Modified Endowment Contracts (MEC) and BOLI
Bank Owned Life Insurance (“BOLI”) is sold either as a single pay or multi pay policy. Banks have an array of life insurance products from which to choose, ranging from term coverage to variable universal life. The Appendix to Bulletin 2004-56 discusses the various types of insurance:
- term vs. permanent;
- whole life vs. universal life;
- general account vs. separate account.
The most popular type of policy historically has been a permanent life insurance life insurance policy with a single premium on a select group of key employees. The bank pays the premium, owns the policy and its cash value, and is the policy’s sole beneficiary. These types of single pay or single premium policies are typically classified as a Modified Endowment Contract (“MEC”).
What is a Modified Endowment Contract?
A MEC policy is a life insurance contract that has exceeded the seven pay limit (often called the “MEC test” or “7-Pay Test”) established by the Internal Revenue Code. MEC policies are treated differently from non-MEC policies under federal income tax law. In more simplistic terms, a policy that is a MEC has too much premium in relationship to the amount of insurance in place. The 7-Pay Test is the annual level amount that could be paid into the policy such that the policy would be paid up after seven years. A paid up policy is one that does not require additional premium dollars to keep the policy in-force to the insured’s assumed death age. Policies can enter into MEC status after the policy is issued because the premium amount in comparison to the amount of insurance is too low based on the 7-Pay Test. Once a policy enters MEC status, it generally can’t be reversed.
The Amendment to OCC 2004-56 defines a MEC as follows: A type of policy that is defined in Internal Revenue Code Section 7702A. A MEC generally involves the payment of a single premium at the inception of the contract; thus, it fails the so-called seven-pay test set forth in the statute. MECs are denied some of the favorable tax treatment usually accorded to life insurance. For example, most distributions, including loans, are treated as taxable income. An additional 10 percent penalty tax also is imposed on distributions in some circumstances. However, death benefits remain tax-free.
Benefits of a BOLI Modified Endowment Contract
A MEC policy is still considered life insurance and benefits from tax-free death benefit and tax-deferred growth of cash surrender value.
Long Term Cost Recovery
A MEC policy is generally the right decision for banks considering BOLI for the long term recovery of non-qualified benefit or general salary and benefit costs through the receipt of the tax-free death benefit. OCC 2004-56 identifies two methods to quantify the amount of life insurance to offset the cost of employee benefits: the cost recovery method and the cost offset method. The cost recovery method involves calculating the projected amount of benefits provided to employees then using a discounted cash flow model to determine the present value. This discounted model is then used to determine the amount of life insurance coverage to purchase.
Historically High Returns
In addition, most BOLI policies that are MECs provide have historically provided above-market returns in comparison to non-MEC policies. Like most other investments, a careful comparison of the current market rates, carriers, individual policies and MEC versus non-MEC policies is required to considering the appropriate type of BOLI for your bank.
Budgeting Purposes
MEC BOLI policies may also be appropriate for banks that are looking to fund a one-time allocation from cash or other funds to put the policy in-force. MEC policies are designed such that no other premium dollars are due after the single-payment is made by the bank. For future budgeting purposes, single pay policies may make sense.
Key-Person Coverage
Finally, because the policy is designed such that it will be in-force for the insured’s lifetime, single pay MEC policies generally make sense when there is a need for key person coverage on a select bank employee or borrower. If liquidity is not a concern, and no distributions are anticipated over the lifetime of the key person’s tenure at the bank, a single pay MEC policy might be the best decision.
Disadvantages of a BOLI Modified Endowment Contract
MEC policies also have several disadvantages that must be considered before determining if a MEC BOLI policy is appropriate for your bank.
Gain-First Treatment
MEC policies are taxed on a last in, first out (“LIFO”) basis. This means that any distributions from the policy through a pre-tax distribution is taxed on the gain in the policy before the basis. For a policy owned by a business entity, a distribution that triggers LIFO taxation include:
- Policy Loans,
- Collateral Assignment,
- Partial or Full Surrender,
- Account Withdrawals, and
- Taking Dividends as Cash.
Despite this gain first treatment, any taxes paid by the bank effectively provide a step-up in basis of the MEC policy. For instance, if a policy loan is received by the bank and taxes are paid, then once the loan is repaid the bank’s basis in the policy is increased in an amount equal to the policy loan.
MEC Penalty
In addition to the LIFO or gain first treatment of a pre-death distribution from a MEC BOLI policy, the other main disadvantage is that any pre-death distribution are subject to an additional 10% tax on the gain.
For example, consider a bank in the 34% effective tax-bracket owns a MEC BOLI policy that has a basis (the original, single pay premium in this case) of $1,000,000 that has grown to $1,500,000. The bank makes a full surrender of the policy. The tax consequences are as follows:
| Current Cash Surrender Value | $1,500,000 |
| Basis | $1,000,000 |
| Total Gain in Policy | $500,000 |
| Less Taxes Due at 34% Effective Tax Rate | ($170,000) |
| Less 10% MEC Penalty | ($50,000) |
| Total Taxes and MEC Penalty | ($220,000) |
| Net Proceeds After-Tax and Penalty (Including Return of Basis) | $1,280,000 |
In effect, the MEC penalty adds an additional 10% to the bank’s effective tax rate when a pre-death distribution is made from the MEC BOLI policy.
Liquidity Disadvantages
Because of the additional 10% MEC penalty, banks that own MEC BOLI policies must consider the associated liquidity risk. OCC 2004-56 defines liquidity risk as “the risk to earnings and capital arising from an institution’s inability to meet its obligations when they come due without incurring unacceptable losses.” A bank that owns MEC policies might be less likely to surrender them based on the 10% MEC penalty. However, unlike other assets that have relatively higher volatility or high transactional costs, MEC BOLI policies offer steady returns with little to no transactional costs. A bank knows the associated liquidity risk beforehand and can plan effectively should a liquidity concern arise.
Conclusion
MEC BOLI policies offer both advantages and disadvantages and can be the right choice for a bank. Like most decisions, the right amount of due diligence and a dedicated advisor with knowledge of the industry is key when deciding if MEC BOLI is the right choice for the bank. EBN can help assist your bank in determining which choice is right for your bank.