A policy is classified as a modified endowment contract (MEC) because it failed the 7-pay test. If the owner takes a policy loan against this contract, the loan is treated as:

Why A is correct

In a modified endowment contract (MEC), distributions, including policy loans, are taxed on a last-in-first-out (LIFO) basis, meaning the taxable gain comes out first. In addition, if the owner is under age 59½, a 10% penalty generally applies to the taxable portion of the distribution. This harsh treatment, imposed by IRC §7702A and §72(e), eliminates the tax advantages normally associated with borrowing against whole life and universal life policies. MECs are created when premiums exceed the 7-pay limit, often from large single deposits.

Why the other options are wrong

• Ordinary policy loans are not taxable, but a MEC loan is specifically recharacterized as a taxable distribution; the MEC status changes the result. This option therefore does not match the facts presented in the question and is not the correct answer to select.
• Distributions from a MEC are not a return of premium first; LIFO ordering pulls the taxable gain out before the basis is recovered. This answer describes a different situation from the one in the question and is therefore incorrect under the facts given here.
• MEC distributions are taxed as ordinary income, not deferred capital gains; the gain is recognized when the distribution occurs. This choice does not fit the arrangement described in the question, so it is clearly not the right option to choose.

Memory hook

MEC loans pull gain out first, trigger tax, and add 10% before 59½.