ESOP owns a modified endowment contract ("MEC") on the life of insured/participant. ESOP also has unrelated taxable income ("UBTI").

Q: If the ESOP withdraws money from the MEC, what type of taxes and penalties apply to the ESOP and to what extent?

A: If the ESOP becomes taxable while it owns the MEC (say, the ESOP receives unrelated business taxable income "UBTI") and then withdraws money from the MEC, those withdrawals would be taxable as ordinary income, at least to (i) the extent of the gain in the MEC and to (ii) the extent that the ESOP is a taxpayer (that is, has UBTI). As for the 10% penalty for early withdrawal, that penalty depends on the age of the policyowner, not the insured/participant. The ESOP itself has no age, so my read is that there would be no 10% penalty applied.

Any thoughts, particularly as to the (ii) part of the above analysis?

An ESOP is a tax-exempt trust. An insurance policy is a tax-deferred investment outside a tax-exempt trust. However, non-MEC status is not required to avoid taxes. Investment income is tax-free to the trust whether from taxable gains in an insurance policy or in an otherwise taxable mutual fund or other investment.
The UBIT fact is a red herring. It doesn't affect taxability of other investments inside the tax-exempt trust.
You seem to believe that because a trust has UBTI, all of the trust's income is taxable. Not so.

But would a MEC be treated as an investment in the first place even assuming that there is no issue of "insurable interest"?

How else would you characterize it?

That is the problem.

To become a MEC the item has to fail being insurance as per IRC 7702 etc. Which raises the question of the original intent for making the purcvhase. Was it purchased to cover an insurable risk then because of either over-funding or higher than expected returns, failed to maintain the corridor and so became a MEC, or was it intentionaly purchased as a MEC? If intentionally set up/purchased as a MEC, that raises issues of suitability and product selection etc.

Life insurance, by state insurance law, NAIC and NASD cannot be referred to or sold as an investment and contributions must be referred to and treated as premiumns and nothing else. As a result life insurance cannot be an investment product. This applies even to Variable life etc with investment components:

http://www.nasd.com/web/groups/rules_regs/...asdw_004016.pdf

Also since it is a MEC, that means that the death benefit has been overshadowed by the cash value component, so Why would this be the product used to insure the losses incurred by the premature death of the insured, which is the purpose of insurance.?

All of the above raises fiduciary and suitability issues regarding what was purchased,and why etc.

If it is not insurance and not an investment, How do the proceeds etc get treated?

NASD opinions are not binding on the insurance industry, state insurance departments, federal agencies, etc. The insurance industry universally disagrees with the NASD on this issue.
I read the IRC as creating three statuses: (1) Non-MEC (falls within the corridor); (2) MEC (outside the corridor but within the definition of insurance); (3) does not meet the definition of insurance contract. A MEC is an insurance contract but is not entitled to all of the favorable tax treatment afforded Non-MEC contracts. Investment income under a MEC still has tax-free inside buildup. However, loans from a MEC are treated as taxable to the extent that they exceed the basis paid in. The entire presumption of the statute and regulations is that there will be an investment value that will cause the contract to be worth more than the premiums paid in. That is an investment.

Because someone calls something an investment does not make it so.

An insurance agent and an insurance company, who are the people who provide MECs, are both prohibited by the insurance and other laws of almost every state from referring to a MEC or any other insurance product as being an investment because it does not meet the definitions etc. How then can it be an investment?

Yes the insurance industry very often disagrees with the NASD but this is not one of those issues. The NASD is and always has been very clear that insurance products, even VAs and VL are not investments. That is why I gave the link to the NASD item where they warn against doing so in the same manner that Insurance Depts do.

I noticed that you did not cite the IRC or Treas Regs in stating your interpretation that there are three statuses.

You seem to be jumping between securities laws and Regs, insurance laws and Regs and IRS laws an Regs. You cite the NASD, a securities industry group and chide me for not citing IRS Regs?
It is the DOL, not the SEC, NASD, or IRS, that determines what is an investment for purposes of ERISA plans. For example, in DOL Regs. they refer to insurance contracts backed by insurance company general accounts as "investments". See http://www.dol.gov/ebsa/regs/fedreg/final/2000000032.htm. This issue was originally addressed by the "plan asset regulations" in 1988, 29 CFR 2510.3-102. The DOL has been clear in its instructions for form 5500. Schedule H lists "value of funds held in insurance company general account" under "General Investments", item 1©(14), and requires that the amount be consistent with the amount reported on Schedule A.

Your interpretation would mean that the thousands of 401(k) plans that wrap mutual funds within annuity contracts have no "investments".

I agree with vebaguru. No matter the type of investment vehicle used, it is an investment. It may be a stupid investment, it may generate UBTI, or lose its value, but it is still an investment.

Nasd rules regulate parties who sell products regulated by NASD- They have no application to plan sponsors or plans subject to ERISA where all plan assets are investments.