14 / What is the “seven pay test” and how does it apply to a modified endowment contract (MEC)?

A life insurance contract will fail the seven pay test if the accumulated amount paid under the contract at any time during the first seven contract years exceeds the sum of the net level premiums that would have been paid on or before such time if the contract provided for paid-up future benefits after the payment of the seven level annual payments.¹ Generally, the “amount paid” under the contract is defined as the premiums paid less distributions, not including amounts includable in gross income.² An amount received as a loan or the repayment of a loan does not affect the amount paid under the contract.³ Additionally, amounts paid as premiums during the contract year but returned to the policyholder with interest within 60 days after the end of the contract year will reduce the sum of the premiums paid during the contract year. The interest paid on the premiums returned must be included in gross income.⁴

When a whole life insurance policy is coupled with an increasing whole life rider plus a term insurance rider, and the amount of coverage provided under the term rider increases or decreases solely in relation to the amount of coverage provided by the base policy and whole life rider, the IRS has ruled privately that the policy’s “future benefits” for purposes of IRC Section 7702A(b) are equal to the aggregate amount of insurance coverage provided under the base policy, the whole life rider, and the term insurance rider at the time the policy is issued.⁵ When a variable whole life policy is coupled with a 20-year decreasing term rider, the future benefits for purposes of IRC Section 7702A(b) are equal to the coverage under the base policy plus the lowest amount of coverage under the term rider at any time during the first seven contract years.⁶

The seven level premiums are determined when the contact is issued, and the first contract year death benefit is deemed to be provided to the contract’s maturity, disregarding any scheduled death benefit decrease after the first seven years.⁷ In one private letter ruling, the death benefit for purposes of applying IRC Section 7702A(c)(1)(B) was the policy’s “target death benefit,” defined as the sum of the base policy death benefit and a rider death benefit.⁸

If there is a reduction in benefits under the contract within the first seven contract years, the seven pay test is applied as if the contract had originally been issued at the reduced benefit level. Any reduction in benefits due to the nonpayment of premiums is not taken into account, however, if the benefits are reinstated within 90 days after the reduction.⁹

In the case of a contract that pays a death benefit only on the death of one insured that follows or occurs at the same time as the death of another insured, if the death benefit is reduced below the lowest level of death benefit provided during the contract’s first seven years, the MEC rules must be applied as if the contract had originally been issued at that lower benefit level. This rule is effective for contracts entered into on or after September 14, 1989.¹⁰