MEC Aggregation Rules and BOLI
One of the key “tax pitfalls” that banks are unaware of when considering whether to surrender, take a loan from or assign a BOLI policy are the MEC Aggregation Rules. A modified endowment policy (“MEC”) is generally a single-premium life insurance policy that does not satisfy the requirements of the 7-Pay test and is therefore subject to an additional set of taxation regulations. In brief, a MEC policy is taxed on the “gain first” in the policy first whereas a non-MEC policy is taxed on the “basis first.” In other words, MEC policies are taxed under a “last in, first out (LIFO)” basis. Further, an additional 10% penalty is payable on the gain in a MEC policy in addition to regular income taxes. Taxation plus the 10% penalty on a MEC policy is triggered on a partial or full surrender, a partial or full withdrawal, a loan or on assignment of the policy. For more basic information on taxation of MEC BOLI policies, read our general overview of MEC taxation. ***Insert link to MEC BOLI: What to Know***
What are the MEC Aggregation Rules?
The MEC Aggregation rules provide an additional level of complexity that a bank must be aware of if they hold multiple BOLI policies. For purposes of determining the gain, all MEC policies issued in the same calendar year from the same insurance carrier to the same policyholder are aggregated and treated as one policy for tax purposes. Even if one of several policies out of a group of multiple MEC BOLI policies was surrendered, all of the gain could be subject to income tax plus a penalty if all of the policies were put into place in the same calendar year from the same insurance carrier. The MEC Aggregation rule is codified in § 72(e)(12) of the Internal Revenue Code under the “Anti-Abuse Rules”. It was put in place in response to companies purchasing multiple smaller MEC policies on the same individual to avoid the LIFO or “income first” treatment. Under previous law, companies would purchase multiple MEC policies on the same individual, and when necessary to access the cash surrender value, surrender, loan or pledge one of the policies. This would bypass LIFO treatment on all but one policies and, in effect, provide access to a large portion of the proceeds.
How are the MEC Aggregation Rules Applied to BOLI?
For example, assume a bank (“Bank A”) purchased 10 single-pay MEC BOLI policies from the same carrier in 2016 for a total premium of $3,000,000 (each policy has $300,000 of premium). Five years later, the total cash surrender value has grown to $3,500,000 (each individual BOLI policy now has $350,000 of cash surrender value). The bank now wants to surrender one of the 10 policies (“Policy #1”). Note that while this example contemplates a full surrender of Policy #1, the same analysis below would be applicable if it was a loan or assignment of Policy #1.
Without the MEC Aggregation Rules – if the MEC aggregation did not apply, the calculation would only be focused on Policy #1 below:
| Current Cash Surrender Value of Policy #1 | $350,000 |
| Basis (Original Premium Paid for Policy #1) | $300,000 |
| Total Gain in Policy #1 (CSV – Basis) | $50,000 |
| Less Ordinary Income Taxes on the Gain in Policy #1 (34% Effective Tax Rate) | ($11,560) |
| Less 10% MEC Penalty on Gain in Policy #1 | ($5,000) |
| Total Taxes and MEC Penalty | ($16,560) |
| Net Proceeds After-Tax and Penalty (Including Tax-Free Return of Basis) | $333,440 |
With the MEC Aggregation Rules – because the bank purchased 10 policies in the same calendar year from the same insurer, the MEC Aggregation Rules require that all 10 policies must be added together to determine the gain. Therefore, the above example becomes:
| Current Cash Surrender Value of All Policies | $3,500,000 |
| Basis of All Policies | $3,000,000 |
| Total Gain in All Policies | $500,000 |
Because of the MEC aggregation rules, if any of the 10 BOLI policies are surrendered then $500,000 (not $50,000) of gain is recognized and subject to ordinary income taxed plus the 10% MEC penalty. Therefore, the entire $350,000 cash surrender value of Policy #1 is considered gain and the taxes are calculated as follows:
| Current Cash Surrender Value of Policy #1 | $350,000 |
| Basis (Original Premium Paid for Policy #1) | $300,000 |
| Total Gain in Policy #1 (Based on MEC Aggregation Rules) | $350,000 |
| Less Ordinary Income Taxes on the Gain (34% Effective Tax Rate) | ($119,000) |
| Less 10% MEC Penalty on Gain | ($50,000) |
| Total Taxes and MEC Penalty | ($169,000) |
| Net Proceeds After-Tax and Penalty | $181,000 |
In the above example, the application of the MEC Aggregation rules resulted in:
- An increase in taxes and MEC penalties paid of almost 1000%;
- A reduction in net proceeds of almost 50%.
The only upside is that the bank would receive an increase in basis, should they surrender a policy in the future. In the example, if another policy was surrendered then the total gain of all 10 policies would be reduced by $350,000. This would help offset some of the taxes and penalties owed in later years.
What are the Bank’s Options if Access to the Policy is Needed and the MEC Aggregation Rules Apply?
If the bank owns multiple MEC BOLI policies that were purchased in the same calendar year from the same insurance carrier and wants to avoid application of the MEC Aggregation rules, then there are a few options to think about:
Consider a 1035 Exchange of Some of the Policies. A 2007 Ruling issued by the Internal Revenue Service clarified the tax-implications involving a tax-free 1035 Exchange of one or more policies that would be aggregated. The ruling held that if a bank or company that owns multiple modified endowment contracts issued by the same insurance company in the same calendar year exchanges some of those MECs for new MECs issued by a second insurance company then the new contracts are not aggregated with the remaining contracts. For example if a bank owned 10 policies subject to the MEC aggregation rules and exchanged 3 of those to a different carrier, then the 3 policies would not be aggregated with the original 7 contracts.
There are some limitations to this option.
First, a 1035 exchange is not available for an insured that is no longer employed with the bank. For insureds that have separated from service, this option would not be available.
Second, taking distributions through a loan or surrender from either the original policies or the newly exchanged policies would still require application of the MEC Aggregation rules. There is also some evidence that the IRS would apply the rule if the sole purpose of the exchange was to avoid taxation.
Hold the Policies Until the Bank is in a Loss Position. If a bank is in a situation where there are no taxes payable for the year, it might be the right time to look at accessing a policy or policies that would be subject to the aggregation rules.
Continue to Hold All of the Policies. The best returns from single pay, non-MEC policies will always occur when the bank holds BOLI until the insured’s death. BOLI is a long term, buy and hold strategy. However, this does not help a bank that needs immediate access to one of a set of policies.
Consider a Full Surrender of All of the Policies. This is the least desirable option. Surrendering or accessing all BOLI policies subject to the MEC aggregation rules would, in reality, avoid the technical application of the rule. However, even if the bank planned to re-invest the after-tax proceeds into other BOLI policies, other issues might affect the bank’s ability to do so. These issues include insurability issues of the group and whether or not the new policies will perform similar to the original policies.
The MEC Aggregation rules are complex and have adverse and possibly unintended tax consequences for a bank that owns MEC BOLI policies. If you find yourself in a situation where your bank has several MEC policies with the same carrier that were purchased in the same year, be aware of the rules and examine your options.