65 / What is a “life insurance contract” for purposes of the death benefit exclusion for contracts issued after December 31, 1984?

Under IRC Section 7702, for death proceeds of a life insurance contract (including an endowment contract) issued after December 31, 1984, to be fully excludable from the beneficiary’s gross income, the contract generally must be a life insurance contract under applicable state (or applicable local foreign) law and must meet one of two alternative tests: the cash value accumulation test ( Q 66) or the guideline premium and corridor test ( Q 67).¹ Any plan or arrangement provided by a church or a convention or association of churches to its employees or their beneficiaries that provides for the payment of a death benefit is not required to meet the requirement that the arrangement constitute a life insurance contract under applicable law.²

The IRS may waive an insurer’s failure to satisfy the requirements of IRC Section 7702(a) if the errors were reasonable and reasonable steps to remedy the errors have been taken.³ For example, when six life insurance policies were temporarily out of compliance with the guideline premium test requirements due to the inadvertence of the insurer’s employees during a change in computer systems, the IRS granted such a waiver after the insurer increased the policy death benefits.⁴ When a combination of clerical errors (including lost records, missed testing dates, and the failure to make scheduled premium adjustments) and the conversion of the insurance company’s policy administration system from a manual procedure to a fully computerized one caused policies to be out of compliance, the IRS granted a waiver, but required that the policies be brought into compliance within 90 days.⁵ When a clerk failed to realize that a certificate holder had paid in additional premiums that put a group universal life certificate out of compliance, the IRS granted a waiver provided that the company refund the excess premiums, with interest, or increase the policy death benefit from the time of noncompliance.⁶ The IRS refused to waive an insurer’s failure to satisfy these requirements, however, when several policies were discovered to be out of compliance due to the company’s use of a software program that contained an “inherent structural flaw.”⁷

Modification of a life insurance contract after December 31, 1990 that is necessitated by the insurer’s insolvency will not affect the date on which the contract was issued, entered into, or purchased for purposes of IRC Section 7702.⁸