A life insurance policy fails the seven-pay test under IRC Section 7702 and becomes a modified endowment contract. Which consequence follows?

Why A is correct

A modified endowment contract (MEC) is created when a life insurance policy is funded faster than the seven-pay test permits. Because the contract is overfunded as an investment, withdrawals and loans are taxed on a last-in, first-out (LIFO) basis, meaning taxable gain is distributed first, and distributions before age 59 and a half are subject to a 10% penalty. The death benefit, however, remains income-tax-free to the beneficiary under IRC Section 101(a), and the contract continues to operate as life insurance.

Why the other options are wrong

• B) MEC status does not make the death benefit taxable; the beneficiary still receives the proceeds income-tax-free. The beneficiary's receipt of proceeds is excluded under Section 101(a) even when the policy is a MEC.
• C) A MEC is still a life insurance contract, not an annuity; it keeps the death benefit and the policy's features. The contract keeps the death benefit and continues to be taxed as life insurance.
• D) Policy loans are still permitted from a MEC, but they are treated as taxable distributions under the LIFO rule, which is why the penalty can apply. Loans remain available but lose their tax-free character, which is exactly the adverse consequence described.

Memory hook

Stuff a policy with cash too fast, it becomes a MEC, and gain comes out first with a penalty kick.