A federal judge has told the Internal Revenue Service it inappropriately requires policyholders who receive stock in a mutual-to-stock conversion to pay taxes on the proceeds when the stock is sold.

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

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

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

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

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

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

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

The decision only applies to a mutual insurance company that distributes stock to its policyholders in a conversion, the attorney said.

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

The Department of Justice, defending an IRS regulation dating to 1971, argued in court papers and in oral arguments that, “When the policy was purchased, the trust had no realistic anticipation of receiving anything of value in exchange for those rights, and none of the policy premium was paid for those rights.”

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

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

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

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

“I think Judge Allegra has come to the right conclusion,” he said. “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 is sufficient to eliminate any taxable gains on the transaction. As a result, 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 deep concern that even though Judge Allegra ruled in November 2006 that the 1971 interpretation and other revenue rulings by the IRS “are not applicable to this case, the IRS and insurance companies, in responding to insured's inquiries, continue to cite the zero basis position of the IRS.”

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

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