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.

Why the need for a MEC Correction Program? Life insurance contracts in general have certain tax-favored characteristics, including the tax deferral of the “inside buildup” and the tax-free distribution of death benefit proceeds. In 1988, 7702A was added to the Internal Revenue Code to create a new class of life insurance contract called a modified endowment contract, or MEC.

A life insurance contract becomes a MEC when it fails the 7-pay test as defined in 7702A. Unlike pre-death distributions from a non-MEC, which are taxed on a return-of-premium first basis, distributions from a MEC (including both withdrawals and policy loans) are generally taxed on an income first basis.

7702A has proved to be complex and quite difficult to administer. In fact, the need for a correction program to allow companies to correct inadvertent MECs has existed since 1988 when Congress first passed 7702A. However, in contrast, 7702 (Definition of Life Insurance) has a built-in correction procedure under 7702(f)(8) and never required the issuance of further correction procedures.

For several years, the insurance industry, through the American Council of Life Insurers, sought a program to allow for the correction of unintentional MECs. Unintentional MECs can arise for a variety of reasons, such as early payment of an annual premium, incorrect processing of 1035 exchanges and incorrect processing of material changes or death benefit reductions.

Other than the statutory provision that allows for the return of excess premium and earnings within 60 days after the contract anniversary, insurers did not have the ability to “un-MEC” a contract. After several years of discussions, the IRS published R.P. 99-27 in May of 1999.

R.P. 2001-42 recognizes that, despite the best efforts of the life insurance companies and policy owners, some policies will become inadvertent MECs. By creating a permanent program, the IRS has created the opportunity for companies that were not able to take advantage of R.P. 99-27 to “cure” their inadvertent MECs.

In addition, those companies that did file will now be able to supplement their filings to include all of their inadvertent MECs.

It is important to note that while the new revenue procedure does re-open the door for companies to bring their in-force policies into compliance, the reporting requirements are still voluminous.

As is well known by the companies that filed under the old revenue procedure, the cost in terms of necessary resources to meet the reporting requirements can be significant. At the same time the new procedure addresses a deficiency that has existed in the MEC rules since their enactment by creating a program to “cure” errors–a benefit to insurers, policyholders, and the IRS.

David C. Miller (top), FSA, MAAA , is vice president, Aon Consulting, in Somerset, N.J. Brian G. King, FSA, MAAA, is vice president, Aon Consulting, Avon, Conn. They can be reached via e-mail at david_miller@aoncons.com and bking@avonconsulting.com, respectively.


Reproduced from National Underwriter Life & Health/Financial Services Edition, September 17, 2001. Copyright 2001 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.


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