Many insurance companies formerly organized as "mutual" companies (i.e., companies owned solely by their policy holders) are converting to regular stock-issuing corporations. As a result, the owners of insurance policies issued by these companies will be entitled to receive stock in the reorganized companies. Many of you have already been notified that your insurance company is "demutualizing." We expect the demutualization trend to accelerate as a result of recently enacted federal legislation.
When an insurance company demutualizes, policy owners are given the option of receiving stock in the reorganized insurance company, receiving cash in lieu of stock, or receiving certain policy enhancements. The policy owner's interest in the company is deemed to have an income tax basis of zero, so that the election of the cash option or, in the case of the stock election, the subsequent sale of the insurance company's stock, will result in a capital gain of 100% of the proceeds received.
Consequences to Life Insurance Trusts
Demutualization creates some special problems for trustees of life insurance trusts that own policies issued by demutualizing companies. Since the insurance trust owns the policy, the trust (not the insured) will receive the stock or cash granted in the demutualization. This does not result in any additional deemed gift to the trust, so no "Crummey" withdrawal notices need be issued to the trust beneficiaries as a result. It does, however, require the trustee of the trust to make some careful decisions about whether to accept cash or stock and, if the stock alternative is selected, what to thereafter do with the stock.
Tax Impact
Most life insurance trusts are "grantor trusts" for income tax purposes. This means that any income or gain recognized by the trust is taxable to the trust's creator (usually this is the insured) on his or her personal income tax return. Thus, in many cases, the election of the cash option or, in the case of a stock election, the subsequent sale of the insurance company's stock by the trustee, will result in a capital gain personally taxable to the trust's grantor. Nevertheless, in some cases, the trust may not entirely be a grantor trust; all or a portion of the gain may be taxable to the trust or even to the trust's beneficiaries. A conclusion as to the tax consequences requires a review of the trust document in light of the amount of insurance premiums that are or may be payable by the trust.
Should a Distribution be Made to the Trust's Beneficiaries?
In most cases, the stock or cash received in a demutualization will become trust principal (as opposed to trust income). If the trust document permits principal distributions during the lifetime of an insured, the stock or cash may be distributed to trust beneficiaries. The trust agreement must be carefully reviewed to determine the options that are available with respect to principal distributions. The trustee may also decide to keep the stock or cash within the trust to be applied to future premiums or to provide income to pay future premiums.
Trustee's Duty to Diversify Trust Assets
If the trustee elects to receive stock, the trustee may still be under a duty to sell all or a part of it in order to prudently diversify the trust's investments. In some instances, the trustee may be absolved of this responsibility in the trust document, or the beneficiaries of the trust may be able to adequately waive this diversification requirement. Again, the trust document needs to be reviewed in light of state law in order to determine the extent of the trustee's obligation to diversify.
Conclusion
Insurance company demutualization creates special issues for trustees of insurance trusts. In order to resolve these issues thoughtfully, the trust document, as well as the various tax consequences, should be reviewed and considered. Other factors, such as the existence of other trust assets, the anticipated future premiums payable on the policy, and the circumstances and needs of the trust beneficiaries, may also be relevant. The issues presented by demutualization are unique, and trustees will need guidance in deciding what, if any, actions to take.
