SECTION 2. BACKGROUND

.01 Definition of a modified endowment contract

(1) Section 7702A(a) provides that a life insurance contract is a modified endowment contract (“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(c)(3) and 7702(f)(4)) after the payment of 7 level annual premiums.

.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 assign

ments 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 Rev. Proc. 2001–42 . The Internal Revenue Service (“Service”) is aware of situations in which, as a result of inadvertent non-egregious failures to comply with the MEC rules, life insurance premiums are collected which exceed the 7-pay limit provided by § 7702A(b). This can produce significant unforeseen tax consequences for the contract holders. To allow issuers to remedy such situations, Rev. Proc. 2001–42 sets forth the circumstances under which the Service will enter into closing agreements which provide that contracts identified in the closing agreements will not be treated as MECs. Under Rev. Proc. 2001–42, an issuer must provide information about the contracts that are subject to the closing agreement, including a template for each contract setting forth the cumulative amounts paid under the contract, the contract’s cumulative 7-pay premium, the overage, if any, for each contract year, the earnings rate applicable for each contract year, and the overage earnings for each contract year. In addition, the issuer must agree to pay under the closing agreement an amount based on the contract’s overage, overage earnings, and tax and interest thereon.

.04 Need for changes to Rev. Proc. 2001–42 . During the 5 years it has admin

February 12, 2007 515 2007–7 I.R.B.

General Account Total Return

Year

General Account Total Return Year

1988 10.2% 1997 7.6% 1989 9.7% 1998 6.9% 1990 9.8% 1999 7.4% 1991 9.2% 2000 8.0% 1992 8.6% 2001 7.5% 1993 7.5% 2002 7.2% 1994 8.3% 2003 6.2% 1995 7.8% 2004 6.1% 1996 7.7% 2005 5.6%

.02 Variable Contracts Earnings Rate Table . Rev. Proc. 2001–42, section 3.07(3), is modified by substituting the following earnings rate table for that

which appears in section 3.07. This table supplements the existing table by providing earnings rates for the years 2001 through 2005:

Variable contracts Earnings rate

Year

Variable contracts Earnings rate Year

1988 13.5% 1997 17.8% 1989 17.4% 1998 19.7% 1990 1.4% 1999 12.8% 1991 25.4% 2000 -5.5% 1992 5.9% 2001 -7.1% 1993 13.9% 2002 -14.1% 1994 -1.0% 2003 19.6% 1995 23.0% 2004 6.9% 1996 14.3% 2005 2.1%