TREATMENT OF MODIFIED ENDOWMENT CONTRACTS.

SEC. 5012. TREATMENT OF MODIFIED ENDOWMENT CONTRACTS. (a) Distribution Rules.— (1) In general.— Subsection (e) of section 72 of the 1986 Code (relating to amounts not received as annuities) is amended by adding at the end thereof the following new paragraph: “(10) Treatment of modified endowment contracts.— “(A) In general.— Notwithstanding paragraph (5)(C), in the case of any modified endowment contract (as defined in section 7702A)— “(i) paragraphs (2)(B) and (4)(A) shall apply, and “(ii) in applying paragraph (4)(A), ‘any person’ shall be substituted for ‘an individual’. “(B) Treatment of certain burial contracts.— Notwithstanding subparagraph (A), paragraph (4)(A) shall not apply to any assignment (or pledge) of a modified endowment contract if such assignment (or pledge) is solely to cover the payment of expenses referred to in section 7702(e)(2)(C)(iii) and if the maximum death benefit under such contract does not exceed $25,000.” (2) Technical amendment.— Subparagraph (C) of section 72(e)(5) of the 1986 Code is amended by striking out “Except to the extent” and inserting in lieu thereof “Except as provided in paragraph (10) and except to the extent”. (b) Additional Tax.— 102 STAT. 3662 (1) In general.— Section 72 of the 1986 Code (relating to annuities; certain proceeds of endowment and life insurance contracts) is amended by redesignating subsection (v) as subsection (w) and by inserting after subsection (u) the following new subsection: “(v) 10-Percent Additional Tax for Taxable Distributions From Modified Endowment Contracts.— “(1) Imposition of additional tax.— If any taxpayer receives any amount under a modified endowment contract (as defined in section 7702A), the taxpayer’s tax under this chapter for the taxable year in which such amount is received shall be increased by an amount equal to 10 percent of the portion of such amount which is includible in gross income. “(2) Subsection not to apply to certain distributions.— Paragraph (1) shall not apply to any distribution— “(A) made on or after the date on which the taxpayer attains age 59 ½, “(B) which is attributable to the taxpayer’s becoming disabled (within the meaning of subsection (m)(7)), or “(C) which is part of a series of substantially equal periodic payments (not less frequently than annually) made for the life (or life expectancy) of the taxpayer or the joint lives (or joint life expectancies) of such taxpayer and his beneficiary.” (2) Technical amendment.— Subparagraph (C) of section 26(b)(2) of the 1986 Code is amended by striking out “or (q)” and inserting in lieu thereof “(q), or (v)”. (c) Modified Endowment Contract Defined.— (1) In general.— Chapter 79 of the 1986 Code is amended by inserting after section 7702 the following new section: “SEC. 7702A. MODIFIED ENDOWMENT CONTRACT DEFINED. “(a) General Rule.— For purposes of section 72, the term ‘modified endowment contract’ means any contract meeting the requirements of section 7702— “(1) which— “(A) is entered into on or after June 21, 1988, and “(B) fails to meet the 7-pay test of subsection (b), or “(2) which is received in exchange for a contract described in paragraph (1). “(b) 7-Pay Test.— For purposes of subsection (a), a contract fails to meet the 7-pay test of this subsection if the accumulated amount paid under the contract at any time during the 1st 7 contract years exceeds the sum of the net level premiums which would have been paid on or before such time if the contract provided for paid-up future benefits after the payment of 7 level annual premiums. “(c) Computational Rules.— “(1) In general.— Except as provided in this subsection, the determination under subsection (b) of the 7 level annual premiums shall be made— “(A) as of the time the contract is issued, and “(B) by applying the rules of section 7702(b)(2) and of section 7702(e) (other than paragraph (2)(C) thereof), except that the death benefit provided for the 1st contract year shall be deemed to be provided until the maturity date without regard to any scheduled reduction after the 1st 7 contract years. 102 STAT. 3663 “(2) Reduction in benefits during 1st 7 years.— “(A) In general.— If there is a reduction in benefits under the contract within the 1st 7 contract years, this section shall be applied as if the contract had originally been issued at the reduced benefit level. “(B) Reductions attributable to nonpayment of premiums.— Any reduction in benefits attributable to the nonpayment of premiums due under the contract shall not be taken into account under subparagraph (A) if the benefits are reinstated within 90 days after the reduction in such benefits. “(3) Treatment of material changes.— “(A) In general.— If there is a material change in the benefits under (or in other terms of) the contract which was not reflected in any previous determination under this section, for purposes of this section— “(i) such contract shall be treated as a new contract entered into on the day on which such material change takes effect, and “(ii) appropriate adjustments shall be made in determining whether such contract meets the 7-pay test of subsection (b) to take into account the cash surrender value under the contract. “(B) Treatment of certain increases in future benefits.— For purposes of subparagraph (A), the term ‘material change’ includes any increase in future benefits under the contract. Such term shall not include— “(i) any increase which is attributable to the payment of premiums necessary to fund the lowest level of future benefits payable in the 1st 7 contract years (determined after taking into account death benefit increases described in subparagraph (A) or (B) of section 7702(e)(2)) or to crediting of interest or other earnings (including policyholder dividends) in respect of such premiums, and “(ii) to the extent provided in regulations, any cost-of-living increase based on an established broad-based index if such increase is funded ratably over the remaining life of the the contract. “(4) Special rule for contracts with death benefits under $10,000.— In the case of a contract— “(A) which provides an initial death benefit of $10,000 or less, and “(B) which requires at least 7 nondecreasing annual premium payments, each of the 7 level annual premiums determined under subsection (b) (without regard to this paragraph) shall be increased by $75. For purposes of this paragraph, the contract involved and all contracts previously issued to the same insurer by the same company shall be treated as one contract. “(5) Regulatory authority for certain collection expenses.—The Secretary may by regulations prescribe rules for taking into account expenses solely attributable to the collection of premiums paid more frequently than annually. 102 STAT. 3664 “(d) Distributions Affected.— If a contract fails to meet the 7-pay test of subsection (b), such contract shall be treated as failing to meet such requirements only in the case of— “(1) distributions during the contract year in which the failure takes effect and during any subsequent contract year, and “(2) under regulations prescribed by the Secretary, distributions (not described in paragraph (D) in anticipation of such failure. For purposes of the preceding sentence, any distribution which is made within 2 years before the failure to meet the 7-pay test shall be treated as made in anticipation of such failure. “(e) Definitions.— For purposes of this section— “(1) Amount paid.— “(A) In general.— The term ‘amount paid’ means— “(i) the premiums paid under the contract, reduced by “(ii) amounts to which section 72(e) applies (determined without regard to paragraph (4)(A) thereof) but not including amounts includible in gross income. “(B) Treatment of certain premiums returned.— If, in order to comply with the requirements of subsection (b), any portion of any premium paid during any contract year is returned by the insurance company (with interest) within 60 days after the end of such contract year, the amount so returned (excluding interest) shall be deemed to reduce the sum of the premiums paid under the contract during such contract year. “(C) Interest returned includible in gross income.— Notwithstanding the provisions of section 72(e), the amount of any interest returned as provided in subparagraph (B) shall be includible in the gross income of the recipient. “(2) Contract year.— The term ‘contract year’ means the 12-month period beginning with the 1st month for which the contract is in effect, and each 12-month period beginning with the corresponding month in subsequent calendar years. “(3) Other terms.— Except as otherwise provided in this section, terms used in this section shall have the same meaning as when used in section 7702.” (2) Clerical amendment.— The table of sections for chapter 79 of the 1986 Code is amended by inserting after the item relating to section 7702 the following new item: “Sec. 7702A. Modified endowment contract defined.” (d) Other Modifications.— (1) Treatment of loans.— Subparagraph (A) of section 72(e)(4) of the 1986 Code (relating to loans treated as distributions) is amended by adding at the end thereof the following new sentence: “The preceding sentence shall not apply for purposes of determining investment in the contract, except that the investment in the contract shall be increased by any amount included in gross income by reason of the amount treated as received under the preceding sentence.” (2) Anti-abuse rules.— Subsection (e) of section 72 of the 1986 Code is amended by adding at the end thereof the following new paragraph: “(11) Anti-abuse rules.— 102 STAT. 3665 “(A) In general.— For purposes of determining the amount includible in gross income under this subsection— “(i) all modified endowment contracts issued by the same company to the same policy holder during any 12-month period shall be treated as 1 modified endowment contract, and “(ii) all annuity contracts issued by the same company to the same policy holder during any 12-month period shall be treated as 1 annuity contract. “(B) Regulatory authority.— The Secretary may by regulations prescribe such additional rules as may be necessary or appropriate to prevent avoidance of the purposes of this subsection through serial purchases of contracts or otherwise.” (e) Effective Dates.— (1) In general.— Except as otherwise provided in this subsection, the amendments made by this section shall apply to contracts entered into on or after June 21, 1988. (2) Special rule where death benefit increases by more than $150,000.— If the death benefit under the contract increases by more than $150,000 over the death benefit under the contract in effect on October 20, 1988, the rules of section 7702A(c)(3) of the 1986 Code (as added by this section) shall apply in determining whether such contract is issued on or after June 21, 1988. The preceding sentence shall not apply in the case of a contract which, as of June 21, 1988, required at least 7 level annual premium payments and under which the policyholder continues to make level annual premium payments over the life of the contract. (3) Certain other material changes taken into account.— A contract entered into before June 21, 1988, shall be treated as entered into after such date if— (A) on or after June 21, 1988, the death benefit under the contract is increased (or a qualified additional benefit is increased or added) and before June 21, 1988, the owner of the contract did not have a unilateral right under the contract to obtain such increase or addition without providing additional evidence of insurability, or (B) the contract is converted after June 20, 1988, from a term life insurance contract to a life insurance contract providing coverage other than term life insurance coverage without regard to any right of the owner of the contract to such conversion. (4) Certain exchanges permitted.— In the case of a modified endowment contract which— (A) required at least 7 annual level premium payments, (B) is entered into after June 20, 1988, and before the date of the enactment of this Act, and (C) is exchanged within 3 months after such date of enactment for a life insurance contract which meets the requirements of section 7702A(b), the contract which is received in exchange for such contract shall not be treated as a modified endowment contract if the taxpayer elects, notwithstanding section 1035 of the 1986 Code, to recognize gain on such exchange. 102 STAT. 3666 (5) Special rule for annuity contracts.— In the case of annuity contracts, the amendments made by subsection (d) shall apply to contracts entered into after October 21, 1988.