A federal judge has told the Internal Revenue Service itinappropriately requires policyholders who receive stock in amutual-to-stock conversion to pay taxes on the proceeds when thestock is sold.

The decision potentially impacts more than 40 conversions datingfrom 1986 with proceeds to shareholders exceeding $200 billion,according to a Minnesota CPA who advised his Rockville, Md.-basedclient to sue. But one Washington, D.C. lawyer familiar with thelong-running issue today cautioned against reading too much intothe decision.

“This decision should be taken with caution. I don't thinktaxpayers should run to the bank just yet,” said an attorney whoasked not to be named because he has clients of both sides of theissue.

In Fisher v. U.S., No. 04-1726T, filed Aug. 6, Judge FrancisAllegra of the U.S. Court of Claims said mutual-to-stockconversions of insurance companies are similar to an “opentransaction,” in which the court cannot distinguish between thevalue of the life insurance policy to the policyholder and thevalue of the policyholder's interest in the insurance company.

The plaintiff is Eugene Fisher, trustee for the Seymour Naganirrevocable trust.

This is a “very important case, one of “first impression,” thatis, the first time a U.S. court has ruled on the issue, the lawyerfamiliar with case noted. But he also called the decision “veryconfusing.”

He noted that this is a court of national jurisdiction, whichgives any taxpayer who wants to contest the IRS regulation anopportunity for redress. He predicted the government would appeal,and it could eventually wind up in the U.S. Supreme Court if thegovernment loses. “Otherwise, all taxpayers could go to this courtand there could be a substantial effect on governmentrevenues.”

A spokesman for the Department of Justice, which litigated thecase on behalf of the IRS, said it has not decided what the nextstep will be.

The decision only applies to a mutual insurance company thatdistributes stock to its policyholders in a conversion, theattorney said.

In the decision, the lawyer said, the court stated “it can'tdetermine the basis of the ownership interest the policyholder hadin the mutual company.” Therefore, “it is an 'open transaction'that doesn't require the policyholder to pay any tax when he sellshis stock.” The basis, the lawyer said, “can only be determinedafter the insurance policy terminates, through death, cancellation,etc.”

The Department of Justice, defending an IRS regulation dating to1971, argued in court papers and in oral arguments that, “When thepolicy was purchased, the trust had no realistic anticipation ofreceiving anything of value in exchange for those rights, and noneof the policy premium was paid for those rights.”

Under these circumstances, DOJ lawyers argued, “no basis can beallocated to those rights, even though at a later date the trustreceived something of value for them,” citing a 2001 decision inthe 9th Circuit U.S. Court of Appeals.

The DOJ also argued, “The evidence at trial will establish thatthe financial services stock represented a windfall to the trustand bore no relationship to the premiums the trust paid.”

In his decision, Judge Allegra said the record “supports theopinion rendered by plaintiff's valuation expert that the value ofthe ownership rights was not discernible, leading the court toconclude that plaintiff has borne its burden of proof in thiscase.”

Don Alexander, a lawyer at Akin, Gump and a former IRScommissioner, supported the decision.

“I think Judge Allegra has come to the right conclusion,” hesaid. “He doesn't establish a tax basis at all. He doesn't have to.Because as he points out, whatever the number is, the number issufficient to eliminate any taxable gains on the transaction. As aresult, the basis exceeds the amount he gains.”

Charles Ulrich, a CPA in Baxter, Minn., who advised his client,Mr. Fisher, to appeal the decision to the Claims Court, voiced deepconcern that even though Judge Allegra ruled in November 2006 thatthe 1971 interpretation and other revenue rulings by the IRS “arenot applicable to this case, the IRS and insurance companies, inresponding to insured's inquiries, continue to cite the zero basisposition of the IRS.”

As a result, he said “policyholders who followed the zero basisdirection of the IRS have therefore been damaged by compliance withIRS instructions by losing refund rights due to the statute oflimitations.”