68 / What is a “life insurance contract” for purposes of the death benefit exclusion for policies issued before January 1, 1985?

A policy issued before January 1, 1985 that is exchanged for one issued after December 31, 1984 will be treated as a contract issued after 1984 and subject to the definitional requirements of IRC Section 7702 discussed in Q 65, according to the General Explanation of the Deficit Reduction Act of 1984 (the General Explanation). The General Explanation states that a change in policy terms after December 31, 1984, could be considered an exchange that would bring the policy under the IRC Section 7702 definitional requirements. Examples of “changes in terms” are changes in “amount or pattern of death benefit, the premium pattern, the rate or rates guaranteed on issuance of the contract, or mortality and expense charges.”¹ A change in minor administrative provisions or a loan rate change generally would not be considered to result in an exchange, the General Explanation adds. Modification of a life insurance contract after December 31, 1990 that is made necessary 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 101(f).²

Otherwise, universal life insurance and any other flexible premium contract, issued before January 1, 1985, qualify for the death proceeds exclusion only if (1) the sum of the premiums does not exceed at any time a guideline premium and the death benefit is not less than a certain percentage of the cash value (140 percent until the start of the policy year the insured attains age 40, thereafter reducing 1 percent for each year over 40, but not below 105 percent) or (2) the contract provides that the cash value may not at any time exceed the net single premium for the death benefit at that time.

The guideline premium is the greater of (1) the single premium necessary to fund future benefits under the contract based on the maximum mortality rates and other charges fixed in the contract and the minimum interest rate guaranteed in the contract at issue, but at least 6 percent, or (2) the aggregate level annual amounts payable over the life of the contract (at least 20 years but not extending beyond age 95, if earlier) computed in the same manner as the single premium guideline (using an annual effective rate of 4 percent instead of 6 percent). The IRS can allow excessive premiums paid in error to be returned (with interest) within 60 days after the end of the policy year; in such case, the policy will still qualify as life insurance.³