SECTION 2. BACKGROUND

.01 Definition of a modified endowment contract (“MEC”).

(1) Section 7702A(a) provides that a life insurance contract is a MEC if the contract—

(a) is entered into on or after June 21, 1988, and fails to meet the “7-pay test” of § 7702A(b), or

(b) is received in exchange for a contract described in paragraph (a) of this section 2.01(1).

(2) A contract fails to meet the 7-pay test if the accumulated amount paid under the contract at any time during the first 7 contract years exceeds the sum of the net level premiums which would have to be paid on or before such time if the contract were to provide for paid-up “future benefits” (as defined in §§ 7702A(e)(3) and 7702(f)(4)) after the payment of 7 level annual premiums.

(3) Section 72(e)(11) provides that, for purposes of determining amounts includible in gross income, all MECs issued

by the same company to the same contract holder during any calendar year are treated as one MEC.

.02 Tax treatment of amounts received under a MEC. Section 72(e)(10) provides that a MEC is subject to the rules of § 72(e)(2)(B), which tax non-annuity distributions on an income-out-first basis, and the rules of § 72(e)(4)(A) (as modified by §§ 72(e)(10)(A)(ii) and 72(e)(10)(B)), which generally deem loans and assignments or pledges of any portion of the value of a MEC to be non-annuity distributions. Moreover, under § 72(v), the portion of any annuity or non-annuity distribution received under a MEC that is includible in gross income is subject to a 10% additional tax unless the distribution is made on or after the date on which the taxpayer attains age 59 ¹ ⁄2, is attributable to the taxpayer’s becoming disabled (within the meaning of § 72(m)(7)), or is part of a series of substantially equal periodic payments (not less frequently than annually) made for the life (or life expectancy) of the taxpayer or the joint lives (or joint life expectancies) of such taxpayer and the taxpayer’s beneficiary.

.03 Need for a correction mechanism. The Internal Revenue Service (“Service”) has become aware of situations in which, as a result of inadvertent non-egregious failures to comply with the MEC rules, life insurance premiums have been collected which exceed the 7-pay limit provided by § 7702A(b). This may produce significant unforeseen tax consequences for the contract holders. To allow issuers to remedy such situations, the Service under the circumstances described below will enter into closing agreements which will provide that contracts identified in the closing agreements will not be treated as MECs.