Who needs Section 7702 compliance testing?
For US policies, insurers are responsible for compliance with §7702. For Canadian and other non- US policies, compliance with §7702 rests with the policy owner.
Anyone subject to US taxation, due to citizenship or residency, who owns a non-US life insurance policy, is responsible for §7702 compliance.
What is Section 7702?
§7702 and §7702A of the U.S. Internal Revenue Code defines what the federal government considers to be a legitimate life insurance contract and determines how such contracts are to be taxed.
Three classes of contracts result:
- Life insurance – A “non-MEC” contract—one that fulfills all the requirements of both §7702 and §7702A—receives all the traditional tax benefits of life insurance.
- MEC – A modified endowment contract (MEC) meets the requirements of §7702, but not §7702A. Gain in a MEC is still shielded from taxation as long as it’s realized through death, but distributions are subject to LIFO taxation and may incur an excise penalty.
- Not insurance – A policy that doesn’t meet the requirements of §7702 isn’t life insurance at all for federal tax purposes.
Financial advisors may recommend the establishment of an Irrevocable Life Insurance Trust (ILIT). For new policies, this may be a good solution.
For existing policies this presents a problem if the policy has a significant Fair Market Value (FMV). For Canadian income tax purposes, the transfer of an existing life insurance policy to an ILIT will trigger a deemed disposition of the policy at FMV, which may result in taxation (the gains are treated as ordinary income).
To avoid the taxation, the Canadian policy could be cancelled, and a new policy purchased through the ILIT. However, doing so would result in losing the substantial FMV build up in the policy.
If it can be shown that the policy would meet the §7702 test, the best course of action could be to do nothing.
Before deciding on (1) Cancellation, (2) Replacement, (3) Maintaining the policy, a §7702 test should be performed. The test can also be accompanied by a FMV calculation to help you decide on the best option.
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