Section 7702

A contract issued by a small insurer is later determined to FAIL the definition of life insurance under Section 7702 because it was overfunded relative to its death benefit. What are the federal income tax consequences to the owner, both during the owner life and at death?

1. A.The contract is treated as an annuity, so all growth is tax deferred until distributionThere is no automatic recharacterization as an annuity, and deferral is exactly what the owner loses.
2. B.The contract is simply reclassified as a modified endowment contract and taxed under the MEC rulesMEC rules apply to contracts that still qualify as life insurance. A 7702 failure is a different and harsher result.
3. C.Nothing changes during life, but the entire death benefit becomes taxable to the beneficiaryThe loss of deferral during life is the immediate consequence, and the death benefit exclusion is only partly lost, not entirely.
4. D.The income on the contract is taxed to the owner annually, and at death only the excess of the death benefit over the net cash surrender value stays income tax freeCorrect. Failure of Section 7702 ends tax deferral and preserves the exclusion only for the pure protection element at death.

Why: A contract that fails Section 7702 loses its status as life insurance for income tax purposes. Two things follow. During the owner life, the annual income on the contract, essentially the increase in cash value plus the cost of insurance protection, is currently taxable to the owner rather than growing tax deferred. At death, the exclusion is only partially preserved: the excess of the death benefit over the net cash surrender value, which is the pure protection element, remains income tax free, while the balance is taxable. So the failure is expensive but not total.

An actuary explains that every contract the company issues must qualify as life insurance under Section 7702 by satisfying one of two alternative tests, and that the company applies a different test to its traditional whole life series than to its flexible premium universal life series. Which pairing correctly describes the two tests?

1. A.The cash value accumulation test, which limits cash value relative to the death benefit, or the guideline premium and corridor test, which caps cumulative premiums and requires a minimum death benefit corridorCorrect. Section 7702 gives two alternative qualification routes, and a contract need satisfy only one.
2. B.The cash value accumulation test and the guideline premium test, BOTH of which every contract must satisfyThey are alternatives. Requiring both would make the guideline premium route pointless.
3. C.The corridor test and the transfer for value test, either of which qualifies a contract as life insuranceThe transfer for value rule governs the taxability of proceeds after a policy is sold. It has nothing to do with qualification under Section 7702.
4. D.The 7-pay test and the guideline premium test, either of which qualifies a contract as life insuranceThe 7-pay test comes from Section 7702A and determines MEC status. It is not a Section 7702 qualification test.

Why: Section 7702 offers a contract two routes to qualify as life insurance. The CASH VALUE ACCUMULATION TEST limits cash value to the single premium that would fund the future benefits, and it is the natural fit for traditional fixed premium whole life, where the relationship between cash value and death benefit is built into the design. The alternative is the GUIDELINE PREMIUM AND CORRIDOR TEST, which caps cumulative premiums paid and separately requires the death benefit to stay above a stated multiple of cash value, the corridor. That two-part test suits flexible premium universal life, where the owner controls how much premium goes in. A contract needs to satisfy only one of the two.

A universal life policyowner with a LEVEL (Option A) death benefit takes a $30,000 partial surrender from her $300,000 policy. The typical contractual effect is:

1. A.The policy automatically becomes a MECWrong. MEC status flows from FUNDING pace, not withdrawals (though face cuts can trigger 7-pay retesting).
2. B.The premium doubles to restore the faceWrong. Restoration requires an elective increase WITH underwriting - never automatic premium hikes.
3. C.The death benefit is unchanged at $300,000Wrong-but-tempting. UNCHANGED faces belong to LOANS - surrenders permanently reduce Option A benefits.
4. D.The death benefit is reduced by $30,000 along with the cash valueCorrect. Dollar-for-dollar face reduction is the standard Option A effect.

Why: Partial surrenders from level-benefit UL reduce both cash value and the specified amount dollar-for-dollar, maintaining the required corridor; non-MEC taxation recovers basis first. Citation: UL partial surrender provisions. Takeaway: Option A withdrawals shrink the death benefit by the amount taken.

Steadfast Mutual must qualify Anneke's 500,000-dollar permanent policy as life insurance under Section 7702 and is choosing between the cash value accumulation test and the guideline premium and corridor test. Which statement correctly contrasts the two?

1. A.The guideline premium test is required for single-premium contracts, and the cash value accumulation test is available only for flexible-premium designsThis is backwards. A single premium would blow through guideline limits, which is why such contracts are typically qualified under the cash value accumulation test.
2. B.A contract that fails either test becomes a modified endowment contractFailing Section 7702 means the contract is not treated as life insurance, so its inside build-up is currently taxable. MEC status comes from failing the separate 7-pay test of Section 7702A, and a MEC is still life insurance.
3. C.Both tests limit cumulative premium; the cash value accumulation test simply uses a lower interest assumptionThe cash value accumulation test contains no premium limitation at all. That is precisely why single-premium contracts are usually written under it.
4. D.The cash value accumulation test sets no premium limit but caps cash value at the net single premium for the death benefit, while the guideline premium test limits cumulative premium and separately forces the death benefit up through a corridor percentageCorrect. One test constrains cash value; the other constrains premium and adds a corridor.

Why: Section 7702 offers two alternative tests. The cash value accumulation test imposes no limit on premium but caps cash value at the net single premium that would fund the death benefit, which is why it suits single-premium and heavily funded designs. The guideline premium test limits cumulative premium to guideline single or guideline level amounts AND separately applies a corridor percentage that forces the death benefit up as cash value grows. The clue is that the insurer must pick one at issue, so the products they serve differ.