Dorrance, et al v. United States of America

Filing 124

AMENDED FINDINGS OF FACT AND CONCLUSIONS OF LAW that Plaintiffs' request for a refund of taxes is granted. ORDER that the Parties shall confer and file, no later than 6/1/13, a proposed form of judgment to be entered in this action. Signed by Judge G Murray Snow on 4/19/13. (TLJ)

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1 WO 2 3 4 5 6 IN THE UNITED STATES DISTRICT COURT 7 FOR THE DISTRICT OF ARIZONA 8 9 Bennett and Jacquelynn Dorrance, Plaintiffs, 10 11 12 15 16 17 18 19 20 21 22 23 AMENDED FINDINGS OF FACT AND CONCLUSIONS OF LAW v. United States of America, Defendant. 13 14 No. CV-09-1284-PHX-GMS On December 18 and 19, 2012, this matter was tried to the Court without a jury. (Doc. 114, 115.) This Order constitutes the Court’s findings of fact and conclusions of law under Federal Rule of Civil Procedure 52(a).1 BACKGROUND In 1996, Bennett and Jacquelynn Dorrance (“Plaintiffs”) purchased several life insurance policies from mutual companies. Along with insurance benefits, those policies granted Plaintiffs mutual ownership rights in the companies (“mutual rights”) for as long as they paid premiums. These mutual companies later demutualized and converted into stock-based companies. In 2000 and 2001, the mutual companies compensated Plaintiffs 24 1 25 26 27 28 During trial, at the conclusion of Plaintiffs’ case, Defendant moved for partial judgment pursuant to Federal Rule of Civil Procedure 52(c). Defendant argued that Plaintiffs failed to meet their burden of proof. Defendant contended that Plaintiffs had not provided an equitable method to apportion cost basis between their mutual rights and insurance benefits. Furthermore, Plaintiffs did not offer evidence that they had a realistic expectation of demutualization and that they paid an additional amount for mutual rights. See Gladden v. Comm’r, 262 F.3d 851, 854-55 (9th Cir. 2001). The Court denied Defendant’s Motion. 1 for the loss of their mutual rights with shares of stock valued at $1,794,771. On June 23, 2 2003, Plaintiffs sold those shares for an aggregate amount of $2,248,806. Consistent with 3 IRS policy that policyholders have no basis in stock received during demutualization of a 4 life insurance company, Plaintiffs listed a zero cost basis when reporting their proceeds 5 for the tax year ending on December 31, 2003 and paid taxes on the full amount. On 6 October 15, 2007, Plaintiffs filed a claim for a refund, arguing that they did not owe tax 7 on their proceeds. Because the IRS did not issue a final determination regarding the 8 refund, Plaintiffs filed suit in this Court to affirm their claim on June 15, 2009.2 9 On July 9, 2012, this Court issued an Order ruling on the Parties’ cross-motions 10 for summary judgment. (Doc. 88.) Defendant argued that Plaintiffs paid premiums to 11 acquire insurance benefits, not to obtain mutual rights under the policy. Accordingly, 12 Plaintiffs had no basis in the stock that was provided in exchange for those mutual rights. 13 However, this Court held that Plaintiffs had met their burden of showing they paid 14 something for the mutual rights because they paid premiums for policies that included 15 both policy rights and mutual rights. 16 Plaintiffs contended that the demutualization should be governed by the “open 17 transaction doctrine” which is employed when the basis in property that is split cannot be 18 allocated to the resulting assets because it is not clear how much each asset cost. See 19 Fisher v. United States, 82 Fed. Cl. 780, 795 (Fed. Cl. 2008) (aff’d without opinion by 20 Fisher v. United States, 333 Fed. App’x. 572 (2009)). For example, under this doctrine, 21 proceeds from Plaintiffs’ sale of stock would be considered return of capital from their 22 premiums, and they would thereby owe no tax. This Court held that the doctrine did not 23 apply because Plaintiffs’ mutual rights were not “elements of value so speculative in 24 2 25 26 27 28 Plaintiffs Bennett and Jacquelynn Dorrance originally sought a refund in the amount of $2,678,411.10 for the taxable years ending December 31, 2002, 2003, and 2004 on three unrelated and distinct bases. (Doc. 1 at 1-2.) They sought a refund of penalties and interest the IRS assessed against them for participation in an allegedly illegal tax shelter. On October 10, 2011, Plaintiffs abandoned that portion of their Complaint. (Doc. 64 at 2.) Plaintiffs also sought to recover an overpayment of taxes due to the miscalculation of their investment interest expense deduction. That issue was settled with Defendant. (Id.) -2- 1 character as to prohibit any reasonably based projection of worth.” Campbell v. United 2 States, 661 F.2d 209, 215 (Ct. Cl. 1981). 3 The remaining issue for trial was to determine an equitable method to allocate the 4 premiums paid by Plaintiffs before demutualization and apply that amount as a cost basis 5 to calculate the taxable gain, if any, on their sale of stock. 6 FINDINGS OF FACT 7 1. In 1995, Plaintiffs formed the Dorrance 1995 Legacy Trust (the “Trust”) 8 and retained a financial consulting firm to assemble a pool of survivor coverage for their 9 heirs. Through that Trust, Plaintiffs purchased the life insurance policies at issue as part 10 of an estate plan. They purchased policies with the Prudential Insurance Company of 11 America (“Prudential”), Sun Life Assurance Company of Canada (“Sun Life”), Phoenix 12 Home Life Mutual Insurance Company (“Phoenix”), Principal Life Insurance Company 13 (“Principal”), and Metropolitan Life Insurance Company (“MetLife”) (collectively, the 14 “Companies”). At that time, all of the Companies were mutual insurance companies. 15 2. On April 28, 1996, Plaintiffs purchased the Principal policy with a face 16 value of $10,000,000 and annual premiums of $124,450. On April 30, 1996, Plaintiffs 17 purchased the Phoenix policy with a face value of $8,000,000 and annual premiums of 18 $106,355. On June 1, 1996, Plaintiffs purchased the Prudential policy, which provides the 19 bulk of their coverage, with a face value of $50,000,000 and fluctuating premiums. On 20 June 10, 1996, Plaintiffs purchased the MetLife policy with a face value of $17,500,000 21 and annual premiums of $254,350. On August 20, 1996, Plaintiffs purchased the Sun 22 Life policy with a face value of $2,275,000 and annual premiums of $33,259. 23 3. Mutual insurance companies issue no stock and have no shareholders. 24 Instead, initial capital requirements come from premiums paid by policyholders. 25 Policyholders are the owners of mutual companies which operate for their benefit and 26 seek to offer reliable insurance at a low cost. 27 28 4. A typical purchaser of a life insurance policy from a mutual company understands that, by virtue of buying a policy, he or she becomes an owner of the -3- 1 company. The possession of mutual rights was a typical selling point to potential 2 policyholders. 3 5. A stock-based life insurance company is organized and operated for the 4 purpose of making a profit for its shareholders. Policyholders may also be shareholders 5 if they purchase stock, but otherwise policyholders have no equity interest in the 6 company and no voting rights. If a stock-based insurance company has surplus, it is 7 distributed to the shareholders, not the policyholders. 6. 8 Mutual rights include the right to share in company profits, to vote, and to a 9 preferred position in the event of liquidation. Each policyholder has one vote regardless 10 of how many policies the policyholder owns and of the size of each policy. These rights 11 arise by operation of state law and under corporate charters. See, e.g., NY Ins. Law § 12 7312(a)(3) (mutual rights defined as “including, but not limited to, the rights to vote and 13 to participate in any distribution of surplus whether or not incident to a liquidation of the 14 mutual life insurer.”). The Companies expressly defined their policyholders’ mutual 15 rights in their plans of demutualization. 7. 16 Prior to demutualization, mutual rights were not separable from ownership 17 of the life insurance policy. A policyholder could not sell or transfer mutual rights 18 regardless of whether he retained the underlying policy to which they were inextricably 19 tied. 20 8. Plaintiffs paid premiums to the Companies which secured life insurance 21 and mutual rights. However, the Companies did not allocate premiums or assign an 22 independent cost to the mutual rights. Some of the Companies stated that policyholders’ 23 mutual rights could not be valued prior to demutualization. 24 9. If an underlying policy was terminated, either because of missed payments 25 or because the death benefit came due, the mutual rights would also be terminated. For 26 Plaintiffs, no such divestiture occurred prior to the five demutualizations in this case. 27 28 10. The Companies demutualized into stock companies by exchanging the policyholders’ mutual rights for shares of stock through processes that culminated in -4- 1 2000 and 2001. They demutualized to raise additional capital through an initial public 2 offering (“IPO”) which occurred at the same time as the demutualization. 3 11. The demutualizations went through several levels of approval. First, the 4 Companies’ boards of directors investigated and voted to approve demutualization. This 5 investigation involved the opinions of independent actuaries and investment banks 6 regarding the fairness of the compensation to be given to policyholders. Second, state 7 insurance commissioners approved the plans. Third, the plans were submitted to 8 policyholders, who approved them by significant majority votes. 9 12. MetLife’s board unanimously approved its Plan of Reorganization on 10 September 28, 1999. Following approval by the New York state insurance commissioner, 11 a public hearing, and an approval vote by policyholders, MetLife’s IPO and 12 demutualization took place on April 4, 2000. 13 13. On December 18, 2000, Phoenix’s board of directors unanimously 14 approved its Plan of Reorganization. Following approval by the New York state 15 insurance commissioner, a public hearing, and an approval vote by policyholders, 16 Phoenix’s IPO and demutualization took place on June 19, 2001. 17 14. On March 31, 2001, Principal’s board of directors unanimously approved 18 its Plan of Conversion. Following approval by the Iowa state insurance commissioner, a 19 public hearing, and an approval vote by Principal’s policyholders, Principal’s IPO and 20 demutualization took place on October 22, 2001. 21 15. On December 15, 2000, Prudential’s board of directors unanimously 22 approved a Plan of Reorganization. Following approval by the New Jersey state 23 insurance department, a public hearing, and an approval vote by policyholders, 24 Prudential’s IPO and demutualization took place on December 12, 2001. 25 16. On September 28, 1999, Sun Life’s board unanimously approved its plan of 26 demutualization. Following approval by the Canadian insurance superintendent and the 27 Michigan state insurance commissioner, and an approval vote by Sun Life’s 28 policyholders, Sun Life’s IPO and demutualization took place on March 23, 2000. -5- 1 17. After the Companies demutualized, Plaintiffs retained their policies and 2 continued to pay premiums but no longer had mutual rights. In exchange for relinquished 3 mutual rights, the Companies provided Plaintiffs with stock compensation. 4 18. When determining how many shares of stock to give policyholders, the 5 Companies calculated (1) a fixed component for the loss of voting rights, since each 6 policyholder was entitled to one vote, and (2) a variable component for the loss of other 7 rights, measured by the policyholder’s past and projected future contributions to the 8 company’s surplus.3 Of the variable component, 60% was an estimate of each 9 policyholder’s past contributions to surplus as of the calculation date while the remaining 10 11 40% was an estimate of future contributions. 19. Although the Companies used different methods to measure policyholders’ 12 contribution to surplus, all obtained independent actuarial opinions that the share 13 allocation methods were sound and that the stock compensation was “fair and equitable.” 14 The Companies also obtained opinions from investment banks, concluding that the 15 compensation was fair to the group as a whole. 16 20. The Companies informed policyholders that their mutual rights were being 17 “exchanged” for stock. (Doc. 70-3 at 12; Doc. 71-1 at 11; Doc. 68-7 at 11; Doc. 69-1 at 18 20; Doc. 69-3 at 12.) In 2000 and 2001, Principal and Sun Life represented to the IRS 19 that the fair market value of the stock policyholders would receive during 20 demutualization approximately equaled the fair market value of mutual rights that 21 policyholders surrendered. (Doc. 24 at 3); I.R.S. Priv. Ltr. Rul. 200020048 at 6 (Feb. 22, 22 2000) (representation (g)) (Sun Life Private Letter Ruling). 23 21. The aggregate IPO value of the shares that the Companies granted to 24 Plaintiffs during demutualization was $1,794,771. At the time of the IPOs, Plaintiffs had 25 paid $15,265,608 in premiums on the five life insurance policies. 26 22. Plaintiffs received 2,721 shares in MetLife’s demutualization. The IPO 27 3 28 “Surplus” is the book value or equity of the insurance company. It is equal to the company’s assets reduced by its liabilities. -6- 1 stock price on April 4, 2000 was $14.25 per share. The IPO value of the shares Plaintiffs 2 received was $38,774. At the time of MetLife’s IPO, Plaintiffs had paid $1,017,400 in 3 premiums. 4 23. Plaintiffs received 1,601 shares in Phoenix’s demutualization. The IPO 5 stock price on June 19, 2001 was $17.50 per share. The IPO value of the shares Plaintiffs 6 received was $28,018. At the time of Phoenix’s IPO, Plaintiffs had paid $638,130 in 7 premiums. 8 24. Plaintiffs received 5,039 shares in Principal’s demutualization. The IPO 9 stock price on October 22, 2001 was $18.50 per share. The IPO value of the shares 10 Plaintiffs received was $93,222. At the time of Principal’s IPO, Plaintiffs had paid 11 $746,700 in premiums. 12 25. Plaintiffs received 58,455 shares in Prudential’s demutualization. The IPO 13 stock price on December 12, 2001 was $27.50 per share. The IPO value of the shares 14 Plaintiffs received was $1,607,513. At the time of Prudential’s IPO, Plaintiffs had paid 15 $12,730,342 in premiums. 16 26. Plaintiffs received 3,209 shares in Sun Life’s demutualization. The IPO 17 stock price on March 23, 2000 was $8.49 per share. The IPO value of the shares 18 Plaintiffs received was $27,244. At the time of Sun Life’s IPO, Plaintiffs had paid 19 $133,036 in premiums. 20 27. Plaintiffs sold all of their shares on June 23, 2003, for an aggregate value of 21 $2,248,806. The MetLife stock sold with proceeds of $76,953. The Phoenix stock sold 22 with proceeds of $15,289. The Principal stock sold with proceeds of $164,603. The 23 Prudential stock sold with proceeds of $1,925,797. The Sun Life stock sold with proceeds 24 of $66,164. CONCLUSIONS OF LAW 25 26 1. This is an action for the refund of federal income taxes in the amount of 27 $2,248,806 for the taxable year ending December 31, 2003. This Court has jurisdiction 28 by reason of 28 U.S.C. § 1346(a)(1) and 26 U.S.C. § 7422. -7- 1 2. Venue is proper in this District under 28 U.S.C. § 1391(e) because 2 Plaintiffs reside in this District and because a substantial part of the events giving rise to 3 this claim took place in this District. 4 3. Taxpayers are required to report “[g]ains derived from dealings in 5 property” in their gross income under I.R.C. § 61(a)(3). In general, the amount of gain or 6 loss recognized upon the sale of property is the difference between the adjusted basis of 7 the property sold and the amount realized from the sale. I.R.C. § 1001(a), (c); Treas. 8 Reg. §§ 1.61-6(a), 1.1001-1(a). 9 4. A taxpayer’s basis in property is equal to the cost of that property to the 10 taxpayer. I.R.C. § 1012. A taxpayer must prove what he actually paid for property to 11 establish a basis in that property. See Gladden, 262 F.2d at 855. However, if “it is clear 12 that the taxpayer is entitled to some deduction, but he cannot establish the full amount 13 claimed, it is improper to deny the deduction in its entirety.” United States v. Marabelles, 14 724 F.2d 1374, 1383 (9th Cir. 1984). 15 5. “[W]hen property is acquired in a lump-sum purchase but then divided and 16 sold off in parts,” Treas. Reg. § 1.61-6(a) requires that “the cost basis of the property 17 should generally be allocated over the several parts.” Gladden, 262 F.3d at 853. Thus, 18 the default rule calls for the taxpayer to “equitably apportion[]” the basis of the property 19 among its elements when those elements are sold. Treas. Reg. § 1.61-6(a). 20 6. Taxpayers must prove their bases in property by a preponderance of the 21 evidence and substantiate the amount of the refund they seek. See Coloman v. Comm’r, 22 540 F.2d 427, 429 (9th Cir. 1976); United States v. Janis, 428 U.S. 433 (1976). The fact 23 that basis may be difficult to establish does not relieve a taxpayer from his burden. 24 Coloman, 540 F.2d at 430. Plaintiffs must prove that there is an equitable method of 25 estimating the amount they paid for mutual rights at the time they purchased insurance 26 policies and paid premiums. 27 28 7. Defendant contends that Plaintiffs did not pay an additional amount for mutual rights and did not have a realistic expectation of demutualization. Therefore, -8- 1 Plaintiffs should not be allocated any basis from the premium payments. See Gladden, 2 262 F.3d at 855. The Gladden Court addressed a situation where taxpayers did not own 3 the asset at issue at the time of a land purchase but rather, obtained unvested water rights 4 contingent on the execution of a government irrigation project. Id. In contrast, Plaintiffs 5 obtained vested mutual rights when they bought insurance policies. At the time of 6 purchase, Plaintiffs had voting rights and the ability to participate in any distribution of 7 the company’s surplus, whether or not that distribution was triggered by a 8 demutualization. Therefore, the Gladden “expectation test” is not applicable to these 9 facts. The correct question is how to allocate cost between mutual rights and policy rights 10 11 under Treas. Reg. § 1.61-6(a). 8. Although Plaintiffs’ mutual rights contributed to the insurance policies’ 12 value from the time the policies were purchased, the cost of the mutual rights could not 13 be determined prior to demutualization. The mutual rights were not separable from the 14 policy rights and could not be sold. Therefore, the cost associated with acquiring mutual 15 rights cannot be established exclusively through Plaintiffs’ payment of premiums. 16 9. The first valuation of what Plaintiffs paid for mutual rights was the IPO 17 price of the shares they received pursuant to demutualization. The Companies determined 18 that the fair market value of the shares were equivalent to the value of the mutual rights. 19 Furthermore, the shares were allocated in exchange for mutual rights in a fair and 20 equitable manner, as determined by the Companies, actuaries, and state insurance 21 commissioners. 22 10. The Companies allocated shares to Plaintiffs based on (1) the value of 23 voting rights, (2) past contributions to surplus, and (3) projected future contributions to 24 surplus. Effectively, Plaintiffs paid for shares of stock in the demutualized Companies by 25 relinquishing voting rights and making contributions to surplus. However, projected 26 future contributions to surplus are a portion of premiums which Plaintiffs had not actually 27 paid before receiving shares and cannot be considered as a part of basis. 28 11. Therefore, Plaintiffs’ basis is equal to the combination of the IPO value of -9- 1 shares allocated to Plaintiffs for (1) the fixed component representing compensation for 2 relinquished voting rights (“fixed shares”) and (2) 60% of the variable component 3 representing past contributions to surplus (“variable shares”). 4 12. The following is the calculation, by insurer, of the IPO value of the fixed 5 shares. For the MetLife policy, Plaintiffs were allocated 10 fixed shares amounting to an 6 IPO value of $143. (Doc. 70-3 at 23.) For the Phoenix policy, Plaintiffs were allocated 18 7 fixed shares amounting to an IPO value of $315. (Doc. 75-6 at 2.) For the Principal 8 policy, Plaintiffs were allocated 100 fixed shares amounting to an IPO value of $1,850. 9 (Doc. 68-7 at 29.) For the Prudential policy, Plaintiffs were allocated 8 fixed shares 10 amounting to an IPO value of $220. (Doc. 69-11 at 33.) For the Sun Life policy, Plaintiffs 11 were allocated 75 fixed shares amounting to an IPO value of $637. (Doc. 69-3 at 31.) The 12 aggregate IPO value of the fixed shares was $3,164. 13 13. The following are the calculations, by insurer, of the IPO value of the 14 variable shares.4 For the MetLife policy, Plaintiffs were allocated 2,711 variable shares 15 amounting to a value of $38,632. For the Phoenix policy, Plaintiffs were allocated 1,583 16 variable shares amounting to a value of $27,703. For the Principal policy, Plaintiffs were 17 allocated 4,939 variable shares amounting to a value of $91,372. For the Prudential 18 policy, Plaintiffs were allocated 58,447 variable shares amounting to a value of 19 $1,607,293. For the Sun Life policy, Plaintiffs were allocated 3,134 variable shares 20 amounting to a value of $26,608. The aggregate IPO value of the variable shares is 21 $1,791,606. Plaintiffs’ past contributions to surplus is equal to 60% of the aggregate IPO 22 value, amounting to $1,074,964. 23 14. Accordingly, Plaintiffs’ basis is equal to the IPO value of the fixed shares 24 ($3,164) combined with 60% of IPO value of the variable shares ($1,074,964). That 25 amounts to a basis of $1,078,128 applicable to Plaintiffs’ sales proceeds of $2,248,806.5 26 4 27 28 The amounts of variable shares, by insurer, are calculated by deducting the amount of fixed shares from the aggregate amount of shares allocated to Plaintiffs. 5 Plaintiffs offer a method to account for additional contributions made to surplus - 10 - 1 After selling their shares in 2003, Plaintiffs paid tax on that basis at a 15% capital gains 2 tax rate. Thus, they are entitled to a refund of $161,719.20. 3 15. Any conclusion of law deemed a finding of fact is so adopted. CONCLUSION 4 5 Plaintiffs paid for shares of stock in the demutualized Companies by contributing 6 to the Companies’ surplus and by relinquishing voting rights in exchange for the shares. 7 Accordingly, they had a cost basis in the shares of $1,078,128. Plaintiffs are entitled to a 8 refund of taxes in the amount of $161,719.20. 9 10 11 12 13 IT IS THEREFORE ORDERED that Plaintiffs’ request for a refund of taxes is granted. IT IS FURTHER ORDERED that the Parties shall confer and file, no later than June 1, 2013, a proposed form of judgment to be entered in this action. Dated this 19th day of April, 2013. 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 between the calculation date for share allocation and the IPO date, as an element of basis in shares. (Doc. 119 at 5-6.) Plaintiffs provide this methodology for the first time in posttrial briefing. Their failure to provide this methodology at trial has waived it for purposes of calculating additional contributions to surplus as an element of basis. See Air Separation, Inc. v. William H. Cauley Ins., Inc., 967 F.2d 583 (9th Cir. 1992); Northwest Acceptance Corp. v. Lynnwood Equipment, Inc., 841 F.2d 918, 924 (9th Cir. 1988). - 11 -

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