EXECUTIVE SUMMARY
Long-term care (LTC)
insurance benefits are tax-free to
the insured for either reimbursement of
qualified expenses or payments up to a
per-diem limit indexed for inflation—$270 in
2008.
Premiums for LTC
insurance are tax-deductible according to
limits that are also indexed to
inflation and increase with the age of the
insured. For an individual purchaser, however,
premiums, along with other qualified medical
expenses, are further subject to the floor of
7.5% of adjusted gross income as an itemized
deduction.
More favorable treatment
is available to self-employed
persons, who may be able to deduct as a trade
or business expense premiums (up to the annual
limit) of an LTC plan sponsored by their
business for themselves or spouse or
dependents.
A company that pays
premiums for nonowner employees is
generally allowed still more favorable
treatment: deduction without regard to the
annual limits. LTC insurance is generally not
allowable as part of a "cafeteria
plan"; however, premiums up to the
eligible amount or LTC expenses may be funded
through a health savings account, medical
savings account or health reimbursement
arrangement.
Daniel R. Finn , Esq., CLU,
is a director in the Advanced Financial
Security Planning Division of The
Northwestern Mutual Life Insurance Co. His
e-mail address is
danielfinn@northwesternmutual.com .
T
he number of baby boomers in or near
retirement is rising, and so too is the demand
for long-term care (LTC) insurance. Depending on
the age of the insured, such coverage can be
expensive, but fortunately for them, Congress
and some states have provided income tax
incentives for the purchase of certain LTC
insurance policies—called “qualified” LTC
contracts—in IRC § 7702B. CPAs who have a
command of these rules will be well-placed to
provide valuable advice to clients. To that end,
this article provides an overview of the income
tax treatment for both premiums paid into and
benefits received from qualified LTC insurance
contracts for individuals (nongroup policies).
As you’ll see, benefits and premiums can be
excluded or deducted from income—within
limits—but the crucial question of who pays can
make the difference ultimately whether that’s
true of any, some or all of the cost.
TAXATION OF BENEFITS
The federal income taxation of benefits
received under an LTC policy depends on the type
of contract. Under a “per-diem,” also known as
indemnity-based, policy, the insurance company
generally pays the same benefit regardless of the
insured’s actual LTC expenses. These amounts are
received income-tax-free up to the greater of (1)
costs incurred for LTC services or (2) a daily
limit indexed for inflation—$270 per day in 2008.
Any excess amount is taxed. (The taxable amount is
further reduced by reimbursements received for LTC
services, but with a per-diem policy, that
reduction often will be zero). See IRC § 7702B(d)
and Rev. Proc. 2007-66. Under a “reimbursement”
policy, the insurer does not pay a set amount.
Instead, it pays for LTC expenses incurred, up to
the maximum benefit under the contract. All
amounts received under a reimbursement policy are
income-tax-free. See IRC §§ 7702B(a)(2) and
104(a)(3).
TAXATION OF PREMIUMS
The federal income tax treatment of premiums
paid into a qualified LTC policy differs not by
the type of contract, but by the type of taxpayer
(or in some respects, the relationship between the
premium payer and insured/policy owner). There are
three categories: individual (good), self-employed
(better) and employer-employee (best).
Individual (Good) . When
individuals personally buy LTC insurance (no
business is involved in the purchase) that covers
themselves, a spouse or a dependent, they can
deduct a portion of the premium. See IRC §§
7702B(a)(4), 213(a) and 213(d)(1). Dependents
generally include the taxpayer’s children and
certain relatives (including parents, siblings,
aunts and uncles) for whom the taxpayer provides
over half the support. See IRC § 152. To determine
the deductible amount, the individual must
consider two limitations: the “eligible long-term
care premium” amount and 7.5% of adjusted gross
income (AGI). The eligible LTC premium
amount is the maximum portion of the LTC insurance
premium that an individual can take into account
when calculating the deduction. See IRC §
213(d)(1) and Rev. Proc. 2007-66. The eligible
amount is dictated by the insured’s age (not the
taxpayer’s) at the close of the taxable year and
is indexed for inflation. In 2008, the amounts
are:
Age 40 or less: $310
41 through 50: $580
51 through 60: $1,150
61 through 70: $3,080
71 or more: $3,850 The
appropriate eligible LTC premium amount is added
to other unreimbursed medical expenses, and this
total is deductible only to the extent that it
exceeds 7.5% of AGI. See IRC § 213(a). At first
blush, it seems few taxpayers will have enough
unreimbursed medical expenses to claim this
deduction (see Exhibit 1
). But some individuals—retirees, for example—
might not have much income in a given year, so
7.5% of their AGI may not be a large number. And
other individuals might be paying LTC premiums not
just for themselves but also for a spouse and
senior generation dependents, any of whom might
also have high unreimbursed medical expenses. So
the aggregate LTC premiums and expenses might be
high enough to exceed 7.5% of their AGI and result
in a deduction.
Self-Employed (Better) .
Self-employed taxpayers generally can deduct as a
trade or business expense the LTC premiums paid
for themselves, their spouses or dependents
pursuant to an employer-sponsored plan. See IRC §
162(l). Unlike the deduction for individuals, the
deduction for self-employed taxpayers is not
subject to the 7.5% of AGI limitation but is
generally limited only by the eligible LTC premium
amount. Well, there are other minor limits: The
deduction is available only to the extent that the
taxpayer has earned income from the business
providing the coverage (W-2 wages or guaranteed
payments), and is not available if the taxpayer is
eligible for LTC coverage under a subsidized
health plan maintained by his spouse’s employer or
by his employer, if he works for one in addition
to running his own business. The mechanics of
these rules mimic those for accident and health
insurance for selfemployed taxpayers, a feature
that, among other things, suggests that it’s wise
to put the plan in writing. See Notice 2008-1 and
Revenue Ruling 91-26; also IRC §§ 162(l)(2),
401(c), 707(c), 1372(a), 1402(a), and 7702B(a)(3).
So who is a self-employed taxpayer? Sole
proprietors, partners of partnerships, members of
limited liability companies taxed as partnerships,
and S corporation shareholders who own more than
2% of the corporation are all self-employed
taxpayers— but only if they provide personal
services to the business. Also, due to ownership
attribution rules under IRC §§ 1372(b) and 318(a),
certain family members of S corporation owners
also might be treated as self-employed owners,
even if they are merely employees. This is
generally undesirable, as treatment for
self-employed taxpayers is less favorable than
that for employees, as shown in exhibits 2 and 3 .
Employer-Employee (Best) . The
best federal income tax treatment occurs when
employers provide LTC coverage to employees (or
their spouses and dependents) under an
employer-sponsored plan. An employer can deduct
LTC premiums it pays on an employee’s behalf as
long as they are ordinary, necessary and
reasonable business expenses; they are not limited
to the eligible LTC premium amount (for premiums
paid by the employee under an employersponsored
plan, see discussion of cafeteria plans below).
Moreover, the premiums are not included in the
employee’s income, and the employee can receive
the ultimate LTC benefits entirely tax-free. See
IRC §§ 106(a), 162(a) and 7702B(a)(3), also Treas.
Reg. § 1.106-1. Clearly, this is an extremely
attractive employee benefit (see Exhibit 3 ).
Unlike self-employed owners of S
corporations or partnerships, owners of C
corporations are allowed to be treated as
employees for this purpose and, therefore,
potentially can enjoy the same generous tax
treatment. But the fact that C corporation owners
can also be employees does not mean they are
assured employee treatment with respect to the LTC
premiums paid by the business; the corporation’s
payments must be made pursuant to a plan to
benefit the individual because of employment
status rather than ownership status. There is no
clear-cut formula to follow to prove LTC coverage
is based on employment status, so it’s often best
to describe plan eligibility in a manner that
could cover a nonowner employee in addition to
shareholders. In fact, it’s safer still to cover
at least one nonowner employee. See Leidy v.
Commissioner , TC Memo 1975-340, aff’d
, 39 AFTR2d 77-877 (4th Cir. 1976);
Larkin v. Commissioner , 48 TC 629
(1967), aff’d , 21 AFTR2d 1307 (1st Cir.
1968). Another caveat arises with
“limited–pay” contracts, which provide coverage
for the rest of the insured’s life after the
payment of only, say, 10 annual premiums. IRC §§
419 and 419A impose rather strict limits on the
amount an employer can deduct when prefunding
welfare benefits (which include LTC). Although
it’s not entirely clear that these Code sections
apply to limited–pay LTC contracts, there’s a good
chance they do (certain nonguaranteed
contracts aren’t covered by sections 419 and
419A, but all qualified LTC contracts are
guaranteed renewable), so any employer
should be prepared to either live within the
limits or explain to the IRS why these Code
sections don’t apply. Presuming these
limits are relevant, an employer can deduct the
cost for the current year’s coverage, and this
would allow LTC premiums to be deducted under a
typical pay-as-you-go contract. But with an
insured plan, additional deductions for funding
welfare benefits for future years is limited to
those amounts needed to create a reserve for
post-retirement benefits, and only to the extent
this reserve is funded on a level basis over the
employee’s remaining working years. So if an
employee has 20 more years to work before
retirement, the employer’s premium payments under
a 10-year limited-pay LTC contract could easily be
too large to be fully deductible (although, in
this situation, payments under a 20-year
limited-pay contract might very well be
deductible). Furthermore, claiming a deduction
under this post-retirement reserve category
introduces nondiscrimination rules and can reduce
the contribution limits to qualified retirement
plans, so using limited-pay contracts can quickly
become complicated. Problems also can
arise with “return of premium” contracts that
offer a refund of unused premiums if the policy is
canceled. Not only might the refund be taxed—see
IRC § 7702B(b)(2)(C)—it might also constitute
deferred compensation under IRC § 409A, which, if
violated, carries a 20% penalty.
CAFETERIA PLANS, ALPHABET SOUP, ERISA AND
STATE LAW
As if all that weren’t enough, there are
even more rules CPAs should know when advising
clients on LTC insurance. First, LTC insurance
cannot be offered as part of a cafeteria plan. See
IRC § 125(f). As for the “alphabet soup” of
medical savings and reimbursement accounts, they
basically break down this way: HSAs (health
savings accounts), MSAs (medical savings accounts)
and HRAs (health reimbursement arrangements) can
be used to pay both LTC expenses and LTC insurance
premiums (up to the eligible premium amount). FSAs
(flexible spending arrangements), however, can be
used to pay only for LTC services, not LTC
insurance premiums. Also, ERISA rules governing
welfare plans generally require that plans be
written and that they contain “fiduciary” and
“claims procedure” provisions, and potentially
“reporting and disclosure” provisions. In
addition, many states provide their own tax
breaks—deductions or credits— so to give their
clients the complete picture, CPAs should also
become familiar with the specific state laws
wherever they practice. Many LTC insurance
carriers can provide state-by-state descriptions.
A KEY TO SECURITY
Whether your clients are individuals,
self-employed taxpayers or employees, they
increasingly will be using LTC insurance as a key
risk management tool in their retirement
portfolios. Therefore, providing and implementing
effective tax planning and management with respect
to LTC will have an important impact on your
clients’ long-term financial security.
Taking Emotion Out of the
Decision by Theodore J. Sarenski
Much has been written in financial planning
periodicals regarding the pros and cons of
long-term care insurance, perhaps because it
is still in its infancy compared to other
insurance products. While most individuals
don’t question the need for homeowner’s,
automobile or life insurance, many are still
reluctant to purchase long-term care
insurance. Why? Possibly because what the
insurance is intended for and how it is
presented evoke fervent emotions. Many
people find it difficult to contemplate a loss
of independence and their own mortality. They
might assume that Medicare or Medicaid will
pick up the tab but haven’t reckoned on
Medicare’s limits on length of stay in a
skilled nursing home and restrictions on
intermediate care and in-home services, or on
Medicaid’s eligibility requirements of low
income and few assets. It may benefit
the potential purchaser of long-term care
insurance to take the emotion out of the
decision by thinking of it as an asset
protection policy. Each of us chooses which
risks we are willing to accept and which we
wish to pay an insurance company to take on
for us. It is always a personal decision. The
owner of a long-term care policy is deferring
the risk of a future in-home or skilled
nursing facility cost to an insurance company
rather than accepting that risk personally.
At today’s level of health care costs,
assets accumulated over a lifetime can
disappear in a few years should the individual
need skilled nursing care. According to the
latest annual survey by the Metlife Mature
Market Institute, the average private-pay cost
of nursing home care in 2007 was $213 per day,
or $77,745 per year, for a private room and
$189 a day, or nearly $69,000 per year, for a
shared room. Some places, such as San
Francisco or Hartford, Conn., reported costs
of more than double the national average.
Moreover, costs have been increasing faster
than the rate of inflation and could further
accelerate if the number of beds doesn’t keep
pace with an aging population. Between 1995
and 2025, the number of elderly people will
double in 21 states, according to the U.S.
Census Bureau. Healthier lifestyles
and advanced medical care are allowing many
people to live longer but with a greater
chance that they will need assistance in their
later years that family or friends are not
equipped to provide physically, emotionally or
competently. Consider that a $5,000
annual premium for a good individual long-term
care policy is 1% of $500,000, or 0.5% of $1
million, or 0.25% of $2 million, etc. Isn’t it
worth one-quarter of 1% per year to ensure
that an individual’s estate tax exclusion,
currently $2 million, is protected and can be
distributed upon death in any manner that
individual has planned? Isn’t it worth the
peace of mind to know that a lifetime of work
and saving will be preserved to benefit future
generations?
Theodore J. Sarenski ,
CPA/PFS, CFP, is the founding member of
DB&B Financial Services LLC in central
New York state and is chairman of the AICPA
Eldercare/PrimePlus Task Force. His e-mail
address is
tjs@dbbllc.com .
AICPA RESOURCES
Articles
" What
Is Long-Term Care and Who Is Responsible
for Its Cost? " The Tax
Adviser , April 08, page 240
" LTC
Insurance for Owners and Executives
," JofA , March 05, page
53
" A
Financially Secure Future ,"
JofA , Dec. 02, page 53
" Long-Term
Care Insurance ," JofA ,
May 02, page 112
Publications
The CPA’s Guide to
Long-Term Care Planning (#017259)
Adviser’s Guide to
Counseling Aging Clients and Their
Families (#091024)
CPA ElderCare—PrimePlus: A
Practitioner’s Resource Guide, Third
Edition (#022511)
CPE
Tax, Healthcare and Asset Protection for
Aging Clients , a CPE self-study
course (#732179)
Conference
AICPA National Conference on Employee
Benefits Plans, May 18–20, 2009, Orlando,
Fla. For more information or to
place an order or to register, go to www.cpa2biz.com
or call the Institute at 888-777-7077.
OTHER RESOURCES
Web sites
National Clearinghouse for
Long-Term Care Information, U.S. Department
of Health and Human Services, www.longtermcare.gov/LTC/Main_Site/index.aspx
National Association of
Insurance Commissioners, www.naic.org
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