Question: My client’s CPA believes that the death benefit from a modified endowment contract is income taxable. Is the CPA correct?
The authority for this answer requires stitching together a few different parts of the Internal Revenue Code.
Section 101(a) says that the death benefit of a life insurance policy is generally income tax free.
(a) Proceeds of life insurance contracts payable by reason of death
(1) General rule
Except as otherwise provided in paragraph (2), subsection (d),subsection (f), and subsection (j), gross income does not include amounts received (whether in a single sum or otherwise) under a life insurance contract, if such amounts are paid by reason of the death of the insured.
Section 7702 defines life insurance, and sets out the kinds of guideline premium tests that must be met for a contract to qualify. MEC life policies must (and do) meet the tests in Section 7702.
Section 7702A explains how the separate seven-pay test works. Contracts that fail to meet the 7702A seven-pay test are MECs—but they are also still life insurance, because they meet the tests in Section 7702.
Finally Section 72(e)(10) explains that MECs are taxed differently from “normal” life policies for the purpose of lifetime distributions. Nothing in Sections 7702A, 101 or 72 says that MECs are taxed differently from normal life policies with regard to the death proceeds. Therefore, the death proceeds of a MEC life policy are income tax free.
There are lots of third party sources online that confirm the same conclusion. Here’s a link to one: