualization

For what precisely did the Dorrances pay when they

purchased policies from the mutual life insurance companies

involved in this case? The majority contends that they paid

only for a death benefit, the right to surrender the policy for

a “cash value,” and annual policyholder dividends

representing their share of the company’s “divisible surplus.”

But if, as the majority contends, the Dorrances paid

nothing for their membership rights, and did not contribute

capital, then why did the several governmental regulators

involved require, as a condition of demutualization of each of

those insurance companies, that they issue stock to their

policyholders to compensate them for the loss of those rights?

Since those who acquired shares in the newly publicly

traded insurance companies during the IPO process paid cash

for their interests, if the policyholders when the insurance

companies were structured as mutual insurance companies

had not paid for the surplus they later received in stock, then

the value of the distributed shares ought to have remained as

the insurance companies’ working capital, and not been

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22 DORRANCE V. UNITED STATES

gratuitously gifted to policyholders. Neither the regulators

nor the IPO investors would have tolerated such a gratuity. 

But the stock distribution to the Dorrances, even if not

specifically contemplated at the time they purchased the

policies, was no gift. While insurance companies may be

powerful, they do not have the power of creation ex nihilo. To

the contrary, by the very nature of a mutual insurance

company, all of its accumulated value comes from premiums

paid by its owners, and the investment of those premiums.

That is why, when allocating shares during the

demutualization process, the insurance companies relied on

a calculation of a fixed component based on the loss of voting

rights and a variable component related to past and projected

future contributions to surplus.

The majority relies on a statement by a government’s

expert: “Some may think that the cash paid out in

demutualization comes from the distribution of positive

surplus of the mutual company; however, such is not the case.

The cash actually comes from new stockholders which

subscribe to the IPO . . . .” Here, the Dorrances received

stock, not cash. Of course, when they sold the stock, the cash

that they obtained from the sale came from the buyers of the

stock, and not from the insurance companies’ bank accounts.

But that is always true in a stock sale. Of course, that does not

mean that all stock sales have a zero basis. Thus, the cited

government expert’s testimony is merely a truism. It provides

no support for the majority’s conclusion.

II. Accrued Surplus or Not? 

Some context is in order. The majority mentions the IPO

value of the Dorrances’ stock: $1,794,771. The majority also

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DORRANCE V. UNITED STATES 23

unworthily mentions the Dorrances’ net worth, which is not

relevant to any issue before us. While the majority concedes

that the premiums the Dorrances had paid to the insurance

companies, which totaled $15,265,608, were “substantial,”

the majority is unimpressed by that figure because the face

value of the policies was substantially larger than the

premium. Of course, that is always the case in insurance. The

relevance of the premiums paid to the question before us is

that the distributed stock represents only 11.7% of the money

the Dorrances had paid the insurance companies. That may

not be far from the usual dividends paid on mutual insurance

policies.1

However, the majority is quick to call that return of a

small proportion of funds expended a “windfall.” But while

the majority asserts that one insurance company official so

characterized the stock distribution, he actually took care to

state that “windfall” was the company’s characterization, not

his. Moreover, the majority ignores the fact that every other

insurance company representative deposed in this case either

expressly rejected that characterization, or in one instance,

did not know how to answer the question.

The majority credits testimony by the government’s

expert that the insurance companies charged the Dorrances

premiums that were based solely on the expected costs of

1 The parties did not identify the dividend rates the policies at issue

provided. Data for the Massachusetts Mutual Life Insurance Company, not

one of the companies at issue, is publicly available. See Historical

Dividend Studies from Massachusetts Mutual Life Insurance Company

(2015), available at https://fieldnet.massmutual.com/public/life/

pdfs/li7954.pdf (last visited Nov. 18, 2015). That data shows that a policy

purchased after March of 1996 yielded a yearly dividend interest rate of

between 8.4% and 7.9% between 1996 and 2003.

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24 DORRANCE V. UNITED STATES

providing insurance benefits, using calculations that were

“very precise in actuarial circles,” such that “there is just no

portion of the premium or charge for membership rights.”

That asserted precision is disproved by the existence of a

surplus accrued within the insurance company. In fact, the

majority elsewhere relies on testimony that, at the time of

demutualization, “less than 10% of the SunLife surplus was

attributable to current policyholders; premiums paid by

former policyholders accounted for over 90% of the surplus.”

In other words, despite their asserted actuarial precision,

the insurance companies had not been returning via dividend

all of the premium surplus. Instead, the surplus accumulated

within the companies, where it served the role that any

accumulation of capital does. Therefore, the majority errs by

stating that “it is well understood that policyholders do not

contribute capital to the companies.”

2

If not from the

policyholders, from whence did that accumulated capital

come?

Certainly, the cited testimony raises the question of how

much the Dorrances contributed to the surplus. That question

2 The majority misconstrues government witness Ralph Sayre’s

testimony in this regard. Sayre testified that, from the view of a mutual

insurance company, “because we don’t have shareholders who have

contributed to surplus or contributed capital to withstand [the demand for

benefit payments], we’re going to have to charge [the policyholder] a little

bit more of that up front. But keep in mind that we will also give it back

to you. As our experience unfolds and we realize earnings from that extra

charge, or from the use of that extra money, we will return it back to you.”

Thus, policyholders do contribute capital—but they are eventually

supposed to get it back. The majority believes that it comes back with a

basis of zero, which complements the majority’s belief that the insurance

companies created something out of nothing.

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DORRANCE V. UNITED STATES 25

was addressed during the demutualization. To determine the

number of shares of stock to issue to each member, the

insurance companies applied a formula approved by the

government regulators, which included a fixed component

and a variable component.According to that formula, 14-25%

of each company’s shares were allocated on a fixed basis to

shareholders. The variable shares were allocated based on the

“contribution-to-surplus” method, which allocated the total

shares based on a policyholder’s contribution.

Thus, even if we were to accept the majority’s conclusion

that the Dorrances had no basis in the voting aspect of the

membership rights—remembering that the fixed shares

granted solely on that basis were worth $3,164, a minuscule

portion of the $1,794,771 of IPO stock at issue—the

calculations expressly accounted for their actual contribution

to the surplus.

III. “Tax Free Exchange” Is Not a Synonym for “Zero

Basis”

The majority also misapplies the concept of a tax-free

exchange in stating that “[t]he taxpayer can’t have it both

ways—a tax-free exchange with zero basis and then an

increased basis upon sale of the stock.”

It is unclear how the Dorrances are trying to “have it both

ways.” All that is required for the exchange to be tax-free is

for the value received in stock to be the same as the value of

the property exchanged. See 26 U.S.C. § 358(a)(1). In this

case, the IRS, citing its own interpretations, opined that the

basis should be zero. Whether that interpretation squares with

the facts is the very question at issue in this case. By relying

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in part on the IRS’s interpretation to answer the question, the

majority assumes the conclusion.

IV. The District Court’s Sound Calculations

After hearing all of the evidence at trial, the district court

determined the Dorrances’ cost basis by deducting the

expected future premium contribution from the IPO value of

the stock, yielding a cost basis of $1,078,128. This was the

sum of: (1) the IPO value of the fixed shares allocated to the

Dorrances ($3,164) and (2) 60% of the IPO value of the

variable shares ($1,074,964). The 60% proportion reflected

an expert estimate of past contributions by the Dorrances to

the life insurance policies; the remaining 40% was an

estimate of the policyholders’ future contributions to the

policies. Applying this formula, the court found that the

Dorrances were required to pay taxes on $1,170,678, which

was their sale proceeds of $2,248,806 less their basis of

$1,078,128.

Thus, the district court quite sensibly reduced the basis by

an expert’s estimate of the future contribution component of

the IPO value, ensuring that the Dorrances would not

underpay the taxes owed. This was a careful analysis using

reasonable methodology based on the evidence presented at

trial. By contrast, the majority’s contrary conclusions do not

follow from the facts. A portion of the assets of the insurance

companies clearly came from the premiums paid by the

Dorrances, and they had a substantial basis in the stock

distributed to them. By contending to the contrary, my

colleagues in the majority have created nothing out of

something. It’s a miracle!

I respectfully dissent. 

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