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(c)(3) and 7702(f)(4)) after the payment of 7 level annual premiums.

(3) Section 72(e)(12) 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 Authority to enter into closing agreements. Under § 7121, the Secretary is authorized to enter into an agreement in writing with any person relating to the liability of such person (or of the person or estate for whom he acts) in respect of any internal revenue tax for any period. Such agreement is generally final and conclusive, except upon a showing of fraud, malfeasance, or misrepresentation of a material fact.

.04 Correction procedure for inadver- tent MECs. Rev. Proc. 2001–42 set forth circumstances under which the Internal Revenue Service (Service) would enter into closing agreements under which life insurance contracts would be treated as if they were not MECs, notwithstanding inadvertent non-egregious failures to comply with the rules of § 7702A. Under Rev. Proc. 2001–42, an issuer was required

July 21, 2008 143 2008–29 I.R.B.

(1) the cash surrender value (as defined in § 7702(f)(2)(A)) of the contract, by

(2) a fraction, the numerator of which is the net level premium (computed in accordance with the rules in § 7702A(c)) that would have to be paid for the changed or new contract if such contract were to provide for paid up future benefits after the payment of 7 level annual premiums, and the denominator of which is the net single premium (determined using the rules in § 7702) for such contract at that time.

.05 Overage. A contract’s overage is the amount of the excess, if any, of—

(1) the sum of amounts paid under the contract during the testing period for the contract year and all prior contract years, over

(2) the sum of the 7-pay premiums for the contract year and all prior contract years of the testing period.

.06 Overage earnings. The overage earnings for a contract year is the amount obtained by multiplying—

(1) the sum of a contract’s overage for the contract year and its cumulative overage earnings for all prior contract years, by—

(2) the earnings rate set forth in section 3.07 of this revenue procedure. .07 Earnings rates. (1) Contracts other than variable con- tracts. Except as otherwise provided in sections 3.07(3) and 3.07(8) of this revenue procedure, the earnings rate applicable to a contract year is the general account total return (as defined in section 3.07(2) of this revenue procedure) for the calendar year in which the contract year begins.

(2) General account total return. (a) Pre-2008 contract years. The general account total return applicable to a contract year that begins before January 1, 2008, is the rate set forth in the following table for the calendar year in which the contract year begins.

to provide information about the contracts that were 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 was required to pay under the closing agreement an amount based on the contract’s overage, overage earnings, and tax and interest thereon. Rev. Proc. 2001–42 was modified and amplified by Rev. Proc. 2007–19, primarily to use indices that are more accessible to taxpayers than those previously required to be used and to permit the submission of information in an electronic format.

.05 Changes to correction procedure. In Notice 2007–15, 2007–1 C.B. 503, the Service requested comments as to how various correction procedures - including those for inadvertent MECs under Rev. Proc. 2001–42 — may be improved. This revenue procedure incorporates a number of changes that taxpayers suggested in response to Notice 2007–15. Significant changes include providing an alternative computation of the amount required to be paid under a closing agreement with regard to an inadvertent MEC, eliminating certain informational items that must be submitted, and revising some language of the model closing agreement.