When To Recommend a Modified Endowment Contract (MEC)

Since June 20th, 1988, life insurance policies that do not meet the guidelines of the “7 Pay Test” of IRC Section 7702A are classified as Modified Endowment Contracts (MEC).  As such, any lifetime withdrawals or loans from the cash value of a MEC in a gain position will result in LIFO (last in-first out) taxable income to the extent of the gain (IRC Section 72(e)(10)).

This LIFO method is similar to the way withdrawals from deferred annuities in a gain position are taxed.  Alternatively, withdrawals up to cost basis and/or loans from the cash value of a non-MEC FIFO (first in-first out) life insurance policy are income tax-free.

Given the LIFO taxation of MECs and FIFO taxation of non-MECs, are there situations where a MEC could be recommended to finance estate tax planning, non-qualified executive benefit plans, or the tax-efficient asset management desires of wealthy clients?

Yes, and we have outlined 5 different situations where a MEC can provide tax-free leverage to efficiently finance certain advanced planning objectives:

1)     Life Insurance Owned by an ILIT Funded by a Lump Sum Gift of any Amount Up to the Current Lifetime Gift Exemption of $5,450,000 for an Individual, or $10,900,000 for a Married Couple

  • A single-pay MEC premium of up to $5.45 million / $10.90 million would buy a very large no-lapse Universal Life (UL) or no-lapse Survivorship Universal Life (SUL) policy owned by the ILIT.  For instance, a $5,450,000 single pay premium for a competitive no-lapse SUL on a Male 70 preferred / Female 70 preferred will purchase a guaranteed death benefit of $16,243,000.  The internal rate of return (IRR) at joint life expectancy (20 years) is a very competitive 5.61% in this continuing low-interest economic environment.  Assuming a 35% combined income tax bracket, the pre-tax equivalent IRR is 8.63%.
  • This concept also works well for a Dynasty Generation Skipping type of ILIT where the estate owner can allocate $5,450,000 of generation-skipping exemption to the lump sum gift.  The filing of the 709 U.S. Gift Tax return form would concurrently allocate both the regular lifetime gift exemption and the generation-skipping exemption. Dynasty type of ILITs work well in states that have extended the rule against perpetuities far into the future and also have no state income taxes on trust income (i.e. Alaska, Delaware, Nevada, South Dakota).
  • The cash value of the no-lapse SUL MEC will never get into a gain position so there is never any potential of lifetime LIFO taxation.  Also, the death benefit from the single pay MEC is also income tax-free and estate tax-free.


2)     Life Insurance Owned by an ILIT Funded by a Lump Sum “Private Split Dollar Economic Benefit” Transferred of Cash from the Estate Owners to the ILIT

  • A single pay MEC premium to purchase a no-lapse UL or SUL policy will provide an income and estate tax-free death benefit.  The policy may have growing cash value for a period of time before the cash value starts to trend downward and eventually falls to zero.
  • The private split dollar interest of the estate owners will typically be defined in the written agreement as the GREATER of the cash value or the cumulative premiums paid.  For a typical no-lapse UL or SUL policy design, the interest of the estate owners will be the lump sum premium paid.  At death, this lump sum amount will be returned to the estate of the deceased and included in the gross estate at a 40% estate tax rate.  The remaining net death benefit paid to the ILIT will be estate tax-free.
  • During the lifetime of the insured(s),  the only reportable gift for gift tax purposes are the low Table 2001 economic benefit rates for single life policies and the super-low joint life Table 2001 economic benefit rates for survivorship policies.
  • This very low reportable value for gift tax purposes is ideal for estate owners who have used most of their $5.45 million / $10.90 million lifetime gift exemptions on prior gifts and don’t want to make any taxable gifts resulting in lifetime gift taxes at a 40% rate.
  • Keep in mind that the current lifetime gift exemption of $5,450,000 is indexed each year and has been growing by a rate of 1-2% since 2012 when indexing became permanent.
  • See Treas. Regs. 1.61-22(d) for detailed tax rules for split dollar economic benefit regime plans.


3)     Life Insurance Owned by an ILIT Funded by a Lump Sum “Private Split Dollar Loan” Transfer of Cash from the Estate Owners to the ILIT   

  • A single pay MEC premium for a no-lapse UL or SUL policy will provide an income and estate tax-free death benefit.  The estate owners execute a written private split dollar loan agreement locking in the current long term AFR rate as the interest rate for the lump sum loan.  The current long term AFR rate is 1.90% and will be considered an imputed gift to the trust each year.
  • For example, if a $5,450,000 private loan is made to the ILIT, the annual imputed interest gift to the trust annually will be $5,450,000 x 1.90% = $103,550.  This imputed gift of $103,550 each year should be easily covered by annual gift tax exclusions and/or annual indexing of the lifetime gift exemption.  So, in most cases there should be little or no cumulative taxable gifts which would result in any lifetime gift taxes.
  • At death, the $5,450,000 loan principal will be repaid to the estate from the total tax-free death benefit paid to the ILIT.  This amount will be included in the gross estate for estate tax purposes as a loan receivable and subject to estate taxes at a 40% rate.  The net death benefit remaining in the ILIT will be estate tax-free.
  • See Treas. Regs. 1.7872-15(e) for detailed tax rules for split dollar loan plans.


4)    Corporate-Owned Life Insurance (COLI) to Fund a Cost-Recovery for a     “Non-Qualified Salary Continuation” Agreement for a C Corp Executive

  • A single pay MEC premium will generally provide an income tax-free death benefit to the corporation to provide cost-recovery for the employer’s costs of providing the lifetime salary continuation benefit.  Rather than buying a cash accumulation type of non-MEC policy and making tax-free withdrawals and loans from the policy to pay the salary continuation benefits, the company buys a lower cost single pay no-lapse MEC.
  • Instead the company will pay the tax deductible salary continuation benefits to the executive at retirement from the future operating revenue of the firm.  A single pay no-lapse MEC allows the company to recover its costs of providing the deferred retirement benefit to the executive.  These costs will equal the lump sum single premium paid plus the cumulative net after-tax cost of the annual tax-deductible salary continuation benefit payments.  These salary continuation benefits are taxable to the executive when received.
  • The cost recovery death benefit paid to a C Corp may be subject to the corporate alternative minimum tax (CAMT) in the year of death.  However, the corporation will receive a dollar for dollar corporate tax credit on their Form 1120 in the subsequent tax year for any CAMT actually paid.  Thus the only financial cost is a minimal time value of money cost between the time any CAMT is paid and the time when the corporation receives the tax credit in the following tax year.


5)     “Private Placement Insurance” for Ultra-Affluent Clients Desiring to Make Their Asset Portfolio More Income Tax Efficient

  • When ultra-affluent clients, including those with a Family Office wealth management structure, desire to make their asset portfolio more income tax efficient, then the cash-rich private placement MEC may serve to balance their portfolio.
  • These types of clients may have assets which produce significant interest, dividends, capital gains, rental income, and K-1 pass-through income of S Corps, LLCs, or partnerships.  A Private Placement type of insurance policy that’s a MEC can give them tax-deferred growth.  Many of these mega-rich may not be too concerned about future LIFO taxable withdrawals or loans from a cash-rich MEC.  They may even decide to simply hold the MEC until death which would result in an income tax-free death benefit.
  • In addition, the life insurance wrapper that holds the underlying private placement assets can be tailored to suit the risk profile of the client.  Private Placement insurance plans often require a minimum cumulative premium commitment upwards of $5,000,000 for wealthy individuals known as a qualified purchaser.
  • Private Placement life insurance must be filed with and approved by state insurance departments and comply with the IRC Section 7702 definition of life insurance.  The policy is typically designed with a minimum death benefit to accelerate tax-deferred cash value growth.  The policy may even be owned personally by the client as part of the client’s overall asset portfolio.  Premium payments options for qualified purchasers include a single pay of $5,000,000 (MEC) or a 5-Pay of $1,000,000 per year (non-MEC) for those clients who want to preserve the option of tax-free lifetime withdrawals and/or loans from the cash value.


Contact your BSMG Life Advisor when considering lump sum premium advances to fund any of the MEC planning concepts described in this article.  BSMG has access to competitive carriers that still provide lump sum premium payment designs.


Russell E. Towers  JD, CLU, ChFC                                                                                     

Vice President – Business & Estate Planning  

Brokers’ Service Marketing Group