Buyer Beware

emember the old man who “bumped his head when he went to bed and couldn’t get up in the morning?” More elderly than ever before need help getting out of bed in the morning—as well as handling many of the other daily activities of living. To maintain a high quality of life when they grow older, all Americans need to include a long-term-care (LTC) strategy in their financial planning. Failure to factor in the cost of such care continues to be the largest omission of many individual financial plans. CPAs whose practice includes personal financial planning, particularly those interested in expanding into ElderCare—one of the new assurance services—need to know more about LTC alternatives and their costs.

Many people use LTC insurance policies as part of a plan to ensure lifetime care. The Health Insurance Portability and Accountability Act (HIPAA), effective January 1, 1997, created a new type of tax-qualified LTC policy. The act’s objective was to encourage individuals to provide for their own long-term care. To induce people to buy LTC insurance, premium payments were made tax deductible. The catch: Policies that qualify may have benefits-eligibility standards so rigorous they could do your client more harm than good in the long run. Even worse, HIPAA may have unintended tax consequences for purchasers of traditional LTC policies.

CPAs should be able to compare the benefits of tax-qualified and non-tax-qualified LTC policies and determine whether a particular LTC policy will provide clients reasonable access to benefits when care is actually needed. Before they can properly advise clients on LTC issues, CPAs may need to lobby for either new legislation or clearer regulations. Such clarification is of critical importance to the nation’s elderly.  

DANGEROUS DEDUCTION

Under HIPAA, tax-qualified LTC insurance policies are now treated as accident and health insurance contracts for tax purposes. Individuals who itemize their deductions and whose medical expenses exceed the 7.5% adjusted-gross-income floor can deduct the premiums. The limit on the amount of a premium a taxpayer can deduct is based on the age of the person filing the return (see exhibit 1, page 29). As a tax incentive, this limited deduction is inadequate. A relatively small percentage of a CPA’s clients will qualify for the deduction, and the size of the deduction makes it moot.

The danger to consumers is that in seeking a tax deduction they may be lured into buying an ineffective policy. Other (so-called by default) non-tax-qualified policies are still available from insurance companies and have benefits that are much easier to obtain. The key to understanding these two classes of policies is in the different eligibility requirements (see exhibit 2, page 29).  

ACCESS TO BENEFITS

All LTC policies impose requirements a client must meet to gain access to insurance benefits. These requirements vary greatly from policy to policy. It may be more difficult to secure benefits under an LTC policy than under a life, medical or auto insurance policy. Such benefit eligibility controversies are comparable to those an individual might face in obtaining disability insurance benefits, although the objective proof of lost income reduces the potential for dispute under a disability insurance policy.

When purchasing an LTC policy, individuals should give high priority to those with the least-rigorous eligibility requirements. These requirements act as independent triggers—that is, the insured must satisfy only one requirement, not several, to activate his or her contractual right to receive benefits. The more triggers a policy has, the higher the probability the client will successfully access benefits. The triggers also may have qualifiers, such as “activities of daily living” (ADLs). Most LTC policies contain only two triggers:

1. Proof of the inability to perform a specified number of ADLs.

2. Proof the insured is “cognitively impaired.”

The number of recognized ADLs varies from state to state, and the number an insured person must lack the ability to perform to access benefits likewise differs. States with the most rigorous consumer protection tend to require insurance companies to recognize seven ADLs (bathing, continence, dressing, feeding, toileting, transferring—the ability to move in or out of a chair or bed—and ambulating). California, for example, requires that insurers provide consumers the right to access benefits after showing the loss of only two of the seven legally recognized ADLs.

Other insurance companies consider the loss of “instrumental activities of daily living” (IADLs) in allowing access to benefits. IADLs include cooking, shopping for groceries, traveling to and from a doctor, cleaning house, doing laundry, managing medication, paying bills and making telephone calls. A policy might allow a client to access benefits when he or she has lost the ability to perform only one ADL but also can no longer perform two or more IADLs.

Some policies offer a critical third trigger. The most popular is the “medical necessity” clause. If this trigger is satisfied, the insured can obtain benefits even if he or she is not cognitively impaired and even if he or she has not lost the ability to perform the required number of ADLs. While the wording of a third-trigger requirement may vary from company to company, the result is essentially similar to the medical necessity clause. This clause is especially helpful to the insured because it allows access to benefits based on certification by the insured’s doctor that LTC assistance is medically necessary, even if the other benefit triggers have not been activated. One insurance company estimates that up to 40% of its home health care benefits were paid under the medical necessity clause.  

WHO MAKES THE CALL?

Most LTC policies permit the insurance company, or a designated administrative agent, to determine whether the insured is eligible to receive benefits. Although a third-party agent might appear to be more objective, the insurance company normally chooses the agency and pays for its services—resulting in some inevitable bias.

A minority of companies permit the insured’s own physician to determine whether the insured has satisfied the eligibility requirements. Assuming the insured is not making exaggerated or false claims, it is unlikely a physician would refuse to decide in a patient’s favor. The tendency of the insured’s physician to make this judgment in the client’s favor (and against the economic interest of the insurance company) is far preferable for the client.

A policy that contains a medical-necessity trigger empowers the insured’s physician to make the decision and substantially increases the accessibility of benefits. It also is important for clients to determine whether all benefits, including home care, are accessible under the medical necessity clause, or by certification of the insured’s doctor.  

TAX-QUALIFIED POLICIES

In selecting a tax-qualified policy, the client must be aware of the potential limitations on access to benefits. A CPA’s primary concern should be to make sure that a client—influenced by meager tax benefits from premium deductions—does not purchase a tax-qualified policy that is likely to be insufficient for his or her needs.

Tax-qualified LTC policies permit two triggers only; medical necessity is not one of them. The IRC allows insurance companies writing tax-qualified policies to recognize as few as five ADLs. (Remember, the more activities a policy recognizes, the greater the accessibility of benefits.) The IRC further reduces eligibility by eliminating ambulation as a trigger. At least one survey reports that ambulation is the ADL an individual is most likely to lose. There is a close connection between ambulation (the ability to move about without a wheelchair), transferring and other ADLs such as bathing, dressing and toileting. Furthermore, the IRC does not expressly limit how many ADLs a company can require the insured to have lost as a condition to benefits eligibility.

HIPAA introduces another barrier to eligibility for LTC benefits: No benefits can be paid unless and until a licensed health care practitioner has certified the insured as “chronically ill.” The triggers that satisfy this requirement are the loss of at least two ADLs for a period of at least 90 days due to lack of functional capacity, or “requiring substantial supervision to protect such individual from threats to health and safety due to severe cognitive impairment.”

Although the Treasury Department issued interim guidelines that essentially allow insurance companies to use preexisting standards (notwithstanding the qualifying adjectives substantial and severe ), there appears to be nothing restraining the insurance industry from applying more-stringent standards—now or in the future. Insurance companies could interpret policies requiring “severe cognitive impairment” or “substantial supervision” differently from policies requiring just “cognitive impairment” or “supervision” if it was in their interest to do so.

It is unclear whether an LTC policy that expressly provides benefits for IADLs meets IRC requirements for a tax-qualified LTC policy. It would be impractical for an insurance company to investigate whether an insured was using policy proceeds to pay for help with IADLs vs. ADLs. As a result, most companies don’t want to scrutinize or reject benefit claims involving IADLs. The IRS, however, has questioned whether such benefits are consistent with the accident and health insurance code provisions and should, therefore, be treated as taxable income.

Many people who need LTC insurance are relatively young (40 to 65). These individuals often have suffered a relatively short-term episode (an accident, heart attack or stroke) and will recover. Help with the major ADLs can be of substantial benefit in their recovery period. The chronically ill requirement substantially reduces their likelihood of receiving benefits from a tax-qualified LTC policy. An individual who determines that buying a tax-qualified policy is desirable should consider adding a post-acute recovery policy to meet this need. Buyers of nonqualified policies can probably cover this risk—with lower total premiums—by acquiring a policy with no elimination period.

Most of the elderly who need LTC, however, are simply frail individuals who find it difficult to accomplish the ADLs and who also need help with IADLs. Under non-tax-qualified LTC policies, assistance with IADLs caused by frailness is often covered. In fact, some companies will sanction the loss of a certain number of IADLs as triggers, permitting the client to access all of the policy’s major benefits.

Insurance companies pay fewer claims under tax-qualified LTC policies than under non-tax-qualified policies. One of the oldest LTC insurance carriers, with one of the largest databases, has done an internal study on this issue. Its research indicates that 20% of the company’s nursing-facility claims and 40% of its home-health-care claims would not have been paid had the individuals been required to qualify under the tax-qualified LTC rules. Exhibit 3, at left, illustrates this point with seven thumbnail case histories of individuals who receive benefits but would not have under the tax-qualified LTC policy rules.

FUZZY TAXABILITY

Most CPAs believe the receipt of long-term care benefits is not taxable income under the tax law that preceded HIPAA. Many tax authorities representing insurance companies, however, maintain that HIPAA intended to make benefits from non-tax-qualified LTC policies taxable.

The IRS now interprets HIPAA as requiring insurance companies to issue 1099s to all recipients of LTC benefits. This is especially curious since HIPAA did not expressly refer to non-tax-qualified LTC policies. Furthermore, both the Treasury Department and the IRS take the position that at least some LTC benefits were taxable even before HIPAA. The IRS maintains that the previous noncollection of taxes on LTC policies was largely a reporting issue.

While many experts believed Congress would clarify issues related to the taxation of non-tax-qualified LTC policies in 1997, this did not occur. Without new legislation, IRS and Treasury personnel foresee no clarification in the near future. The IRS has said that regulations to clarify the issues are unlikely in the absence of substantial public demand. Having convinced insurance companies to report LTC benefits as income, the IRS is satisfied to make rulings on a case-by-case basis.

Fortunately, however, the IRS and the Treasury Department have said they are willing to hear the opinions of CPAs. If CPAs express interest in having these issues clarified, better regulations may be forthcoming. (See “A Call for CPA Opinions,” at right.)

At this point, IRS personnel have identified at least three possible scenarios. The worst case scenario would be that reported income from non-tax-qualified LTC policies would qualify for offsetting deductions under IRC section 213(a). Of course, those deductions would be subject to the 7.5% of AGI floor and other rules effectively limiting deductions. Since the cost of LTC can easily amount to more than $50,000 per year, the deductible portion of LTC costs would quickly exceed the 7.5% of AGI restriction. For most people, deductible medical expenses would offset the income reportable to the IRS.

IRS personnel have said that an even more unfavorable tax consequence is possible. They argue that medical care deductions qualify under section 213(a) only if they are not reimbursed by insurance or otherwise. In other words, even if income is not excludable under IRC section 104 as an accident or health benefit, it nevertheless also may not be deductible under section 213(a).

Yet another possibility is that income from non-tax-qualified LTC policies is excludable under section 104 “to the degree that” it is allocated to health issues. Nevertheless, some argue that LTC payments are largely to the frail elderly, who are not necessarily receiving benefits for medical care but are receiving them because they are frail and cannot perform ADLs and IADLs. At this point it is difficult to agree with the insurance industry’s claim that it was successful in bringing about legislation that gives favorable tax incentives to consumers and the private sector to deal with LTC needs. However, the industry-sponsored legislation resulted in a tax incentive for a very small percentage of the population, and has minimal economic significance for those who might benefit from the purchase of a tax-qualified policy. If the proponents of taxing benefit payments from so-called non-tax-qualified LTC policies prevail, there will be a huge disincentive for the majority of Americans to purchase LTC insurance.

At the very least (if LTC benefits are taxable), the effective cost of such insurance will rise and the tax law touted as creating a positive inducement will have resulted in nothing more than a huge revenue increase for federal and state governments.  

ADVISING CLIENTS?

Since this issue may not be clarified for years, how should CPAs advise their clients? CPAs can tell them not to buy LTC insurance that offers a relatively small tax deduction at the risk of foregoing access to benefits. Even those who could benefit financially in the short run by purchasing a tax-qualified LTC policy should give careful consideration to the extraordinary cost of the tax savings—in the form of decreased access to benefits—when the time comes for claiming those benefits.

HIPAA requires all companies to permit the exchange of a non-tax-qualified policy for a tax-qualified policy. There is no provision requiring the exchange of a tax-qualified policy for a non-tax-qualified policy. Since the latter provide greater access to benefits, the increase in claims from such a transfer provision would not benefit most insurance companies. Some companies do, however, provide for this limited exchange benefit (see “Evaluating an LTC Policy,” page 33).

Obtaining a policy that contains a medical-necessity clause may benefit some clients. The client whose doctor certifies the benefits as being medically necessary may have a better argument (on a case-by-case basis) that such benefits are excludable from income. Remember, however, that most LTC policies do not contain a medical-necessity trigger.  

TAKING RESPONSIBILITY

If the government truly supports taking individual responsibility for LTC financial planning, additional legislation is needed. The IRS position is that deductions and exclusions are “matters of legislative grace” and, in the absence of legislation, non-tax-qualified LTC policies will be judged on a case-by-case basis. The current views of the IRS and Treasury Department would effectively result in tax increases.

Legislative solutions could be as simple as clarifying that HIPAA was never intended to result in the taxation of benefits from any LTC policy. Since premiums from non-tax-qualified policies are never deductible, the legislation could clarify that the benefits from such policies—paid for with aftertax premium dollars—are not taxable. An alternative solution would be to provide that if an LTC policy has been approved by the state in which it was issued, the benefits would not be taxable.

Since the IRS has indicated it will take the opinions of CPAs into consideration, CPAs can help by seeking clarification of the tax treatment of non-tax-qualified LTC policies. IRS personnel agree, however, that legislative action would be best. Direct communication to the Joint Committee on Taxation (see “The Need for New Legislation,” at left) could pave the way to a clearer, more beneficial structure for the massive number of citizens who will undoubtedly need LTC. In addition, CPAs should encourage clients to join them in seeking legislation that offers a true incentive for all Americans to plan for LTC costs.