JUNE
14, 2017 07:00 AM
EXECUTIVE
SUMMARY
With the 1996
introduction of “tax-qualified” long-term care insurance under the Health
Insurance Portability and Accountability Act and IRC Section 7702B, Congress
affirmed that long-term care insurance benefits are tax-free, and began to
offer tax benefits for purchased LTC insurance coverage.
However, over the
years the evolving landscape of both individual tax deductions in general, and
long-term care insurance tax preferences in particular, have created a
confusing myriad of options to purchase LTCI and receive favorable tax
treatment.
In this article, we
explore the full range of options, from the most favorable (purchasing on
behalf of employees, or for employee-owners of a C corporation or who are
less-than-2% shareholders of an S corporation), to the slightly less favorable
(purchasing for owner-employees of partnerships and LLCs, more-than-2% owners
of S corporations, and sole proprietors), to the least favorable (paying for
LTC insurance premiums directly, subject to age-based limitations, medical expense
AGI thresholds, and itemized deduction limitations). And there are also the
less-common-but-also-sometimes-appealing alternatives, like using the money in
a Health Savings Account (HSA) to purchase LTC insurance, or funding it via a
partial 1035 exchange into a standalone LTC insurance or hybrid LTC policy.
Ultimately, the
reality is that some people won’t actually have many choices about how to
pay for coverage – the choice will simply be whether to purchase or not, and
write a check for the premiums as the only means eligible. Nonetheless, it’s
important to understand the full breadth of options for how to pay premiums on
LTC insurance, especially given the nuanced but substantial difference in tax
treatment across the different choices!
Deducting Individual Long-Term Care Insurance Premiums
Under IRC Section 213(d)(1)(D), premiums for
long-term care insurance are deductible along with other individual medical
expenses.
Notably, to be eligible for deductibility, the
long-term care insurance must be (tax-)“qualified” coverage (as defined
under IRC Section 7702B(b)),
though in practice virtually all long-term care insurance issued today (and in
the past 20 years) is tax-qualified. (Non-Tax-Qualified, or NTQ long-term care
insurance, is primarily characterized by either not requiring
a minimum Activities of Daily Living restriction, or being more lax in the
certification requirements to be eligible for claims.)
Premiums paid for tax-qualified LTC insurance
are deductible if paid for the individual taxpayer themselves, his/her spouse,
or any dependent as defined under IRC Section 152, which can include both
dependent children and even dependent parents, if they otherwise
qualify as dependents for tax purposes, and without regard to the
must-be-unmarried or income tests that otherwise apply to a “qualifying
relative” dependent.
While premiums are deductible, though, the
amount of the deduction is limited.
First and foremost, the standard rule for
medical expenses still applies – that in order to claim a deduction (for both
LTC insurance premiums, and all other medical expenses, added together), the
taxpayer must itemized deductions on Schedule A, and only the portion in excess
of 10% of Adjusted Gross Income (AGI) is actually deductible (as the 7.5%-of-AGI threshold expired
at the end of 2016 under the Affordable Care Act).
Second, in addition to the limitation on
(total) medical expense deductions (including LTC insurance premiums), there is
a further limitation on the amount of LTCI premiums that can be counted as a
medical expense in the first place. Under IRC Section 213(d)(10), premiums can only be
deducted up to a specific maximum annual dollar amount (which itself is
annually indexed for inflation). The LTC insurance premium deductibility limits
for 2017 are shown below, with age thresholds evaluated based on the taxpayer’s
age at the end of the tax year.
Example 1. This year,
Allen and Jennifer turned ages 62 and 59, respectively. Each recently bought a
(tax-qualified) long-term care insurance policy. Allen’s policy costs
$3,200/year, and Jennifer’s costs $2,800. As a result, in 2017, Allen will be
permitted to deduct $3,200 (the cost of his policy, since it is below the
$4,090 threshold), though Jennifer will only be permitted to deduct $1,530 of
her premium (capped at the up-to-age-59 threshold). Which means in total, the
couple can claim $3,200 + $1,530 = $4,730 of long-term care insurance premiums
as deductible medical expenses. To the extent that $4,730, when added to other
medical expenses, exceeds 10% of the couple’s AGI, the excess above the
threshold will be deductible.
Next year when Jennifer turns 60, her
deductibility limit will rise to $4,090, which is more than enough for her to
deduct her entire premium. Thus, in the future, the couple’s LTC insurance
premium deduction will rise to the full $3,200 + $2,800 = $6,000 (which, again,
must be added to other medical expenses to determine how much above the
10%-of-AGI threshold is actually deductible). Notably, because the couple’s LTC
insurance premiums themselves are less than the $4,090 limit (by the time
they’re in their 60s), their deductions are still “capped” at the actual amount
of LTC insurance premiums being paid each year.
Notably, as the above example illustrates,
even if LTC insurance premiums have limited deductibility early on, the tax
deductions may become more feasible later as the policyowner crossed the
deductibility age bands.
In addition, because LTCI premiums are only
deductible to the extent they exceed 10% of AGI, premiums may be partially or
fully deductible in some years but not others, simply due to unrelated changes
in income (that impact the AGI threshold). Conversely, significant shifts in
other deductions can also indirect impact LTCI premium deductions, as none of
them are deductible until/unless the taxpayer can itemized in the first place
(rather than claiming the standard deduction). Which also means that potential
tax reform proposals, which may substantially increase the standard deduction,
could also reduce the deductibility of LTC insurance premiums, by making the
standard deduction so high that few have enough LTC premium (and medical, and
other itemized) deductions to reach the threshold.
In addition, some states also provide
individuals with a tax deduction or small credit for purchasing long-term care
insurance. In some cases, the deduction or credit is only for the
first-year premium/purchase; in other scenarios, it is permitted on an ongoing
basis (as long as premiums continue to be paid). Furthermore, some states have
no limits on the amount of LTC insurance premiums eligible for the deduction or
credit, while others conform to the age-based premium limitations. Individuals
should check on the rules applicable in their particular state.
Paying For (And Deducting) LTC Insurance Through A Business
The rules and limitations on the deductibility
of long-term care insurance are substantially different when premiums are paid
through a business, rather than as an individual.
Under the general rules of IRC Section 162, compensation to employees is
deductible to the business (which may include long-term care insurance), and
the related IRC Section 106stipulates
that payments for “accident and health plans” (which includes tax-qualified
long-term care insurance) are not included in the employee’s income, either.
And under IRC Section 105(b),
payments to reimburse medical expenses of an employee are not taxable benefits
to the employee, and IRC Section 7702B(a)(2) stipulates that
LTC insurance premiums will be treated as reimbursement for medical expenses…
which means claims from employer-paid LTC insurance are not treated
as taxable benefits.
The end result is that, akin to other employee
benefits, a business’ payment of LTC insurance premiums on behalf of employees
is a pre-tax expense for the business, without causing income to the employee
that receives the coverage or claims benefits against under that coverage
(though if the employee also pays some of the premium
themselves, it is treated as after-tax and the out-of-pocket portion will only
be deductible or not under the usual individual limitations).
However, to prevent abuses by business owners
who may also be “employees” in their own businesses, the tax law imposes
several limitations on the deductibility of long-term care insurance premiums
for the business owners themselves.
SOLE
PROPRIETORS
In the case of a sole proprietor, IRC Section 162(l) provides that
long-term care insurance can be deducted as a self-employed
health insurance expense, but the dollar amount of the deduction will be
limited to the age-based premium limitations of IRC Section 213(d)(10) (as shown in the
earlier chart). However, because the self-employed health insurance deduction
is claimed as an above-the-line deduction (on line 29 of Form 1040) and not as an itemized
deduction, sole proprietors paying for their long-term care insurance are not subject
to the 10%-of-AGI limitation.
In the event that the sole proprietor
purchases LTC insurance coverage for both themselves and a
spouse, the age-based premium limits apply to both. However, if the
spouse is a bona fide employee of the business, and the policy is purchased and
paid for as employee compensation, the full amount of the premium can be
deducted as a business expense (and only the owner’s LTCI premiums would face
the age-based limitation). In addition, it’s notable that LTC insurance
coverage provided to bona fide employee-spouse that also covers
the sole proprietor employer may be fully deductible as employee-family
coverage for both (e.g., where the business buys the employee-spouse individual
coverage that has a shared-care family rider attached).
PARTNERSHIPS
(AND LLCS TAXED AS A PARTNERSHIP)
In the case of a partnership (or an LLC taxed
as such), long-term care insurance premiums paid on behalf of partners may be
deductible to the business as guaranteed payments under IRC Section 707(c), but since partners are not
treated as employees, the cost of the coverage must then be added back to the
partner’s income (which means the net result may shift partnership
income amongst the partners, but doesn’t directly produce any tax savings).
Subsequently, though, the partners are still
treated as self-employed, which means they can personally deduct the long-term
care insurance premiums as “self-employed health insurance” coverage on line 29
of Form 1040. As with sole proprietors, the deduction will be limited to the
age-based premium restrictions, but as an above-the-line tax deduction, will
not face the 10%-of-AGI or itemized deduction threshold requirements.
Example 2. Ashley and
Sally are 50/50 members of an LLC that last year produced $200,000 of income,
and the two want to purchase LTC insurance and “route” it through the business.
Ashley is 57 and her LTC premium is $2,700; Sally is 62, and her LTC premium
will be $3,700.
Absent the LTC insurance, their respective
income shares as 50/50 partners would be $100,000. However, with the LTC
insurance premiums being deductible as guaranteed, business income is reduced
by $2,700 + $3,700 = $6,400 to only $193,600. With their 50/50 shares, this
reduces income to $96,800. Then, Ashley and Sally must each include the
premiums paid on their behalf in their respective incomes, which brings
Ashley’s total income up to $99,500 and Sally’s up to $100,500. (Notably, total
business income is still $200,000, but Sally’s taxable share is now slightly
higher, due to the higher LTC premium.)
As a final step, Ashley and Sally may each
deduct their LTC insurance premiums from their tax returns as a self-employed
health insurance deduction. Due to her age, Ashley is limited to a deduction of
just $1,530 of her $2,700 premium, while Sally is able to claim the entire
$3,700 premium (since her age-based cap is as high as $4,090).
Notably, to get the favorable treatment for a
partnership or LLC (where ultimately, the premiums are at
least deductible as self-employed health insurance without the medical expense
AGI or itemized deduction thresholds), the premiums must actually be paid by the
business. If the business owners pay the premiums directly as individuals, they
may still be subject to the standard rules for individual LTC insurance
premiums (including the below-the-line medical expense limitations).
S
CORPORATIONS
Under IRC Section 1372, a more-than-2% owner of an S
corporation is treated as though he/she is a partner in a partnership, which
means all the aforementioned rules apply – premiums paid may be deductible to
the business, but must be included in the income of the more-than-2% owner, who
may then claim the premium deduction as an above-the-line self-employed health
insurance deduction (but only up to the age-based premium limitation).
In order to be treated as a more-than-2%
owner, the shareholder must actually own more than 2% (not
just exactly 2%), but the threshold is met if he/she owns more
than 2% on any day of the taxable year (i.e., even if
ownership changes intra-year, being a more-than-2% owner at any point
in the year counts for that tax year).
In addition, the family attribution rules
of IRC Section 318 apply
when evaluating the more-than-2% ownership requirement. Thus, stock owned by a
spouse, children, grandchildren, or parents (including indirect beneficial
ownership via a trust) also counts towards meeting the 2% ownership threshold.
C
CORPORATIONS
When it comes to a C corporation, the
“standard” rules for employees continue to apply, including that long-term care
insurance is deductible as part of compensation (as an “accident and health
insurance” benefit) under IRC Section 162, and that the premium payments
are not taxable to the employee under IRC Section 106.
Again, though, for favorable tax treatment,
the premiums must be paid directly by the employer, not via a Section 125
cafeteria plan (as LTC insurance is explicitly denied favorable treatment
under IRC Section 125(f)). And
if the premiums are paid under a Flex Spending Account, the premiums become
taxable to employees under IRC Section 106(c) (although then at
least they could be deducted under the rules for individuals paying LTC
insurance premiums).
In the case of a C corporation, there rules
apply equally to owners and other employees, and there’s no less-favorable
treatment for employee-shareholders. However, to substantiate the
LTC premiums as a employee compensation business expense under IRC Section 162,
the shareholders must actually be employees, doing bona fide
work, and the compensation (including those LTC premiums) must be “reasonable
compensation” (for the services rendered) to maintain its deductibility. In
general, LTC insurance premiums are moderate enough that reasonable
compensation shouldn’t be an issue, but be wary trying to allocate deductible
LTC premiums to family member “employees” who don’t actually do much of anything for
the business, and be cognizant that limited-pay LTC policies (e.g., 10-pay,
5-pay, or single-pay policies) that lump larger premiums into fewer years could
potentially run afoul of reasonable compensation (although in practice such
policies are rarely even available anymore).
In addition, while LTC insurance is not subject
to non-discrimination testing as an employee benefit – which means it can be
offered selectively to employees, including shareholder-employees – it’s still
necessary to substantiate it as employee compensation and not
just a shareholder dividend. As a result, eligibility to participate in the
employer’s “LTC insurance employee benefit program” should not be
based solely on whether the participant is a shareholder; instead, it should be
determined based on other factors, such as providing to a “class” of employees
(e.g., officers of the corporation), based on a particular length of service,
etc.
Alternative Tax-Preferenced But Non-Deductible Strategies For
Paying LTC Premiums – 1035 Exchanges And HSAs
Beyond the rules for deducting long-term care
insurance premiums as an individual, or via various types of businesses, there
are a few other ways that LTCI coverage can be purchased in a tax-preferenced
manner, including via a Health Savings Account (HSA), an annuity 1035 exchange,
or a hybrid LTC insurance (or annuity) policy.
PAYING
LTC INSURANCE PREMIUMS FROM AN HSA
Under IRC Section 223, contributions to a Health
Savings Account (HSA) are tax-deductible, the account grows tax-deferred, and distributions
are tax-free when using for “qualified medical expenses”. And while the HSA qualified distribution
rules generally only apply to medical expenses – and not
medical insurance – IRC Section 223(d)(2)(C)(ii) explicitly
states that (tax-qualified) long-term care insurance premiums are eligible.
However, since IRC Section 213(d)(10) limits
the portion of LTC insurance premiums that can be treated as “medical expenses”
to the age-based limits, only LTCI premiums up to those age-based limits can be
withdrawn tax-free from an HSA as qualified medical expenses. Which means any
“excess” premiums above the age-based thresholds must be paid out-of-pocket
(not with HSA dollars).
In addition, it’s notable that under IRC
Section 223(f)(6), any medical expenses (includes LTCI premiums) paid via a
Health Savings Account cannot also be claimed later as a
medical expense itemized deduction. In other words, LTCI premiums (up to the
age-based limits) can be deducted as an individual medical expense, or paid
for with a tax-free HSA distribution, but never get both favorable treatments
for the same premium dollar.
PAYING
LTC INSURANCE PREMIUMS VIA A 1035 EXCHANGE
The Pension Protection Act of 2006
modified the “like-kind exchange” rules of IRC Section 1035(a) to allow life
insurance and annuity contracts to be exchanged for a long-term care insurance
policy. Up until that point, annuity policies could only be exchanged for other
annuity policies, and life insurance policies could only be exchanged for other
life insurance or annuity policies.
Under the new rules, though, an
existing life insurance or annuity policy could be 1035 exchanged for a
(tax-qualified) long-term care insurance policy. The existing
policy must be a non-qualified annuity or life insurance
policy (i.e., not held inside of an IRA or employer retirement
plan).
Of course, given that life insurance or
annuity policies often accumulate significant cash value, while the premiums on
long-term care insurance are far more modest (at least on a relative basis), in
most cases the exchange would just be a partial 1035 exchange
of some life insurance or annuity cash value for an LTC
insurance policy.
Fortunately, Revenue Procedure 2011-38 affirms that
partial 1035 exchanges are permitted, and when they occur,
gains and basis are simply allocated pro-rata between the old and new
contracts. Though since a long-term care insurance generally has no cash value,
the gains allocated to the LTC insurance policy effectively vanish without
every being taxed.
Example 3. Charlie has
a $120,000 existing non-qualified annuity contract with a cost basis of only
$70,000 (and thus an embedded gain of $50,000). He is also purchasing a
(qualified) LTC insurance policy with a $3,000/year premium. Under the existing
1035 rules, Charlie can fund his LTC insurance premium with a partial 1035
exchange for $3,000, reducing the cash value of the annuity to only $117,000
and the cost basis to $68,250 (since the transfer is treated as $70,000 /
$120,000 * $3,000 = $1,750 of basis, and the remaining $1,250 of gain). Thus
after the exchange, Charlie’s embedded annuity gain has decreased from $50,000
to just $48,750, as $1,250 of the gains are ‘shifted’ to the LTC insurance
policy. Yet since the exchange was tax-free – as a 1035 exchange – and the LTC
insurance has no cash value to liquidate, the end result is that the $1,250 of
gain is simply eliminated.
Unfortunately, one major caveat for doing a 1035
exchange to an LTC insurance policy is that to complete the
transaction, the existing annuity or life insurance company must directly
assign the policy (or part thereof) to the new LTC insurance company, which in
turn must be capable of accepting, processing, and liquidating the assigned
share. In practice, not all LTC insurance companies have the systems in place
to do so, and thus may not be willing to permit or cooperate with a partial
1035 exchange. If the insurance company cannot facilitate the transaction, the
opportunity is simply unavailable; it cannot be done by merely taking a
distribution and “rolling it over” to an LTC insurance policy, if the 1035
exchange is not facilitated directly.
Nonetheless, for companies that do permit
an incoming partial 1035 exchange, the strategy can help to whittle down
otherwise taxable gains. Which is especially appealing in the case of an
appreciated non-qualified annuity, given that such annuities remain taxable
even after death (to the beneficiaries) and do not receive a step-up in basis,
providing no other alternative to eliminate the embedded gain.
(1035
EXCHANGING INTO) HYBRID LTC INSURANCE POLICIES
The last option for funding LTC insurance on a
tax-preferenced basis, also introduced as part of the Pension Protection Act
(PPA) of 2006, is to do a 1035 exchange from a(n
appreciated) life insurance or annuity policy, into a “hybrid” version of a
life insurance or annuity policy that includes an LTC insurance rider.
Specifically, PPA 2006 modified the definition of what constitutes a “like
kind” exchange under IRC Section 1035(b) to stipulate that
it’s permissible to exchange into a life insurance or annuity policy that has
an LTC insurance rider, and still be treated as “like kind” as long as the
exchange would have otherwise been permitted into a similar policy without such
a rider.
The advantage of this strategy is that,
under IRC Section 72(e)(11)(B),
any charges for the LTC insurance rider against the insurance or annuity policy
are not treated as a taxable distribution. (By contrast,
without these rules, subtracting LTC insurance premiums from the cash value of
life insurance or an annuity would have generally been treated as a taxable
withdrawal.) Instead, the premiums are simply subtracted from the cost basis of
the policy.
Notably, the fact that the premiums subtracted
from the hybrid policy already receive preferential treatment, they may
not also be claimed as a medical expense deduction under IRC Section 7702B(e)(2). However, claims paid
out for the LTC portion of the policy can also be received tax-free (as LTC
insurance benefits), even if they otherwise would have been a taxable
distribution from the policy’s cash value. This is likely to be a more
favorable treatment than “just” taking a taxable distribution from the
insurance or annuity policy directly, paying long-term care expenses, and
trying to claim a medical expense deduction later.
Example 4. Continuing
the prior example, Charlie decides that instead of doing partial 1035 exchanges
to an LTC insurance policy from his non-qualified annuity with $120,000 of cash
value and a $70,000 cost basis, he will do a full 1035 exchange to a hybrid
annuity/LTC policy instead. After the exchange, his $120,000 is invested into a
new hybrid annuity/LTC policy, and carries over his $70,000 cost basis. Shortly
thereafter, his first $3,000 premium is subtracted from the policy’s cash
value, which reduces his cash value to $117,000 and the cost basis to $67,000.
Notably, after the LTC insurance premium is
paid, he still has a $50,000 gain exposure; unlike the prior scenario of
exchanging to an LTC insurance policy directly, the potential
gain is not reduced. However, if Charlie subsequently has an LTC insurance
claim, and uses the $120,000 to cover his long-term care expenses, he will not
owe any taxes on the liquidation of his entire cash value, despite the $50,000
gain, because the LTC claims are still able to be distributed tax free. On the
other hand, if he never actually has a claim, in the future Charlie (or his
heirs) will still need to contend with the $50,000 embedded gain (plus any
subsequent growth that occurs in the future).
Given that LTC premiums in a hybrid policy are
only subtracted from basis (not gains), and the embedded gain is only reduced
when actual claims are paid, an exchange to a hybrid policy will
be most appealing in situations where there is an existing contract, with
substantial embedded gains, and a relatively high likelihood of actually using
the dollars for future claims.
Ultimately, the Internal Revenue Code provides
a substantial number of different ways to purchase LTC insurance with favorable
tax treatment.
In general, the “most favorable” rules are to
purchase via a business that allows for the full deduction of LTC insurance
premiums without any age-based limits (though that is only available for
employees, C corporations, and 2%-or-less owners of S corporations).
The next best alternative, which at least
maximizes the deduction – albeit subject to the age-based limits – including
claiming a deduction for LTC insurance as a business owner (self-employed,
partner or LLC member, or more-than-2% owner of an S corporation), or via a
Health Savings Account.
After that, the most appealing remaining
option is to purchase as an individual, claiming a deduction for only the
age-based premium limitation as a medical expense itemized deduction (subject
to the associated limits).
And in some cases as a last resort, it may be
appealing to purchase the coverage either via a direct 1035 exchange, or what
is often the least favorable (but still better than nothing!) treatment of
using a hybrid LTC insurance policy. Though the greater the existing embedded
gains, particularly in the case of a non-qualified annuity, the more appealing
this strategy may be!
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