A—Definition Of "Life Insurance" For Income Tax Purposes
Code §7702 defines life
insurance for federal tax purposes. This definition applies to all policies
A certain class of life insurance contracts are also considered modified endowment contracts. A modified endowment contract is defined as any contract that qualifies as life insurance under Code §7702 but fails to meet a "seven-pay test." For tax purposes, amounts received under a modified endowment contract are treated first as income and then as recovered basis. The rules applicable to modified endowment contracts are discussed below in more detail.
Cash Value Accumulation Test
Under the Cash Value Accumulation test, the cash surrender value of a life insurance policy cannot exceed, at any time, the net single premium that would be required at such time to fund the future benefits (death benefits, endowment benefits, and charges for certain additional benefits, such as disability waiver) of the policy [I.R.C. §7702(b)(1)]. The cash surrender value, for this purpose, is determined without reference to any policy loan, surrender charge, or reasonable termination benefits. The net single premium is determined by using: 1) an interest rate of 4 percent, or the rate guaranteed in the policy, nonforfeiture values if higher, 2) the mortality charges specified in the contract, if any, and 3) any other charges specified in the contract. If the contract is silent on mortality charges, the charges assumed in computing statutory reserves must be used.
Guideline Premium/Cash Value Corridor Test
The Guideline Premium/Cash Value Corridor test is really two tests combined into one overall test, both halves of which must be satisfied. The "guideline premium" half is met if the aggregate premiums paid to date under the contract do not, at any time, exceed the greater of the "guideline single premium" or the sum of the "guideline level premiums." The guideline single premium is that one-time premium which would fund the future benefits of the contract. Mortality charges are determined in the same manner described earlier, but the interest rate to be used is the greater of 6 percent annually or the rate(s) guaranteed at the inception of the contract.
The "guideline level premium" is that level annual amount which would fund the future benefits of the policy over a period lasting at least until the insured`s 95th birthday. Charges for ancillary benefits should be leveled over the period provided. Mortality charges are determined the same as above; but the interest rate is the higher of 4%percent or the policy guaranteed rate(s).
A policy will satisfy the cash value corridor half of the test if the death benefit available under the policy is at all times no less than the applicable percentage of the cash surrender value in the following table [I.R.C.§7702(d)].
40 or less 250
95 or more 100
For purposes of the above table, the insured`s age is determined as of the beginning of the contract year, not his/her birthday.
Nick Davis was 42 years old at the beginning of the contract year, and the policy on his life has a cash value of $37,000. It must have a minimum death benefit of $87,320 (236 percent of $37,000) to satisfy the cash value corridor test.
It is important to keep in mind that the cash value corridor is only one-half of the second alternative test; the guideline premium must also be met.
In implementing the preceding tests, certain assumptions are made. First, the death benefit under the contract generally is presumed to remain level. Therefore, one cannot have a contract that moves the death benefit up or down freely in order to satisfy the guideline premium test. Nevertheless, in the case of a guideline level premium, an increasing death benefit may be assumed so that the excess of the death benefit over the cash value (pure insurance) does not decrease as cash values increase. Similarly, in the cash value accumulation test, the cash surrender value must be no more than the net level reserve, determined as if level annual premiums were paid to age 95. The net level reserve then replaces the net single premium in computing the cash value accumulation test.
Under the cash value accumulation test, increases in death benefits may be taken into account for certain small policies. The policy must have an initial death benefit of $5,000 or less. It must provide for a fixed annual increase in the death benefit, not to exceed 10 percent of the initial death benefit or 8 percent of the previous year`s death benefit. Finally, it must have been purchased to cover burial expenses or in connection with pre-arranged funeral expenses.
Contracts endowing before age 95 generally cannot be treated as life insurance for tax purposes. The maturity date can be no earlier than age 95, and no later than age 100.
If a policy fails to qualify as life insurance, the income tax consequences to the policy owner for the year are computed as follows:
Increase in net surrender value
+ Cost of life insurance provided
+ Dividends received by policy owner
- Premiums paid
= Taxable income to policy owner for year
Only the pure insurance portion of a disqualified policy (death benefit minus cash value) would be eligible for the income tax exemption for death proceeds.
The cost of life insurance will be the lesser of the mortality charge specified in the contract, or the table cost under a table to be provided in IRS regulations.
Modified Endowment Contracts
In order to curb the use of life insurance as a tax-sheltered investment, particularly the use of single premium plans, Congress enacted Code §7702A as part of the Technical and Miscellaneous Revenue Act of 1988 (TAMRA). Code §7702A created a new class of life insurance contracts known as "modified endowment contracts." A modified endowment contract is any contract entered into on or after June 21, 1988, that qualifies as life insurance under Code §7702 but fails to meet a so-called "seven-pay test". Prior to TAMRA, life policies were widely marketed as tax shelter vehicles in which substantial amounts of money could be invested, earn tax-deferred interest and afford tax-free withdrawal privileges by means of nontaxable policy loans. Code §7702A discourages the use of life insurance as a tax shelter by treating distributions from modified endowment contracts as income first, and then as recovered cost.
Modified Endowment Contracts Defined
A modified endowment contract is defined as any life insurance contract entered into on or after June 21, 1988, that meets the life insurance requirements of Code §7702, but which fails to meet a special seven-pay test or is received in exchange for a modified endowment contract [I.R.C. §7702A(a)].
A life insurance contract that fails to meet the seven-pay test will be classified as a modified endowment contract. The seven-pay test is not met if the accumulated amount paid at any time during the first seven years is more than the total of the net level premiums that would normally have been paid on or before such time if the contract provided for paid-up future benefits after payment of seven level annual premiums [I.R.C.§7702A(b)].
The net level premiums under the seven-pay test are determined by applying the computational rules used to determine the net single premium under the cash value accumulation test [I.R.C. §7702A(c)]. The death benefit, however, is deemed to be provided until the maturity date without regard to any scheduled reduction after the first seven contract years [I.R.C. §7702A(c)(1)(b)].
For purposes of the seven-pay test, "amounts paid" means the premiums paid under the contract reduced by any distributions but not including amounts includable in gross income [I.R.C. §7702A(e)]. Amounts paid as premiums that are returned to the policyholder with interest within 60 days after the end of the contract year reduce the sum of premiums paid under the contract [I.R.C. §7702A(e)]. However, the interest paid with the returned premium must be included in the gross income of the recipient. The receipt of any amount as a loan or the repayment of a loan is not to be taken into account in determining the amount paid under a contract. [Conference Committee Report on The Treatment of Single Premium and Other Investment-Oriented Life Insurance Contracts, from the Technical and Miscellaneous Revenue Act of 1988.]
It should be noted that any contract that is materially changed is considered to be a new contract that is subject to the seven-pay test as of the date that the material change takes effect [I.R.C. §7702A(c)(3)(A)]
The intent of Congress in creating the seven-pay test is clear. If the contract provides an incentive for earnings comparable to other types of investment, even though life insurance is present in substantial amounts, the contract owner must forego the traditional advantages of policy loans as a tax-free method of withdrawal.
If there is a "material change" in the benefits or terms under a life insurance contract, then the policy is treated as a new contract as of the day the material change takes effect [I.R.C. §7702A(c)(3)(A)]. In addition, the amended contract must re-qualify under the seven-pay test [I.R.C. §7702A(c)(3)(A)]. However, a life insurance contract that is modified after December 31, 1990 because of the insurer`s financial insolvency will not cause a new seven-year period to begin for purposes of the seven-pay test.
A material change includes any increase in the death benefit under the contract or any increase in, or addition of, a qualified additional benefit (but not any decrease) [I.R.C. §7702A(c)(3)(B)]. There are two exceptions to this rule. First, any increase in a future benefit due to the payment of premiums necessary to fund the lowest death benefit payable in the first seven contract years or due to the crediting of interest or other earnings is not a material change. Second, to the extent provided by regulations, a cost-of-living increase paid over the remaining life of the contract and based on an established broad-based index is not a material change [I.R.C. §7702A(c)(3)(B)].
In the case of a contract that is materially changed, the seven-pay premium for each of the first seven contract years after the change is reduced by the cash surrender value of the contract as of the date of the material change multiplied by the following fraction: the numerator is the seven-pay premium for the future benefits under the contract and the denominator equals the net single premium for future benefits under the contract [Conference Committee Report on The Treatment of Single Premium and Other Investment-Oriented Life Insurance Contracts, from the Technical and Miscellaneous Revenue Act of 1988].
Tax Treatment Of Modified Endowment Contracts
Modified endowment contracts receive different treatment for federal tax purposes than regular life insurance. If a contract is a modified endowment contract:
Exemptions From The Modified Endowment Contract Rules
There are two types of distributions from modified endowment contracts that are exempt from the harsh "income-first" rule. These are:
Ten-Percent Additional Tax
Any amount received under a modified endowment contract that is includable in gross income, is subject to an additional 10 percent tax [I.R.C. §72(v)]. This means that amounts received from a modified endowment contract are taxed twice--once at the taxpayer`s normal rate and again through a 10 percent additional tax. The 10 percent tax, however, does not apply if a distribution is made (a) to a policy owner who has reached the age of 59 1/2, (b) to a policy owner as a result of his or her disability, or (c ) as part of a life annuitization arrangement [I.R.C. §72(v)(2)].
Effective Date Of Modified Endowment Contract Rules
With certain limited exceptions, all life insurance contracts entered into, or materially changed, on or after June 21, 1988 must comply with Code §7702A and the seven-pay test. Contracts entered into before June 21, 1988 are considered "grandfathered" and are generally not subject to the seven-pay test [TAMRA §5012(e)].
For purposes of
determining whether a contract was entered into on or after June 21, 1988, if
the death benefit payable on October 20, 1988, increases by more than $150,000,
the material change rules apply (see "Material Changes" above) from
the date the benefit exceeds the threshold. As a result the contract may lose
its grandfathered status. This $150,000 rule does not apply, however, if as of
June 21, 1988, the contract required at least seven level annual premium
payments and the policyholder continues to make level annual premium payments
over the life of the policy [Technical and Miscellaneous Revenue Act of 1988, §
5012(e)]. To determine whether the death benefit increase constitutes a
material change, the death benefit, payable as of
The modified endowment contract rules also govern a contract entered into before June 21, 1988, if: (1) the death benefit under the contract is increased (or a qualified additional benefit is increased or added) on or after June 21, 1988 and (2) the owner of the contract did not have a unilateral right to obtain the increase without providing additional evidence of insurability before June 21, 1988. In addition, a term contract will lose its grandfathered status if the contract is converted after June 20, 1988 to life insurance providing coverage other than term insurance [TAMRA §5012(e)].
The Effect Of Code §1035 Policy Exchanges
Contracts entered into
Congress also provided a limited period of time during which policies that passed the seven-pay test could be exchanged for modified endowment contracts, and not be treated as modified endowment contracts after the exchange. Under this provision, if a modified endowment contract that required the payment of at least seven annual level premiums was entered into after June 20, 1988, but before November 10, 1988 (the date TAMRA was enacted), and was then exchanged within three months following November 10, 1988 for a contract that satisfied the requirements of the seven-pay test, the new contract would not be treated as a modified endowment contract if the taxpayer recognized gain on the exchange.
Limited Role For Modified Endowment Contracts In Financial Planning
Most of the tax benefits of single-premium life insurance vanished with the creation of the modified endowment contract (MEC) taxation regime under the Code. Although loans are no longer available on a tax-free basis, a modified endowment contract can offer a tax-free buildup for accumulating cash value, and death benefits remain free of income tax.
Insurance Company Requests For Waivers Of Disqualification Of Life Insurance Contracts From Tax Treatment As Life Insurance Under §7702
Internal Revenue Code (I.R.C.) §7702 sets forth certain technical requirements which a life insurance policy must meet in order for it to be classified as a life insurance contract, and entitled to tax treatment as such, for federal tax purposes. Thus, a contract must qualify as a life insurance contract under applicable state law and must also meet either of two alternative tests (generally intended to prevent the use of insurance policies as vehicles primarily for the tax-free accumulation of excessive investment income): (1) the cash value accumulation test of §7702(a)(1), or (2) the guideline premium and cash value corridor tests of §7702(a)(2)(A) and (B). These rules apply with respect to insurance contracts issued subsequent to 1984.
With respect to contracts issued before January 1, 1985, I.R.C. §101(f) applies, and this section excludes from gross income any amount paid by reason of the death of the insured under a life insurance contract described as a flexible premium contract only if the contract satisfies either (1) the guideline premium limitation and the applicable percentage limitation of section 101(f)(1)(A)(i) and (ii), or (2) the cash value test of section 101(f)(1)(B).
The rules applicable to post-1984 contracts and to pre-1985 contracts, although technically different, have a common theme of assuring that the premiums paid into a flexible premium contract are not excessive in relation to the value of the death benefit (the assumption being that the excess is intended primarily for tax-free investment within the policy).
Potential Adverse Consequences Of Failure To Qualify As An Insurance Contract
The consequences of failure of a contract to meet the applicable requirements of the foregoing Code sections can be quite severe, as follows:
Fortunately, the policy death benefit remains tax-free. See I.R.C. §7702(g)(2).
Potential IRS Waiver Of Technical Failures In Meeting The Statutory Requirements
Recognizing the severity of the consequences to insurance policy holders in the event that their insurance contracts are determined not to meet these statutory requirements, the Code provides for potential IRS waiver of the requirements in circumstance where the failure was merely technical in nature, caused by inadvertence, clerical error or other excusable unintended cause. Thus, under I.R.C. §§101(f)(3)(H) and 7702(f)(8), the Secretary of the Treasury (through delegates at the IRS) may waive a failure to satisfy the requirements of §101(f) or §7702. Such a waiver may be granted, upon application, if the applicant can satisfactorily establish that (A) the failure to satisfy the statutory requirements for any contract year was "due to reasonable error," and (B) "reasonable steps are being taken to remedy the error." §7702(f)(8). This latter requirement of remedying the error has been interpreted by IRS as including both (a) arranging for the specific non-complying contracts to be brought into compliance (generally, through refunding excess premium amounts or increasing the death benefit), and (b) taking steps to assure that similar incidents of non-compliance will not likely occur in the future.
Applying For A Waiver
If an insurer has discovered that there was a violation of the §7702 or §101(f) technical requirements, and the circumstances were such that it can be shown to have been due to reasonable error, a formal waiver request should be prepared and submitted to IRS. In connection with such waiver request, it will be necessary (if not already done) to develop a plan for steps to be taken to change the company`s systems and/or procedures to prevent such violations in the future. It will also be necessary to develop a plan for bringing all of the non-complying contracts into compliance within a stated period of time after issuance of the IRS waiver. (This is ordinarily accomplished through refunds of the applicable excess premium with interest to the date of refund, or upward adjustment in the policy death benefit, or a combination of the two.) Most of the waivers granted in past private letter rulings allow 90 days from the date of the waiver to complete the correction process, but in some cases 30 or 60 day periods are stated. If a longer period is needed this would probably be a subject of negotiation with the IRS.
Such remedial plans can be developed with implementation contingent upon the issuance of the waiver, which would seem to be the prudent course, since these plans can presumably be altered or fine-tuned prior to implementation if necessary to satisfy IRS in connection with the waiver application.
The waiver application submission would have to provide considerable factual detail as to what happened and why (including the number of contracts involved), presented in a manner so as to show that the violation or violations were due to reasonable error.
Waiver Qualification Factors, Based Upon Survey Of Prior IRS Waiver Actions
The IRS has published its decisions on numerous waiver applications since 1991 in private letter rulings. A survey of these rulings gives valuable insight into the types of §7702/§101(f) violations which have been considered for waiver by IRS in the past, and the factors deemed relevant in determining the reasonableness of the errors and the corrective actions taken or proposed. Below is a summary of the relevant facts and "reasonableness" factors critical to the granting or denial of the waiver in most of these rulings.
It should be noted that in only one case (PLR 9202008) was a waiver denied, and even in that case the waiver was granted with respect to 9 of the 21 contracts involved). In the case of the denial, the company was utilizing a purchased software program for testing guideline premium compliance which failed to include as premiums paid, large single deposits or exchange proceeds—an apparently inexcusable shortcoming in the system.
Most of the rulings involve situations of clerical mistakes or inaction caused by "inadvertent human error." However, even in situations where employees knowingly took actions inconsistent with established systems and procedures, the resulting non-compliance was held to have been "reasonable error." In most such instances the rulings point out that the company actually had in place a system or an established procedure which, if properly followed, would not have resulted in a compliance failure. Thus, the existence of proper systems and procedures is deemed more significant than isolated failures of employees to follow them, whether or not intentional. See, for example, PLR 9601039 discussed below, in which employees sometimes accepted and credited premiums which exceeded guideline limitations, in circumstances where this could only be done by manually disabling the computer system feature which automatically tested for compliance upon entry of each premium deposit. This was characterized as "reasonable error" in the granting of the waiver.
With the foregoing information and the abstracts of past private rulings which follow, the insurer should be in a position to evaluate the situation with knowledge of the factors involved.
Survey Of IRS Private Letter Rulings On Insurance Company Requests For Waivers
The following is a listing of previously issued IRS private letter rulings (PLRs) in response to requests from insurance companies for waivers of technical violations of the statutory tests for qualification of flexible premium policies as insurance under I.R.C. §§101(f) and 7702. Each ruling is abstracted to summarize the facts which led to the violation(s), and the remedial steps taken or to be taken. The waiver was fully granted in all of the rulings discussed below except one, PLR 9202008, discussed last in the following list.
The following were all held to have been clerical errors resulting from inadvertent human error, at a time when there was no overall computer system:
1. 1. the face amount was decreased;
2. 2. a change occurred between the initial compliance testing and the issuance of the policy;
3. 3. a qualified additional benefit was removed after issuance;
4. 4. a change in underwriting took place after issuance of the policy;
5. 5. there was a change of the insured party.
The following types of compliance failures occurred under company`s computerized system:
· In a single case, the computer twice rejected an attempted premium payment which the computer determined would violate §7702 guidelines. Nonetheless, "due to human error, the person investigating the rejection overrode the system so that the premium payment was accepted."
The ruling involves the following three types of errors (involving a total of five contracts)
The following is a published letter ruling in which a waiver was denied: