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Taxation and Business Uses of Insurance - MECs and Transferring For Value

MODIFIED ENDOWMENT CONTRACTS (MECS)

Definition

A life insurance policy where the amount a policy owner pays during the first years exceeds the sum of net level premiums that would have been payable to provide paid-up future benefits in seven years (7- pay test). Also, keep in mind that once a policy becomes a modified endowment contract it can never go back, it will ALWAYS remain a MEC.

For a producer who sells life insurance and for the customer who purchases life insurance, the significance is the way a life policy, if it is deemed a MEC, will be taxed. In the past, life insurance has been granted very favorable tax treatment. However, for those policies that do not meet the specific test, it is the policy owner who pays.

If a policy is deemed a MEC and the policyowner receives any amount from it in the form of a loan or withdrawal, that amount will be taxed first as ordinary income and second as return of premium. There may also be a 10% penalty assuming the policyowner has not obtained age 59½.

TRANSFER FOR VALUE
If a policy is transferred for "valuable consideration" (sold to another party) and the insured deceases, the person who now owns the policy will be taxed on the excess of the proceeds less consideration paid. There are several important exceptions to the transfer for value rule. The transfer for value rule may not apply if--

  • The basis of the policy in the hands of the transferee is determined in whole or in part by reference to the transferor's basis (the basis carryover exception);
  • The transferee is the insured;
  • The transferee is a partner of the insured;
  • The transferee is a partnership in which the insured is a partner; or
  • The transferee is a corporation in which the insured is a shareholder or officer.

The detrimental economics associated with replacing existing whole-life insurance policies with new ones and the changing health conditions of the insured often create the need to transfer existing policies rather than simply acquiring new ones with similar characteristics. The potential for less obvious transfers and more subtle elements of consideration triggering the transfer for value rule and the inconsistent nature of the exceptions to this problems, make this a dangerous area for the uninformed. 1035 Exchanges

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