Sec. 162 demutualization payment deductible, but not until paid.

• Author: Gantman, Andrew

In Letter Ruling (TAM) 200126008, the IRS concluded that a mutual insurance company may deduct a demutualization payment made to its state's treasury in the year in which it made the payment, based in large part on the origin-of-the-claim doctrine. The payment was one of several requirements the company had to satisfy before the state approved the company's conversion from a mutual insurance company to a domestic stock insurer.

Origin-of-the-Claim Doctrine

Under the origin-of-the-claim doctrine, a transaction's nature, not a taxpayer's motive for or possible consequences of making the payment, governs whether an item is nondeductible, currently deductible or a capital expenditure.

In Gilmore, 372 US 39 (1963), the taxpayer deducted legal fees incurred in his divorce. He argued that if his spouse were successful in her suit against him, he would have lost his controlling stock interest in three companies, as well as his employment as president of those companies. Thus, the taxpayer asserted that he could deduct the legal fees as expenses for the conservation of property held for the production of income. The Court held that the origin of the claim was the taxpayer's marriage, and therefore personal in nature.

In the TAM, the taxpayer was originally incorporated as a nonstock, non-profit corporation. It was the successor to organizations originally formed as hospital service plans and medical service plans, providing prepaid hospitalization and medical services. At the time of the IRS audit, the taxpayer was in the health insurance business. Over time, it has been subjected to a series of changing regulatory regimes, and was classified at one time under applicable state law as a "health services plan," rather than as an insurance company. At some point, after concluding that its status as a health services plan placed it at a competitive disadvantage compared to commercial insurance companies, the taxpayer converted to a mutual insurance company.

Some time later, the taxpayer concluded that it needed better access to equity markets, from which it was excluded because of its mutual status. It sought access primarily in response to the rapid changes in the health insurance industry that required large investments for system development and expansion. The taxpayer began exploring the possibility of demutualizing, by which it would become a stock insurance company.

Following extensive negotiations with various state authorities, the taxpayer...