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In 1988, Congress and the President signed into law the Tax and Miscellaneous Revenue Act.  It goes by the acronym TAMRA, but for all the tidal waves the legislation sent through the insurance industry, TRAUMA might have suited better.  One of the items of the debris that washed up on shore was the Modified Endowment Contract (MEC).

By way of quick review, if too much money is paid into a policy too quickly it can be categorized as a MEC which means that its cash value is treated like an annuity for income tax purposes; i.e. tax-deferred build-up (and tax-free death benefits), but money taken from the contract is taxed as a withdrawal of the policy’s gain first (ordinary income), then as a non-taxable return of basis.  If the taxpayer is not 59-1/2 then the tax rate on the gain is increased 10%.  Mama, what a mouthful, but well said!

In addition, if the policy is used as security on either a loan from the carrier (commonly called a policy loan) or on indebtedness from an outside source, any gain in the contract is reportable as ordinary income to the extent of the loan amount: which brings us to the purpose of this discussion.

Take an example: a MEC is created when a single premium of $100,000 is dumped into a new contract.  At the end of policy year one there is a CV of $105,000.  The carrier makes a loan of $50,000 to the policy owner from its general assets (which is where the proceeds of “policy loans” actually come from).  All agree that $5,000 of the loan proceeds (the amount of gain in the contract at the time of the loan) is reportable as ordinary income and the remaining $45,000 is non-reportable.  But what happens next year when the cash value goes up to, say, $110,000.  The loan is now being secured by a policy that has a $10,000 gain, only $5,000 of which has been recognized.  Is the borrower home free – having gotten the horse out of the barn before the door closed?  Or does the emerging gain portion of the MEC’s have to be considered in the current tax year?

Our good friends at Principal Financial tell us that this is how loan transactions involving MECs are reported there:

• Internal policy loans – Not a problem unless interest on the loan is capitalized.  Then the amount of interest that is capitalized that year is taxable to the extent there is unrecognized gain in the policy.  If interest is actually paid each year, no gain is reported.
• Loans from an independent source (on which the policy serves a security as evidenced by a collateral assignment) –  Because of the open-ended nature of most collateral assignments, emerging gain in the policy will be recognized each year as it accrues to the extent of the full loan including any capitalized interest.

Occasionally clients will want to intentionally create a MEC to maximize accumulation in the product from day one.  In addition they may want to take advantage of the early opportunity to leverage the premiums through a loan.  Be sure to alert them that, like Freddy Krueger or the Cat in the Hat, adverse tax consequences can keep coming back each year unless they plan properly.

Call with any questions you have on MEC taxation or other planning issues that arise in your casework at 706-354-0401, or wire addison@meritins.com.   Best to ya!

Companies help.