Single-Premium UL and an Investor-Funded Policy: MEC and STOLI
Dana, 63, owns a fixed deferred annuity worth $300,000 with a $150,000 cost basis. Her agent proposes a 1035 exchange into a single-premium universal life policy with a $500,000 death benefit, funded entirely from the annuity. Separately, Dana's nephew Craig wants to buy a $1,000,000 policy on Dana's life. Craig earns $45,000 a year and cannot pay the $28,000 annual premium, so a group of investors he met online will pay it; in exchange, Dana would sign an assignment giving the investors 60% of the death benefit, effective in month 25. Dana is in good health, has no dependents relying on her income, and has no business relationship with Craig.
1. Analyze the proposed 1035 exchange into the single-premium UL. Will the contract be a modified endowment contract, and what are the practical tax consequences for Dana at 63?
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Likely a MEC. A single premium of $300,000 on a $500,000 UL at age 63 will almost certainly fail the 7-pay test - the contract is funded far faster than seven level annual premiums would require. MEC status is determined at issue and is permanent; it cannot be cured by later premium changes.
Consequences if it is a MEC:
- The 1035 exchange itself is tax-free; the annuity's $150,000 of deferred gain carries over.
- Any distribution - including a policy loan - is taxed income first (LIFO) to the extent of gain, then as return of basis. This is the reverse of a non-MEC life policy, where loans are generally tax-free while the policy stays in force.
- The 10% additional tax on the taxable portion applies only before age 59½. Dana is 63, so no penalty - but the gain is fully ordinary income when accessed.
- The death benefit remains income-tax-free to the beneficiary under IRC §101(a); MEC status does not change that.
Practical judgment: Dana traded a tax-deferred annuity (already LIFO) for an insurance contract with high mortality charges, and she lost the ability to take tax-free loans. If her real goals are a death benefit and liquidity, a 7-pay-compliant flexible-premium UL funded with a partial 1035 - or keeping the annuity and buying term - serves her better.
2. Evaluate the Craig/investor arrangement. Assuming the assignment is signed at the same time as the application and executed in month 25, does waiting two years make it lawful?
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No. The two-year wait does not launder the transaction.
Insurable interest is tested at inception. Craig is a nephew with no dependency, no support relationship, and no expectation of pecuniary loss from Dana's death; Dana has no dependents relying on her income. The interest is thin at best on its own facts.
The investor funding makes it a stranger-originated life insurance (STOLI) arrangement. The defining facts are all present:
- Premiums paid by parties with no insurable interest.
- A pre-arranged agreement, at or before application, to assign most of the death benefit to those parties.
- A designed holding period (month 25) chosen to clear the contestability clock.
Because the intent to transfer existed at inception, the policy was procured as a wagering contract from day one. North Carolina's insurable interest requirement and its viatical/STOLI rules prohibit this, and the incontestability clause protects against misstatements in the application - it does not validate a policy that never had a lawful insurable interest.
Consequences: the insurer may rescind and refund premiums; the producer faces license discipline and possible fraud referral; Craig and the investors may lose their investment; Dana's own insurance record and future underwriting are compromised.
3. Dana's agent asks, "Can we just write it and let the attorneys sort it out in year three?" What should the agent do, and what lawful alternatives exist?
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The agent should decline to submit the arrangement. Writing a policy the agent knows is investor-funded to clear the contestability period is participation in the scheme, not a gray area. The agent should document the request, refuse to submit, and retain the notes.
Lawful alternatives to present:
- Dana insures herself. She has a genuine insurable interest in her own life and can own a policy with her estate or a charity as beneficiary, funded within 7-pay limits to avoid MEC status.
- Craig's interest must be real and documented. If Craig genuinely depends on Dana (co-signed debt, documented support), a modest policy owned and paid for by Craig may be supportable. The face amount must bear a reasonable relationship to the actual economic loss - not $1,000,000 on a $45,000 income.
- No third-party premium payers. Craig must fund the policy from his own funds; investor money is disqualifying regardless of who is named owner.
- If Dana's goal is charitable giving, a policy owned by the charity avoids the entire insurable-interest problem.
If the client insists: the agent declines the case and, where required, reports the suspected fraudulent arrangement to the insurer and the Department of Insurance.