A—Definition Of "Life Insurance" For Income Tax Purposes

Code §7702 defines life insurance for federal tax purposes. This definition applies to all policies issued after December 31, 1984. To qualify as life insurance, a policy must meet the definition of life insurance under applicable state (or foreign) law, and must also meet one of two "tax tests:" a cash value accumulation test, or a guideline premium/cash value corridor test. It is not sufficient to meet the test once; it must be met throughout the life of the contract. If a policy fails to meet the state-law-plus-one tax test, it will be separated into its pure insurance and savings portions, and the income earned on the savings portion will be taxable to the policy owner each year, much like a savings account or mutual fund.

A certain class of life insurance contracts are also considered modified endowment contracts. A modified endowment contract is defined as any contract that qualifies as life insurance under Code §7702 but fails to meet a "seven-pay test." For tax purposes, amounts received under a modified endowment contract are treated first as income and then as recovered basis. The rules applicable to modified endowment contracts are discussed below in more detail.

Cash Value Accumulation Test

Under the Cash Value Accumulation test, the cash surrender value of a life insurance policy cannot exceed, at any time, the net single premium that would be required at such time to fund the future benefits (death benefits, endowment benefits, and charges for certain additional benefits, such as disability waiver) of the policy [I.R.C. §7702(b)(1)]. The cash surrender value, for this purpose, is determined without reference to any policy loan, surrender charge, or reasonable termination benefits.  The net single premium is determined by using:  1) an interest rate of 4 percent, or the rate guaranteed in the policy, nonforfeiture values if higher,  2) the  mortality charges specified in the contract, if any, and 3) any other charges specified in the contract. If the contract is silent on mortality charges, the charges assumed in computing statutory reserves must be used.

Guideline Premium/Cash Value Corridor Test

The Guideline Premium/Cash Value Corridor test is really two tests combined into one overall test, both halves of which must be satisfied. The "guideline premium" half is met if the aggregate premiums paid to date under the contract do not, at any time, exceed the greater of the "guideline single premium" or the sum of the "guideline level premiums." The guideline single premium is that one-time premium which would fund the future benefits of the contract. Mortality charges are determined in the same manner described earlier, but the interest rate to be used is the greater of 6 percent annually or the rate(s) guaranteed at the inception of the contract.

The "guideline level premium" is that level annual amount which would fund the future benefits of the policy over a period lasting at least until the insured`s 95th birthday. Charges for ancillary benefits should be leveled over the period provided. Mortality charges are determined the same as above; but the interest rate is the higher of 4%percent or the policy guaranteed rate(s).

A policy will satisfy the cash value corridor half of the test if the death benefit available under the policy is at all times no less than the applicable percentage of the cash surrender value in the following table [I.R.C.§7702(d)].

  Insured`s        Applicable
    Age             Percentage

      40 or less           250
      41                       243
      42                       236
      43                       229
      44                       222
      45                       215
      46                       209
      47                       203
      48                       197
      49                       191
      50                       185
      51                       178
      52                       171
      53                       164
      54                       157
      55                       150
      56                       146
      57                       142
      58                       138
      59                       134
      60                       130
      61                       128
      62                       126
      63                       124
      64                       122
      65                       120
      66                       119
      67                       118
      68                       117
      69                       116
      70                       115
      71                       113
      72                       111
      73                       109
      74                       107
      75-90                  105
      91                       104
      92                       103
      93                       102
      94                       101
      95 or more          100

For purposes of the above table, the insured`s age is determined as of the beginning of the contract year, not his/her birthday.

Example

Nick Davis was 42 years old at the beginning of the contract year, and the policy on his life has a cash value of $37,000. It must have a minimum death benefit of $87,320 (236 percent of $37,000) to satisfy the cash value corridor test.

It is important to keep in mind that the cash value corridor is only one-half of the second alternative test; the guideline premium must also be met.

In implementing the preceding tests, certain assumptions are made. First, the death benefit under the contract generally is presumed to remain level. Therefore, one cannot have a contract that moves the death benefit up or down freely in order to satisfy the guideline premium test. Nevertheless, in the case of a guideline level premium, an increasing death benefit may be assumed so that the excess of the death benefit over the cash value (pure insurance) does not decrease as cash values increase. Similarly, in the cash value accumulation test, the cash surrender value must be no more than the net level reserve, determined as if level annual premiums were paid to age 95. The net level reserve then replaces the net single premium in computing the cash value accumulation test.

Under the cash value accumulation test, increases in death benefits may be taken into account for certain small policies. The policy must have an initial death benefit of $5,000 or less. It must provide for a fixed annual increase in the death benefit, not to exceed 10 percent of the initial death benefit or 8 percent of the previous year`s death benefit. Finally, it must have been purchased to cover burial expenses or in connection with pre-arranged funeral expenses.

Contracts endowing before age 95 generally cannot be treated as life insurance for tax purposes. The maturity date can be no earlier than age 95, and no later than age 100.

If a policy fails to qualify as life insurance, the income tax consequences to the policy owner for the year are computed as follows:

      Increase in net surrender value
    + Cost of life insurance provided
    + Dividends received by policy owner
-  Premiums paid                                     
    = Taxable income to policy owner for year

Only the pure insurance portion of a disqualified policy (death benefit minus cash value) would be eligible for the income tax exemption for death proceeds.

The cost of life insurance will be the lesser of the mortality charge specified in the contract, or the table cost under a table to be provided in IRS regulations.

Modified Endowment Contracts

In order to curb the use of life insurance as a tax-sheltered investment, particularly the use of single premium plans, Congress enacted Code §7702A as part of the Technical and Miscellaneous Revenue Act of 1988 (TAMRA). Code §7702A created a new class of life insurance contracts known as "modified endowment contracts." A modified endowment contract is any contract entered into on or after June 21, 1988, that qualifies as life insurance under Code §7702 but fails to meet a so-called "seven-pay test". Prior to TAMRA, life policies were widely marketed as tax shelter vehicles in which substantial amounts of money could be invested, earn tax-deferred interest and afford tax-free withdrawal privileges by means of nontaxable policy loans. Code §7702A discourages the use of life insurance as a tax shelter by treating distributions from modified endowment contracts as income first, and then as recovered cost.

Modified Endowment Contracts Defined

A modified endowment contract is defined as any life insurance contract entered into on or after June 21, 1988, that meets the life insurance requirements of Code §7702, but which fails to meet a special seven-pay test or is received in exchange for a modified endowment contract [I.R.C. §7702A(a)].

Seven-Pay Test

A life insurance contract that fails to meet the seven-pay test will be classified as a modified endowment contract. The seven-pay test is not met if the accumulated amount paid at any time during the first seven years is more than the total of the net level premiums that would normally have been paid on or before such time if the contract provided for paid-up future benefits after payment of seven level annual premiums [I.R.C.§7702A(b)].

The net level premiums under the seven-pay test are determined by applying the computational rules used to determine the net single premium under the cash value accumulation test [I.R.C. §7702A(c)]. The death benefit, however, is deemed to be provided until the maturity date without regard to any scheduled reduction after the first seven contract years [I.R.C. §7702A(c)(1)(b)].

For purposes of the seven-pay test, "amounts paid" means the premiums paid under the contract reduced by any distributions but not including amounts includable in gross income [I.R.C. §7702A(e)]. Amounts paid as premiums that are returned to the policyholder with interest within 60 days after the end of the contract year reduce the sum of premiums paid under the contract [I.R.C. §7702A(e)]. However, the interest paid with the returned premium must be included in the gross income of the recipient. The receipt of any amount as a loan or the repayment of a loan is not to be taken into account in determining the amount paid under a contract. [Conference Committee Report on The Treatment of Single Premium and Other Investment-Oriented Life Insurance Contracts, from the Technical and Miscellaneous Revenue Act of 1988.]

It should be noted that any contract that is materially changed is subject to revision in the application of the seven-pay test. If there is a reduction in benefits under the contract within the first seven contract years, the seven-pay test is applied as if the contract had originally been issued at the reduced benefit level [I.R.C. §7702A(c)(2)]. A material change that increases benefits is considered to be a new contract that is subject to the seven-pay test as of the date that the material change takes effect [I.R.C. §7702A(c)(3)(A), discussed in more detail below]

The intent of Congress in creating the seven-pay test is clear. If the contract provides an incentive for earnings comparable to other types of investment, even though life insurance is present in substantial amounts, the contract owner must forego the traditional advantages of policy loans as a tax-free method of withdrawal.

Material Changes That Increase Benefits

If there is a "material change" that increases the benefits under a life insurance contract, then the policy is treated as a new contract as of the day the material change takes effect [I.R.C. §7702A(c)(3)(A)]. In addition, the amended contract must re-qualify under the seven-pay test [I.R.C. §7702A(c)(3)(A)]. However, a life insurance contract that is modified after December 31, 1990 because of the insurer`s financial insolvency will not cause a new seven-year period to begin for purposes of the seven-pay test [Rev. Proc. 92-57, 1992-2 CB 410].

For purposes of the foregoing rule, a material change includes any increase in the death benefit under the contract or any increase in, or addition of, a qualified additional benefit [I.R.C. §7702A(c)(3)(B)]. (Decreases in benefits are dealt with separately under §7702A(c)(2), as discussed above.) There are two exceptions to this rule. First, any increase in a future benefit due to the payment of premiums necessary to fund the lowest death benefit payable in the first seven contract years or due to the crediting of interest or other earnings is not a material change. Second, to the extent provided by regulations, a cost-of-living increase paid over the remaining life of the contract and based on an established broad-based index is not a material change [I.R.C. §7702A(c)(3)(B)].

In the case of a contract that is materially changed (under the definition set forth in §7702A(c)(3)(B)), the seven-pay premium for each of the first seven contract years after the change is reduced by the cash surrender value of the contract as of the date of the material change multiplied by the following fraction: the numerator is the seven-pay premium for the future benefits under the contract and the denominator equals the net single premium for future benefits under the contract [Conference Committee Report on The Treatment of Single Premium and Other Investment-Oriented Life Insurance Contracts, from the Technical and Miscellaneous Revenue Act of 1988].

Tax Treatment Of Modified Endowment Contracts

Modified endowment contracts receive different treatment for federal tax purposes than regular life insurance [I.R.C. §72(e)(10)]. If a contract is a modified endowment contract:

1. amounts received under the contract are treated first as distributions of the income earned within the contract, and then as recovery of cost;
2. loans under the contract are treated as amounts received and considered income first before any cost recovery; and
3. an additional 10 percent income tax, described below, is imposed on certain amounts received that are includable in gross income.

An amount considered to be a dividend or like distribution which is retained by the insurance company as a premium or other type of consideration for the contract is not considered a distribution subject to the MEC taxation rules. Such amounts are accorded the same treatment as under the usual rules applicable to insurance contract distributions under Code §72(e); they are considered a tax-exempt return of investment in the contract until, in the aggregate, they exceed the cumulative total of actual premium payments [see Reg. §§1.72-11(b)(1) and 1.72-6(a)(1)(i)].

Exemption From The Modified Endowment Contract Rules

There is a limited exemption to the harsh "income-first" rule applied to modified endowment contract distributions. Thus, the income-first rule does not apply to any assignment (or pledge) of a modified endowment contract if the assignment (or pledge) is solely to cover the payment of burial or prearranged funeral expenses, but only if the maximum death benefit under the contract does not exceed $25,000 [I.R.C. §72(e)(10)(B)].

Ten-Percent Additional Tax

Any amount received under a modified endowment contract that is includable in gross income, is subject to an additional 10 percent tax [I.R.C. §72(v)]. This means that amounts received from a modified endowment contract are taxed twice--once at the taxpayer`s normal rate and again through a 10 percent additional tax. The 10 percent tax, however, does not apply if a distribution is made (a) to a policy owner who has reached the age of 59 1/2, (b) to a policy owner as a result of his or her disability, or (c ) as part of a life annuitization arrangement [I.R.C. §72(v)(2)].

Effective Date Of Modified Endowment Contract Rules

With certain limited exceptions, all life insurance contracts entered into, or materially changed, on or after June 21, 1988 must comply with Code §7702A and the seven-pay test. Contracts entered into before June 21, 1988 are considered "grandfathered" and are generally not subject to the seven-pay test [TAMRA §5012(e)].

For purposes of determining whether a contract was entered into on or after June 21, 1988, if the death benefit payable on October 20, 1988, increases by more than $150,000, the material change rules apply (see "Material Changes" above) from the date the benefit exceeds the threshold. As a result the contract may lose its grandfathered status. This $150,000 rule does not apply, however, if as of June 21, 1988, the contract required at least seven level annual premium payments and the policyholder continues to make level annual premium payments over the life of the policy [Technical and Miscellaneous Revenue Act of 1988, § 5012(e)]. To determine whether the death benefit increase constitutes a material change, the death benefit, payable as of June 20, 1988, is to be taken into account rather than the lowest death benefit payable during the first seven contract years.

The modified endowment contract rules also govern a contract entered into before June 21, 1988, if: (1) the death benefit under the contract is increased (or a qualified additional benefit is increased or added) on or after June 21, 1988 and (2) the owner of the contract did not have a unilateral right to obtain the increase without providing additional evidence of insurability before June 21, 1988. In addition, a term contract will lose its grandfathered status if the contract is converted after June 20, 1988 to life insurance providing coverage other than term insurance [TAMRA §5012(e)].

The Effect Of Code §1035 Policy Exchanges

Contracts entered into before June 21, 1988 are considered "grandfathered" and, as such, are not subject to the 7-pay test. [TAMRA, Sec. 5012(e).]  If a life insurance contract which is grandfathered from the seven-pay test because it was issued before June 21, 1988 is exchanged on or after June 21, 1988, the grandfathering is lost and the new policy must qualify under the seven-pay test to avoid being a modified endowment contract. If a modified endowment contract is exchanged for another policy, the new policy (even if on its own it wouldn`t be a modified endowment contract) is also a modified endowment contract.  Code §7702(a)(2).

Congress also provided a limited period of time during which policies that passed the seven-pay test could be exchanged for modified endowment contracts, and not be treated as modified endowment contracts after the exchange.  Under this provision, if a modified endowment contract that required the payment of at least seven annual level premiums was entered into after June 20, 1988, but before November 10, 1988 (the date TAMRA was enacted), and was then exchanged within three months following November 10, 1988 for a contract that satisfied the requirements of the seven-pay test, the new contract would not be treated as a modified endowment contract if the taxpayer recognized gain on the exchange.

Limited Role For Modified Endowment Contracts In Financial Planning

Most of the tax benefits of single-premium life insurance vanished with the creation of the modified endowment contract (MEC) taxation regime under the Code. Although loans are no longer available on a tax-free basis, a modified endowment contract can offer a tax-free buildup for accumulating cash value, and death benefits remain free of income tax.

Insurance Company Requests For Waivers Of Disqualification Of Life Insurance Contracts >From Tax Treatment As Life Insurance Under §7702

Internal Revenue Code (I.R.C.) §7702 sets forth certain technical requirements which a life insurance policy must meet in order for it to be classified as a life insurance contract, and entitled to tax treatment as such, for federal tax purposes.  Thus, a contract must qualify as a life insurance contract under applicable state law and must also meet either of two alternative tests (generally intended to prevent the use of insurance policies as vehicles primarily for the tax-free accumulation of excessive investment income): (1) the cash value accumulation test of §7702(a)(1), or (2) the guideline premium and cash value corridor tests of §7702(a)(2)(A) and (B).  These rules apply with respect to insurance contracts issued subsequent to 1984.

With respect to contracts issued before January 1, 1985, I.R.C. §101(f) applies, and this section excludes from gross income any amount paid by reason of the death of the insured under a life insurance contract described as a flexible premium contract only if the contract satisfies either (1) the guideline premium limitation and the applicable percentage limitation of section 101(f)(1)(A)(i) and (ii), or (2) the cash value test of section 101(f)(1)(B).

The rules applicable to post-1984 contracts and to pre-1985 contracts, although  technically different, have a common theme of assuring that the premiums paid into a flexible premium contract are not excessive in relation to the value of the death benefit (the assumption being that the excess is intended primarily for tax-free investment within the policy).

Potential Adverse Consequences Of Failure To Qualify As An Insurance Contract

The consequences of failure of a contract to meet the applicable requirements of the foregoing Code sections can be quite severe, as follows:

• The policy owner is taxable on the annual income on the contract (the increase in cash value, plus the cost of the life insurance protection, less the premium paid in).  See I.R.C. §7702(g)(1).
• The issuer is responsible for withholding, and payment over to IRS, of tax on such annual inside build-up, and is subject to potential penalties for failure to withhold.  See I.R.C. §3405 and Rev. Rul. 91-17, 1991-1 C.B. 10.

Fortunately, the policy death benefit remains tax-free.  See I.R.C. §7702(g)(2).

Potential IRS Waiver Of Technical Failures In Meeting The Statutory Requirements

Recognizing the severity of the consequences to insurance policy holders in the event that their insurance contracts are determined not to meet these statutory requirements, the Code provides for potential IRS waiver of the requirements in circumstance where the failure was merely technical in nature, caused by inadvertence, clerical error or other excusable unintended cause.  Thus, under I.R.C. §§101(f)(3)(H) and 7702(f)(8), the Secretary of the Treasury (through delegates at the IRS) may waive a failure to satisfy the requirements of §101(f) or §7702.  Such a waiver may be granted, upon application, if the applicant can satisfactorily establish that (A) the failure to satisfy the statutory requirements for any contract year was "due to reasonable error," and (B) "reasonable steps are being taken to remedy the error."  §7702(f)(8).  This latter requirement of remedying the error has been interpreted by IRS as including both (a) arranging for the specific non-complying contracts to be brought into compliance (generally, through refunding excess premium amounts or increasing the death benefit), and (b) taking steps to assure that similar incidents of non-compliance will not likely occur in the future.

Applying For A Waiver

If an insurer has discovered that there was a violation of the §7702 or §101(f) technical requirements, and the circumstances were such that it can be shown to have been due to reasonable error, a formal waiver request should be prepared and submitted to IRS.  In connection with such waiver request, it will be necessary (if not already done) to develop a plan for steps to be taken to change the company`s systems and/or procedures to prevent such violations in the future.  It will also be necessary to develop a plan for bringing all of the non-complying contracts into compliance within a stated period of time after issuance of the IRS waiver.  (This is ordinarily accomplished through refunds of the applicable excess premium with interest to the date of refund, or upward adjustment in the policy death benefit, or a combination of the two.)  Most of the waivers granted in past private letter rulings allow 90 days from the date of the waiver to complete the correction process, but in some cases 30 or 60 day periods are stated.  If a longer period is needed this would probably be a subject of negotiation with the IRS.

Such remedial plans can be developed with implementation contingent upon the issuance of the waiver, which would seem to be the prudent course, since these plans can presumably be altered or fine-tuned prior to implementation if necessary to satisfy IRS in connection with the waiver application.

The waiver application submission would have to provide considerable factual detail as to what happened and why (including the number of contracts involved), presented in a manner so as to show that the violation or violations were due to reasonable error.

Waiver Qualification Factors, Based Upon Survey Of Prior IRS Waiver Actions

The IRS has published its decisions on numerous waiver applications since 1991 in private letter rulings.  A survey of these rulings gives valuable insight into the types of §7702/§101(f) violations which have been considered for waiver by IRS in the past, and the factors deemed relevant in determining the reasonableness of the errors and the corrective actions taken or proposed.  Below is a summary of the relevant facts and "reasonableness" factors critical to the granting or denial of the waiver in most of these rulings.

It should be noted that in only one case (PLR 9202008) was a waiver denied, and even in that case the waiver was granted with respect to 9 of the 21 contracts involved).  In the case of the denial, the company was utilizing a purchased software program for testing guideline premium compliance which failed to include as premiums paid, large single deposits or exchange proceeds—an apparently inexcusable shortcoming in the system.

Most of the rulings involve situations of clerical mistakes or inaction caused by "inadvertent human error."  However, even in situations where employees knowingly took actions inconsistent with established systems and procedures, the resulting non-compliance was held to have been "reasonable error."  In most such instances the rulings point out that the company actually had in place a system or an established procedure which, if properly followed, would not have resulted in a compliance failure.  Thus, the existence of proper systems and procedures is deemed more significant than isolated failures of employees to follow them, whether or not intentional.  See, for example, PLR 9601039 discussed below, in which employees sometimes accepted and credited premiums which exceeded guideline limitations, in circumstances where this could only be done by manually disabling the computer system feature which automatically tested for compliance upon entry of each premium deposit.  This was characterized as "reasonable error" in the granting of the waiver.

With the foregoing information and the abstracts of past private rulings which follow, the insurer should be in a position to evaluate the situation with knowledge of the factors involved.

Survey Of IRS Private Letter Rulings On Insurance Company Requests For Waivers

 The following is a listing of previously issued IRS private letter rulings (PLRs) in response to requests from insurance companies for waivers of technical violations of the statutory tests for qualification of flexible premium policies as insurance under I.R.C. §§101(f) and 7702.  Each ruling is abstracted to summarize the facts which led to the violation(s), and the remedial steps taken or to be taken.  The waiver was fully granted in all of the rulings discussed below except one, PLR 9202008, discussed last in the following list.

PLR 9144020

• 157 contracts were overfunded due to rounding (most by less than 10 cents).  Technical noncompliance due to rounding held not to violate the statutory requirements.
• 11 contracts were overfunded (from $14 to $4,520) due to clerical errors in manual computations.  Company had procedures in place which, if followed, would have avoided the problem.
• Refunds of excess premiums with interest to be made within 30 days of issuance of IRS waiver.

PLR 9146011

• Computer flagged overfunding, but employees failed to follow up by sending refunds.
• After discovery, system was revised to reduce likelihood of recurrence.
• "The failures in contract administration resulted from inadvertent human error."
• Policy holders to be offered 3 options to cure the violations: cancellation of the policy; refund of excess premium with interest; or increase in the face amount.

PLR 9146016

• Computer programming error "which included an amount allocable to expense which was twice as great as it should have been."
• Also, "inadvertent clerical errors relating to acceptance of excess premiums," and failure of manual follow-up on overfunded contracts that the computer did pick up.
• Steps taken to correct the system.
• Violations to be cured by premium refunds with interest, increased death benefit, or some combination.

PLR 9203049

• Systems were in place to monitor compliance, but 104 contracts overfunded due to clerical errors (some as long ago as 3 years prior to the waiver request):
1. automatic billing of planned premiums even though planned payments would result in overfunding;
2. unbilled extra payments that manual clerks missed;
3. calculation errors in manual checking in connection with policy changes.
• Corrective action already taken: refunds or increases in face amount.
• Some refunds had been paid without interest.  These cases are to be further corrected by paying the interest plus interest on the late interest, or giving option to apply this sum to purchase increased death benefit.
• Systems to be changed to improve compliance.
• Errors were held reasonable, "especially in view of the small number of failed contracts compared to the large number of contracts … issued."

PLR 9214039

• Computer monitored compliance and put out a list of potential noncomplying contracts, for manual analysis.  Employees "inadvertently failed to follow established manual procedures to properly retest the contracts.
• Computer system was refined so as to reduce by 80% the list of potential non-complying contracts needing further manual retesting, thereby reducing the probability of human error in manual testing through reduction in the volume of such testing.
• Within 90 days of waiver letter issuance, noncomplying policy holders to be offered choice of refund, increased death benefit or a combination.

PLR 9235013

• 3 contracts overfunded "due to failure of individual employees to follow the manual procedures implementing the computer system monitoring . . ."  Held to be clerical errors resulting from inadvertent human error.
• Procedures instituted to eliminate potential for some forms of errors and substantially reduce potential for others.
• Policy holders to be offered refund, increased death benefit or combination.

PLR 9244010

• In computing the guideline premium limitation, the company used the applicable annual mortality table.  However, the actual mortality charges provided in the contract were stated on a monthly basis, based upon the annual charge divided by 12 and rounded down.  This discrepancy between the actual mortality charge and the charge used in the compliance testing resulted in overfunding of contracts, which the IRS holds to be a failure in the nature of a rounding variation, which is a "reasonable error."
• Three policies had face amount decreases, and the guideline compliance was recomputed under the so-called "start-all-over" method required under §7702 before it was amended in 1986.  As a result of a retroactive amendment of §7702 in 1986, another method, the so-called "attained-age-decrement" method was required, which has the effect of reducing the guideline premium below the amount determined under the start-over method.  As a result, three contracts which had undergone changes were out of compliance.  Waiver was granted as to these contracts.
• One contract failed because the wrong age was used in the compliance testing after a face amount increase.  This was held to be inadvertent clerical error.
• Overfunding on all contracts discussed was refunded with 6 percent interest from date of violation to date of refund.
• Company found to have taken reasonable steps [not specified] "to remedy the errors."

PLR 9322023

• Computer correctly flagged overfunded contracts, but employees failed to act under established procedures to correct the overfunding.
• New procedure established whereby a second department in the company is to get the computer lists and monitor whether the people responsible for the corrective action have done so.
• Refunds with interest to be paid.

PLR 9416017

The following were all held to have been clerical errors resulting from inadvertent human error, at a time when there was no overall computer system:

• Pre-1982 contract holders were sent a letter proposing a change in the death benefit which would assure compliance with the newly-enacted §7702.  There was a failure to follow up on some of the policy holders who did not respond to accept this change.
• In some policies designed with first year premiums higher than in following years, there was a failure to apply the procedure which would trigger the reduction in the billed premium amount after the first year.
• New business clerks responsible for monitoring compliance of new contracts inadvertently accepted contracts with initial premiums too high.
• Employees erroneously accepted non-planned premiums which caused overfunding.
• When a new computer was installed there were some errors in inputting contract data, with the result that future premium payments which appeared to be in compliance were actually causing overfunding.
• New computer system and verification procedures now in place.
• Past overfunded cases to be corrected by increasing death benefit, but waiver will not apply to any contracts "not cured within 90 days . . ."

PLR 9436037

• Employees manually input wrong rate for specific ages.  Data was corrected before policies issued, but they did not think of recalculating the guideline premium limitation.
• Problem to be corrected in future by computer being programmed to automatically recalculate guideline premium limitation whenever there is such a change.
• Failed contracts to be remedied by either premium refund or increase in death benefit.

PLR 9438015

• Company had written procedure for triggering guideline compliance recalculation (and refunding payments if needed) at the time of any change in face amount or in a qualified additional benefit.  These procedures were not followed in several of the following types of situations:

·

1. the face amount was decreased;

2. a change occurred between the initial compliance testing and the issuance of the policy;

3. a qualified additional benefit was removed after issuance;

4. a change in underwriting took place after issuance of the policy;

5. there was a change of the insured party.

• Computer will in the future automatically recalculate compliance when these events occur.  Personnel instructed carefully on importance of compliance recalculations and timely refunding.  Regular computer monitoring of all contracts.
• Clerical errors in administration resulted from inadvertent human error.  Reasonable steps [unspecified] were proposed to cure the existing failures.

PLR 9441022

• 2 contracts included a 5-year term rider, which was a "qualified additional benefit" for purposes of applying the §7702 compliance tests (see §7702(f)(5)).  This additional benefit is taken into account under the company`s administrative procedures in testing for §7702 compliance.  However, the system had erroneously been manually overridden to indicate that the rider coverage was provided to age 95, rather than for only 5 years, with the result that premiums thought to be within the guidelines were in fact in excess.  "No policy or formal procedure authorized such overrides."  IRS holds that inadvertent human was the cause of the failure.
• The company subsequently issued explicit written prohibitions against further overrides, and "has in place automated procedures designed to prevent future noncompliance."
• Company will refund excess premiums with interest within 90 days of receipt of the waiver ruling.

PLR 9441023

• A contract contained a 5-year term rider which was a qualified additional benefit.  However the compliance monitoring system was manually overridden causing the system to treat the term rider as a part of the death benefit.  No policy or formal procedure authorized the override.  This was held to be reasonable error caused by inadvertent human error.
• Company to refund excess premium within 90 days of receipt of waiver.
• Company "has in place automated procedures designed to prevent future noncompliance."

PLR 9517042

The following types of compliance failures occurred under company`s computerized system:

• Premiums received before the policy anniversary date, but not processed until after the anniversary date.  Although these premium are credited to the contract as of the date of receipt, they are not tested for §7702 compliance until the actual processing date.  At that point the computer program has  already increased the guideline premium sum by the scheduled premium for the policy year beginning on the anniversary date, an incorrect guideline with respect to a premium which is to be credited as of a date prior to the anniversary date.
• In one contract there was an inadvertent use of  an incorrect issue age (29 instead of 25).
• With respect to a series of modified endowment contracts issued in 1988 the guideline premium limitations were calculated using the 1958 C.S.O. Mortality tables, instead of the 1980 tables which contain lower mortality charges.  The problem occurred as a result in a short gap in the process of transition from one computer system to another.
• In connection with policies issued in tax-free intracompany exchanges, there were no front-end load charges, but the computer program tested for §7702 compliance of such exchange policies as if they had been new policies subject to the normal front-end load.
• Company modified its computer system and its manual procedures so that these errors should not reoccur.  Computer will make monthly tests for excess premiums and weekly searches for computer messages of non-compliance cases.
• Company proposes to remedy past failures by either increasing death benefits or refunding excess premiums.
• The first 3 categories of failure listed above were found to be clerical errors resulting from human error.  The fourth category was simply described as "reasonable error within the meaning of sections 101(f)(3)(H) and 7702(f)(8)."

PLR 9452023

• The contracts in question permitted surrender only on a contract anniversary date.  However, on a discretionary basis, some surrenders were allowed between anniversary dates, and as to these the surrender value was computed in a manner which caused a technical violation of the §7702 tests, as interpreted under 1992 proposed regulations defining "cash value."
• Waiver was granted based upon the fact that the proposed regulations had not yet become effective, and the company`s commitment to issue, within 30 days after granting of the waiver, riders which would increase death benefits to the greater of the face amount or an amount computed under a formula relating to the theoretical surrender value on the date of death.

PLR 9524021

· In a single case, the computer twice rejected an attempted premium payment which the computer determined would violate §7702 guidelines.  Nonetheless, "due to human error, the person investigating the rejection overrode the system so that the premium payment was accepted."

• Waiver granted as due to reasonable error.
• Procedures [unspecified] instituted to reduce likelihood of recurrence.
• Overfunding to be remedied by either refund of excess, increased death benefit, or a combination.

PLR 9601039

• The interest rate used to determine the scheduled premiums was 4%, yet the rate used in calculating the guideline premium limitation was 7% (equal to the rate used for guaranteed cash values).  This would result in scheduled premium payments violating the guideline limit.
• Although the company`s computer system and internal procedures would ordinarily flag each such noncomplying premium and require refund of the excess, certain employees, instead of following procedures to refund such flagged overpayments, took steps to manually disable the computer feature that automatically tests all incoming premiums for compliance.
• Acceptance of such premiums in contravention of established procedures was held to be "human error."
• Within 30 days after issuance of waiver, excess premiums to be refunded with interest at a rate equal to the rate credited to the respective policy`s accumulation value, but not less than the 7% guaranteed cash value rate.
• Computer system modified to ensure that its overfunding safeguards may not be overridden.

PLR 9621016

• In the process of converting to a new computer system, a staff person erroneously input the date of the conversion as the issue date for certain flexible premium contracts. This caused subsequent computations of the maximum guideline premium to exceed what would be the correct amount based upon actual issue dates, and premiums were accepted which exceeded such correct amount.
• The erroneous programming was subsequently corrected.
• Failed contracts to be remedied by refunding excess premiums within 90 days after waiver issuance, with interest at the contract crediting rate.

PLR 9623068

The ruling involves the following three types of errors (involving a total of five contracts)

• The employee responsible for manually recomputing the guideline limitation upon a contract change failed to make the required recomputation.
• In another case the recomputation was made, and a premium refund was made, but the refund was not large enough since, in the recomputation, the employee erroneously treated the insured as a smoker.
• Contracts were administered manually with respect to §7702(a)(2) compliance.  In one instance, an actuarial clerk failed to detect that additional premiums had been paid in.
• These cases to be remedied by either refunding excess premiums with interest or retroactively increasing death benefit.
• Company "has instituted a comprehensive audit program which will be administered monthly."  Also, a new automated system will adjust for correct guideline limitations upon policy changes.

PLR 9625046

• This 20-page ruling involves a complex set of factual circumstances involving the company`s regularly-employed methods of applying additional benefit charges and expense charges, and applying interest, in the determination of the applicable death benefit.  The methods used did not technically conform with the terms of the contracts, with the result that the calculated death benefit was less than that which strict adherence to the contract would have produced.  Because of this reduction in actual death benefits, while guideline compliance calculations were being made using the higher death benefit amounts (computed under the contract terms), premium payments were permitted which violated the §101(f)(1)(B) and 7702 requirements.
• The company undertook to pay the correct higher death benefits, including retroactive supplemental payments with respect to all contracts on which the death benefit had previously been paid.  Such supplemental payments will be with interest at a rate equal to the greater of the quarterly rate applicable under the contract, or "any rate required under state law."
• The company also undertook to correct its "administrative errors."  The waiver was granted, although it should be noted that there appears to be no specific finding that the non-compliance was "due to reasonable error," as the Code requires.

The following is a published letter ruling in which a waiver was denied:

PLR 9202008

• "Omissions in the [computer] programming process had caused calculation errors."  The computer system failed to treat unscheduled premiums (e.g., large single deposits and exchange proceeds) as premiums paid.  In addition, the system did not adjust the guideline premium limitation after a partial withdrawal or reduction in death benefit.  Twelve contracts failed as a result solely of these programming shortfalls, and the waiver was not granted with respect to these.  The ruling states that the overfunding in these contracts was "due to an inherent structural flaw in the software program purchased and used by the Taxpayer to insure compliance of its contracts with federal tax law."
• Four contracts which had been manually tested during a period when the computer system was being upgraded failed due to clerical errors in the manual calculations.  Waiver was granted with respect to these.
• An additional four contracts failed because, although the overfunding was picked up by the computer, "due to human error … the excess premiums for these four contracts were inadvertently not returned to the policyholder during the 60 day period allowed in section 7702(f)(1)(B) …"  Waiver was granted with respect to these four contracts.  Waiver was also granted with respect to one contract which failed by 12 cents, due to rounding.
• In all cases the policyholders were eventually offered the choice of a refund of the excess premium with interest or an increase in the death benefit.
• The company "has in place automated procedures designed to prevent future noncompliance."

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