New Revenue Procedure Provides A Second Chance For MEC Correction
The Internal Revenue Service recently issued Revenue Procedure 2001-42, which establishes a permanent method for companies to correct contracts that inadvertently become modified endowment contracts (MECs). R.P. 2001-42 replaces R.P. 99-27, which provided a temporary correction program that expired on May 31, 2001.
This new procedure also allows for the correction of a far greater number of contracts than permitted under R.P. 99-27.
Despite the difficulty of meeting the requirements of R.P. 99-27, some 50 to 75 companies filed closing agreements to correct their inadvertent MECs. While many companies made use of the program, for a variety of reasons many others did not.
In working with more than two dozen companies that did file under R.P. 99-27, as well as with several companies that did not, we found three principal areas of concern and criticism with the original correction program, two of which have been addressed by R.P. 2001-42.
1. Temporary Procedure. The “one-bite-at-the-apple” rule in R.P. 99-27 generally gave insurers only one opportunity to submit all of their contracts for correction and required the filing be done by May 31, 2001. R.P. 2001-42 is a permanent program that does not limit companies to a single filing request.
2. Limited Scope. Under R.P. 99-27 “eligibility tests” that contracts were required to satisfy were designed to limit the ability to correct contracts the IRS viewed as investment-oriented, including certain corporate-owned life insurance contracts (COLI). Companies found these tests, especially the 300% test, particularly frustrating.
R.P. 2001-42 expands the scope of the correction program by eliminating these tests. Even without these tests, the IRS still has the authority to reject contracts it determines are part of a program to sell investment-oriented contracts or to be in clear violation of rules.
3. Reporting Requirements and “Toll Charge” Calculation. In order to generate the templates and compute the toll charge required to correct inadvertent MECs, companies need to collect significant amounts of historical policy level data, that often prove difficult to obtain. R.P. 2001-42 carries over the reporting requirements and toll charge mechanism of R.P. 99-27.
Interestingly, most companies that filed closing agreements under R.P. 99-27 were left with contracts they could not correct because of the imposed eligibility restrictions. These contracts posed potential problems for insurers, particularly if insureds were unaware of their contracts status as a MEC. Notifying insureds of adverse tax consequences caused concern over potential legal or other action that might be initiated by policyholders.
In addition, there were potential tax reporting issues that would need to be addressed if prior distributions had been incorrectly reported to either the IRS or policyholders. Expanding the scope of R.P. 99-27 and eliminating the one-bite-at-the-apple rule will now provide a means to correct these contracts and minimize future administrative and legal concerns.