Modified Endowment Contracts and the 7-Pay Test

Commentary May 01, 2017 at 06:50 AM

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The term modified endowment contract, or MEC, has been around for almost 30 years, yet it continues to confuse and "mystify" policy owners and agents alike. Since qualification as a MEC results in last-in first-out tax treatment and a potential 10% additional tax on distributions, agents need to understand its features and possible consequences. What is it? How can it affect a life insurance policy? Can a policy be "fixed" if it becomes a MEC?

To understand the concept, we need to go back before November 10, 1988 when President Ronald Reagan signed the Technical and Miscellaneous Revenue Act of 1988, or TAMRA, into law, and examine the effects of TEFRA and DEFRA.

TEFRA and DEFRA

In the early 1980s, policy owners of flexible premium life insurance policies could make substantial premium payments to contracts that would purchase a very small amount of death benefit. The result was that these life insurance policies morphed from instruments designed to provide death benefits to tax-free investment vehicles. Congress showed its concern by passing the Tax Equity and Fiscal Responsibility Acts of 1982, or TEFRA. The new law established two tests that all flexible premium policies must satisfy in order to qualify as life insurance and thereby retain tax-deferred cash value build-up. Those tests required:

The cash surrender value policy could not exceed a net single premium. (This test limits the amount that can be paid into a single premium life insurance policy in its first year.)
The death benefit had to represent a certain percentage of the cash value, which declined as the policyholder got older (a cash value corridor test).

Two years later the Deficit Reduction Act of 1984, provided a statutory definition of life insurance. DEFRA applies to all cash value life insurance policies, not just flexible premium policies. A life insurance contract issued after 1984 can qualify as a life insurance contract only by meeting the requirements of one (or both) of the following two tests:

The Guideline Premium Test is actually two tests: the Guideline Single Premium and Guideline Annual Premium tests limit the amount of premium that can be paid into a life insurance policy over the life of the contract and still qualify as a tax-favored life insurance policy. The total amount of the premiums paid into the contract cannot exceed the greater of the GSP, or the cumulative GAP.
Compliance with the Cash Value Accumulation Test requires a life insurance policy's death benefit to increase when too much cash value accumulates relative to the amount of insurance for which the insurance company is at risk. This is also known as the Cash Value Corridor Test.

If a policy fails to satisfy the TEFRA or the DEFRA tests, the contract is not considered a life insurance contract. By extension, the resulting contract cannot be considered a MEC because a MEC is, by definition, a life insurance contract. Additionally, if TEFRA and/or DEFRA are violated because the policy is no longer considered a life insurance policy, the contract's total accumulated gain will be taxed as ordinary income in the year of violation and any subsequent gains will be similarly taxed each year thereafter.

TAMRA

The Technical and Miscellaneous Revenue Act of 1988, or TAMRA, defines a special class of life insurance policies for tax purposes, and indicate different treatment of distributions from those policies: the "modified endowment" policy, or MEC.

A "modified endowment" policy is a life insurance policy that has failed a "7-pay test." The result is that all loans and cash withdrawals are taxed using the last-in first-out, or LIFO, accounting method. The 7-pay test must be passed every year. Once the test is failed, modified endowment treatment applies for the remaining life of the contract. Reformation of the policy is not possible.

Historically, life insurance withdrawals (with the exception of certain withdrawals during a policy's first 15 years), were taxed on a first-in first-out, or FIFO, basis, which meant that all premiums paid into the contract were returned free of tax before any income was recognized. Likewise, policy loans were free of tax unless the contract was surrendered. In order to take advantage of that situation, some life insurance companies aggressively marketed cash rich policies (notably single-premium whole life), which qualified as life insurance with a fairly thin veneer of risk over the underlying investment.

These policies had a very low net cost to borrow (sometimes no cost at all). The "insured" was able to access his or her interest earnings continuously through borrowing and never pay any taxes. When the insured died, the life insurance would pay off the loan and a small amount would be paid to the policy beneficiary, again with no tax (Internal Revenue Code Section 101). Congress perceived this technique as inappropriate since it appeared to be unfair relative to the treatment received by alternative investments, the actual life insurance coverage was minimal, and that the failure to tax such a transaction was harmful to the public revenue.

(Related: 5 FAQs About Adjustable Life Insurance)

Congress set about correcting this by augmenting Section 72 and adding Section 7702A to the Internal Revenue Code. IRC Section 72 is the section that taxes non-annuitized distributions from life insurance contracts. In essence, the amendment to this section requires LIFO taxation on distributions from modified endowment contracts. The augmented Section 72 also includes a 10% additional tax on distributions from a modified endowment except when the taxpayer is over age 59 1/2, is disabled or the distribution is in the form of a life annuity.

IRC Section 7702A defines the term "modified endowment," which identifies the computation involved in the 7-pay test, and denotes certain "material changes."

The section also includes some definitions and rules pertaining to small policies and refunds. Section 7702A is complex. It was written with traditional whole life insurance in mind. It's also apparent that the section was written by individuals who have little appreciation of the problems taxpayers face in applying the obtuse writing style of the Internal Revenue Code to practical everyday problems. (At the time a House Ways and Means Committee staff person stated that "a number of the things we find troubling about the statute were just not given any thought during the drafting process.")

The definition

A modified endowment contract means any contract meeting the requirements of Section 7702 that was entered into on or after June 21, 1988 and fails to meet the 7-pay test, or a policy that was received in exchange for another modified endowment contract, (See IRC Section 7702A(a)).

Let's examine the parts of the definition:

Meets the requirements of Section 7702: Section 7702 defines life insurance contracts. DEFRA '84 supplied a series of tests that one could use to determine whether a policy was a life insurance contract. Although the DEFRA and TAMRA tests refer to similar calculations, the important thing to remember is that they are different tests with different results and penalties, and operate independently of each other. It is quite possible to pass one test and fail the other.
Entered into on or after June 21, 1988: We have already identified situations that will break the grandfathering of policies issued before this date.
Fails to meet the 7-pay test: To perform the 7-pay test one needs to refer to a set of rates that would pay up the policy at either the greater of 4%, or the rate guaranteed in the contract, assuming a reasonable mortality assumption and no expenses. Given the perception that one or more insurance companies were using some unusual expense charges in certain years to attempt to beat the tax system, this provision penalizes the entire industry by denying any expense assumption, reasonable or otherwise. Remember that the rates will vary from company to company and from product to product within a company depending on the guaranteed interest rate and mortality assumed for the product. We believe that amounts deposited into a policy that are in excess of these rates would cause a violation of the 7-pay test. The rates should be used as follows:

RATE * FACE * DURATION

For example, Tom Sisney, a 45-year old male nonsmoker, wants to purchase a $1 million policy and pay a premium that does not violate the 7-year test since he wishes to make withdrawals to help finance his child's education in ten years.

We have identified the maximum rate as $41.016 per thousand. Since we know that the face amount is $1 million, and we are interested in the first policy year, a.k.a. "Duration One," the 7-pay test premium is calculated as follows ($41.016 * 1000 * 1 = $41,016); $41,016 is the maximum amount Tom can deposit in the policy this year.

Policy Year	Cumulative Modified Endowment Limit	Annual Paid Premium	Cumulative Annual Paid Premium

1	$41,016	$25,000	$25,000
2	$82,032	$25,000	$50,000
3	$123,048	$25,000	$75,000
4	$164,064	$50,000	$125,000
5	$205,080	$50,000	$175,000
6	$246,096	$50,000	$225,000
7	$287,112	$50,000	$275,000

This is not a problem for Tom since he can only afford to deposit $25,000 per year for the next three years anyway.

Tom expects a distribution from a trust in three years, which would allow him to make $50,000 deposits beginning in Year 4. He wants to know if he can catch up in later years. The answer is "Yes." The table above shows Tom's maximum allowable cumulative premium (cumulative modified endowment Limit), proposed annual premium and sum of annual paid premiums.

As you can see, Tom's policy never becomes a MEC since the policy's premiums never exceed the allowable cumulative premium for a given year. In order to pass the 7-pay test, Tom must never exceed the cumulative allowable premium during the seven-year period.

The lowest face amount during the first seven-year period (in this case, $1 million) determines the 7-pay test premium. This also applies to any other seven-year period initiated by a material change. Face amount reductions during a seven-year period are deemed retroactive to the start of the period. For instance, if a 45-year old male non-smoker purchased $1M policy, his 7-pay test premium would be $41,016. If he paid $30,000 per year for five years, he would pass the test. If he reduced his face amount to $500,000 during year five, his policy is treated as if the face amount had been $500K from issue. Since the test premium for $500K would have been $20,508 per year ($1,002,540 cumulative), he has failed the test since he paid in $1.5 million in total premium. Face amount reductions outside a given seven-year period are not taken into account. [Case studies are based on real life applications of the strategy presented, however client names, specific circumstances, and financial information have been changed to protect privacy.]

Or received in exchange for a MEC: As stated above, once a contract is a MEC, it retains the distinction forever. This carries through a Section 1035 exchange. Of course, a common surrender where the owner recognizes gain followed by the purchase of a new policy would not retain the MEC characteristics in the new contract.

The modified endowment provision also covers a number of items of lesser importance that we shall not attempt to explain but just mention in passing:

Mortality charges must be reasonable:

Policies of less than $10,000 face amount get to add an extra $75 expense charge to the premium payable (not a "per policy" basis, but a "per owner" basis.)
Premiums paid more often than annually may get to add a "collection charge."
Rules are stated relative to the reinstatement of lapses during the first seven years.
Amounts paid from the contract, which are not taken into income, may not be treated as additional basis.

The Penalty

Distributions from modified endowment contracts will be taxed based on the LIFO method of accounting. This simply means that interest income will be recognized first and the recovery of premiums paid (basis) will occur last. The policy cash value will need to drop below basis before any money can be removed free of tax.

The foregoing brings to mind some situations where modified endowment treatment is not important.

The client wishes to pay up the contract with a premium larger than the test premium and he knows that he will never take a withdrawal or loan from the policy.
The client wishes to take advantage of the deferred taxation on the interest growth on his excess premium payments that is available within a life insurance policy. Even where the interest growth is taxed earlier than before, life insurance may still outperform the alternatives.

Distributions from modified endowments will suffer an additional 10% tax unless the taxpayer is over age 59-1/2, disabled or the distribution is taken as a life annuity. Since the taxpayer in question is the owner (not necessarily the insured), you may wish to let him or her know that the 10% additional tax exists since companies do not keep a record of the owner's age.

A number of transactions are treated as distributions:

Assignments: If a modified endowment contract happens to be assigned for value, the lesser of the assignment value or the gain in the contract is taxable to the owner as ordinary income. (Think, for instance, of a loan regime split dollar agreement.)

Since premium dinancing cases often require an assignment of a portion of the life insurance policy to the funder as part of the security for the repayment of the loan, any cash value growth that is in excess of premiums paid will be treated as taxable income annually and taxed at ordinary rates. A 10% penalty tax is also imposed if the insured is under age 59-1/2. This tax liability exists whether or not an IRS Form 1099 reports the income.

Assignments that are for purely the purpose of covering prepaid funeral or burial expenses are not be treated as distributions. Many assume that the collateral assignment involved in a split-dollar case would not be a distribution since IRS already has a method of taxing that transaction.

Dividends or similar distributions: An amount received as a cash dividend, surrender or withdrawal would be an amount received. However, a dividend or "similar distribution" that is retained by the insurer as a premium is not an amount received. We believe that the definition of "similar distribution" is broad enough to include the surrender of paid-up additions to pay premium. Dividends surrendered to pay on loans or interest should be treated as amounts received and as additional basis since they are taxed.
Loans: Loans from a modified endowment are treated as amounts received. Under prior law, loans were not considered income at all since the owner was required to repay the loan at some time. Loans retained by the insurer to pay premiums do not receive the preferential treatment accorded to dividends used for the same purpose. They are taxed as amounts received and added to the basis in the contract.

Insurance companies have an obligation — imposed by IRS regulation — to report certain distributions from its policies to policy owners. Companies often produce a IRS Form 1099R in each situation where it is believed that the owner will have taxable income as a result of a distribution.

Material Changes

Perhaps the most confusing and troublesome aspect is the material change rule. One might assume that once a policy's 7-pay test premium was established, that the owner could pay that premium for the life of the contract. Nothing could be further from the truth. Material changes in the contract will trigger a re-calculation of the 7-pay test premium based on the insured's attained age(s) and the new face amount. The resulting premium must be further reduced to take the policy's existing cash value into account. Except in cases of scheduled increases, it seems that whenever a policy has a paid-up value greater than the lowest death benefit during the first seven years, a material change is the result.

Let's look at the definition of a material change. A material change includes any increase in the future benefits provided under a life insurance contract with two exceptions.

The exceptions are:

Benefit increases as a result of premium payments necessary to fund the lowest death benefit in the first seven years.
The crediting of interest or other earnings (including policyholder dividends) with respect to such premiums.

In order to determine whether an increase in death benefit is triggered as a result of the payment of a premium not necessary to fund the lowest death benefit in the first seven years, we can simply look at the guaranteed paid-up column on a proposal, so long as there is a level scheduled death benefit. If the paid-up column shows a value larger than the lowest death benefit during the first seven years, then we have a material change. The actual calculation compares the net single premium for the given policy year which would pay up the lowest death benefit during the first seven years against a "deemed cash value." The definition of deemed cash value takes into account the guaranteed interest, mortality and expense charges. In short, the deemed cash value incorporates substantially the same factors that go into determining our guaranteed cash values. At the point where the guaranteed cash value exceeds the net single premium for the lowest face amount during the first seven years, the guaranteed paid-up face amount would increase and exhibit a material change.

After a material change is determined, a premium input test is performed to determine the allowable premium for the year of the material change. If a premium larger than the test premium is deposited into the contract, a MEC results. The multi-step calculation works like this:

Determine the 7-pay test premium using the attained age and face amount.
Reduce that number by the following calculation:

Current cash value * ((7-pay test premium) / (net single premium))

In short, the same additional dollar that would produce a material change would also violate the allowable premium test and produce a MEC. To avoid MEC status, a policy that is in a guaranteed paid up status should not accept more premium.

Scheduled increases in death benefit are also material changes. We believe that material changes can occur any time after the first year and that the second policy year should be tested for allowable premium.

In cases where the scheduled increase is relatively large, the premium for the new face amount can grow faster than the cash value offset calculation. This is because the new net single premium for the increased face is growing faster than the actual cash value growth, at least in the early years.

Where a Section 1035 exchange causes a material change, the same adjustment to the attained age 7-pay test premium needs be performed. The amount of cash value transferred is the "current cash value" for purposes of the calculation. The adjusted 7-pay test premium is then compared to the new scheduled premium. The transferred cash value is not counted as new premium.

Fixing a Modified Endowment Contract

On May 18, 1999, the IRS issued Revenue Procedure 1999-27 which provided procedures that an issuer could use to remedy an inadvertent non-egregious modified endowment contract. Since that time the IRS has promulgated revenue procedures 2001-42, 2007-19, and 2008-39 to better and further refine the procedures.

(Related: IRS Updates Life and Annuity Rules)

In recognition of the fact that the MEC rules are complex and difficult to interpret, this revenue procedure was designed to allow insurers to correct situations where a MEC was issued both inadvertently and non-egregiously where the resulting correction is a non-MEC policy. Supposing that the erroneous policy issue was truly both inadvertent and non-egregious, the insurer may cure the problem and pay a 'toll charge' tax on any earnings recognized on excess premiums paid. In addition, the policyholder must recognize the interest component of any resulting distribution and pay tax and a penalty on that income.

A way that the policyholder can repair MEC status requires an intermediate step: The modified endowment contract is exchanged for an annuity via 1035 exchange. As with most non-qualified annuities, distributions from the annuity will be subject to income taxes and the after-tax values can be used to pay the premiums on a new non-MEC policy.

What Types Of Sales Are Affected?

The most typical type of sale affected by a MEC policy status is the single-premium sale — often, grandparents or relatives establishing a life insurance policy where the intention is to use the life insurance policy's cash values to help pay for a child's future education.

By definition, any single premium typically creates a modified endowment contract. In instances when a life insurance company's illustration software allows one to solve for a non-MEC death benefit for a single premium, the solved-for death benefit is so large that, even if issued, the resulting policy usually lapses in a short time under its own "weight."

We should also recognize that there are instances where employing a MEC is really inconsequential. When life insurance policies are sold for the primary purpose of providing death benefits — policies owned by and used to leverage trust assets — it really doesn't matter whether the policy is a MEC or not. In fact, many trustees actually tend to prefer this arrangement since it requires less annual reporting.

Conclusion

Congress intended to stop the use of single-pay life as a tax shelter investment and accomplished that goal. Even so, a great deal of flexibility is available for premium input without violating the 7-pay test. If the maximum allowable premium is deposited, substantial withdrawals may still be available on a FIFO basis.

If you have tested the premium on a policy illustration and it is a modified endowment, a few options are available:

Ask yourself whether modified endowment status is an issue. Does the client ever expect to get money from the policy? Does life insurance still beat the other options even if it suffers FIFO taxation?
Raise the face amount or lower the premium.
Try a scheduled face amount increase. This option may allow more premium if the increase is above five percent.
Use a premium deposit account. Some carriers can hold amounts paid in excess of the 7-pay test premium in an account separate from the policy. These excess amounts would then be applied to the policy in later years. Of course, interest earnings in a discounted premium account are taxable as earned.

Although the sales of some types of policies have been and continue to be impaired, the law has not proven to be as detrimental to life insurance sales as when first proposed. Many times, if the policy owner plans to access policy cash values in the future, a MEC result can be avoided by careful and thorough planning. In other situations, as when a policy is bought strictly to provide a death benefit, a MEC status doesn't matter.

— Read The MEC's Last Stand on ThinkAdvisor.

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