Advanced Underwriter Volume 8, Issue 1 Advanced Underwriter Qualified Long Term Care Insurance (LTCi) A Tax Primer Tax Planning Strategies FOR FINANCIAL PROFESSIONAL AND PROFESSIONAL ADVISOR USE ONLY. NOT FOR USE WITH THE PUBLIC.
Advanced Sales Department Patrick F. Olearcek, AVP JD, CLU, ChFC The MassMutual Advanced Sales Department is a hallmark of excellence and is staffed with dedicated and skilled professionals who provide consultation to producers and other professionals. Our objective is to ensure that each client s estate and business planning goals are met in a custom-tailored manner to suit the unique and individual needs of each of our clients. Our areas of focus include the following: Business Succession Planning Estate Planning Charitable Giving Arrangements Employee Benefit Arrangements Please call 1.800.767.1000, extension 41555 with any questions. Jeffrey I. Hollander, AVP JD Albert R. Kingan, AVP JD, LL.M, CLU, ChFC Tom Barrett JD, LL.M Marc Belletsky JD, CLU, ChFC Steven A. Brand M.T., ChFC, CLTC Michele B. Collins JD Todd L. Janower JD, LL.M, CLU, ChFC Todd A. McGee JD, LL.M Bruce A. Tannahill JD, CPA/PFS, CLU, ChFC, AEP Kathryn Wakefield JD, CLU Jacqueline Ellisor Wiggins JD, LL.M, CLU, ChFC
Qualified Long Term Care Insurance (LTCi) A Tax Primer Updated By Bruce A. Tannahill, JD, CPA/PFS, CLU, ChFC, AEP Contents 2 Quick Facts 5 Tax Treatment of Insurance Options for Long Term Care 5 The Need for Long Term Care and Importance of Long Term Care Benefits 6 Eligible Long Term Care Premiums 6 Qualified Long-Term Care Insurance Policies (IRC 7702B) 6 Medical Expense Deduction (IRC 213(a)) 7 Amounts Received Under a Qualified LTCi Policy 8 Medical Care Gift Tax Exclusion (IRC 2503(e)) 8 Health Savings Accounts (IRC 223) 9 Can Trusts and Other Third-Parties Own LTCi and Life Insurance Policies Providing LTC Benefits? 10 Income Tax Treatment of Trusts Owning LTCi Policies and Life Insurance Offering LTCi Benefits 11 Estate Tax Treatment of Trusts Owning LTCi and Life Insurance Policies Providing LTC Benefits 12 Employer-provided LTCi (IRC 105, 106, 162) 15 Special Rules for Certain S Corporation Owner-Employees 17 Special Rules for Partners 18 Self-Employed Health Insurance Deduction 19 Refunds of Premium 21 Cafeteria Plans/Salary Reduction Arrangements 21 Health Reimbursement Arrangements (HRAs) 22 LTCi and Qualified Retirement Plans 23 Tax Treatment of Whole Life Policies with the LTCAccess Rider 25 Tax Treatment of the MassMutual CareChoice SM One Policy 28 Tax Reporting Form 1099-LTC and Form 8853 29 Conclusion 1
Quick Facts Tax Treatment of Whole Life Policies with LTCAccess SM Rider Premium deductions Tax treatment of benefit payment Not available. The LTCAccess SM Rider is not intended to qualify as a long term care contract eligible for premium deductions under Internal Revenue Code (IRC) 7702B. Payments to the insured or the insured s spouse as LTC benefits are treated as an income tax free advance of the policy s death benefit, even if the policy is a MEC. Payments to anyone else are treated as withdrawals from the policy, not as an income tax free advance of the policy s death benefit. 1035 Exchanges A policy with LTCAccess SM Rider can accept 1035 exchange proceeds from other life insurance policies. Premium Deduction A policy with LTCAccess SM Rider can be exchanged into another life insurance policy, annuity, or LTCi policy. Tax Treatment of Qualified Long Term Care Insurance (LTCi) and CareChoice SM One. General Rules Treated as accident and health insurance. IRC 7702B(a)(1.) Deduction limited to lesser of actual premium paid or eligible LTCi premium. IRC 213(d)(1)(D), 213(d)(10). The Care Choice One illustration specifies the portion of the premium allocable to the LTCI rider. Reimbursement benefits are not included in income. IRC 104(a)(3), 7702B(a)(2). Per diem or indemnity benefits are not included in income, except those amounts that exceed the greater of: Eligible LTCi Premium in 2017: (Rev. Proc. 2016-55) Attained Age Premium Limitation Age 40 or less $ 410 Age 41-50 $ 770 Age 51-60 $1,530 Age 61-70 $4,090 Age 71 and older $5,110 Total qualified LTC expenses; or $360 per day (in 2017). IRC 104(a)(3), 7702B(a)(2), 7702B(d)(4) 2
Premium Deduction Type of Taxpayer Individual taxpayer who does NOT itemize deductions Individual taxpayer who itemizes deductions HSA & Archer MSA owners Employees (non-owner) and C Corporation owner/employee Other business owners: Sole Proprietor 2%-plus shareholder in S Corporation Partner in a partnership Member in an LLC not filing as a C Corporation Premium Deductions No deduction Medical expense deduction is allowable to extent that such expenses (including payment of eligible LTCi premium) exceed 10% of AGI. IRC 213(a). IRC 213(f). Eligible LTCi premium is a qualified medical expense. IRC 213(d)(1)(D) Premiums paid by employees: Deductible by employee who itemizes (subject to limitations outlined above) May NOT be paid through cafeteria plan. IRC 125(f) May NOT be paid through an FSA or similar arrangement. IRC 106(c) May be paid through an HSA (IRS Notice 2004-50, Q&A 40) but premiums paid exceeding eligible LTCi premiums are includible in income and may be subject to the 20% penalty for individuals under age 65 (IRS Notice 2004-50, Q&A 41) Premiums paid by employer: Employer-provided LTCi treated as accident and health plan. IRC 7702B(a)(3) Deductible by employer (subject to reasonable compensation). IRC 162(a) Total premium excluded from employee s income (not limited to eligible premium). IRC 106(a) Eligible for self-employed health insurance deduction, taken on Line 29 of IRS Form 1040. IRC 162(l) Limited to lesser of actual premium paid or eligible LTCi premium. IRC 213(d)(1)(D), 213(d)(10) Eligible LTCi premium in 2017 is shown above. (Rev. Proc. 2014-61) Deduction is NOT limited to 10% of AGI threshold (outlined above). 3
Quick Facts Continued Taxation of Benefits Reimbursement benefits are not included in income. IRC 104(a)(3), 7702B(a)(2) Per diem or indemnity benefits are not included in income except those amounts that exceed the greater of: Total qualified LTC expenses; or $360 per day (in 2017). IRC 104(a)(3), 7702B(a)(2), 7702B(d)(4) Non-forfeiture benefit (return of premium benefit): Available only upon total surrender or death May not be borrowed or pledged Included in gross income to extent of any deduction or exclusion allowed with respect to premium. IRC 7702B(b)(2)(c) Differences in Treatment Between LTCi Policies Owned by the Insured (or Spouse) and a Third Party Taxation of benefits Premium deduction Unpaid benefits included in insured s estate Insured Owned Reimbursement benefits are not taxable; per diem/indemnity benefits are taxable to the extent they exceed total qualified LTC expenses of $360/day (2017) Qualified LTCi premiums are deductible up to age-based limit Yes Third-Party Owned Same if owned by a grantor trust; uncertain otherwise Deductible by insured if owned by a grantor trust Only if the insured has retained an interest in policy benefits (e.g., an arrangement exists that the benefits will be used to pay the insured s LTC expenses) 4
Tax Treatment of Insurance Options for Long Term Care The tax treatment of long term care (LTC) premiums and benefits can be an important consideration in planning for long term care expenses. The expansion of long term care insurance options beyond stand-alone LTC insurance (LTCi) policies to annuity and life insurance policies with LTC benefits increases the options for clients but requires an understanding of the tax treatment for each option. The Need for Long Term Care and Importance of Long Term Care Benefits Increased life expectancies and advances in medical care increase the possibility an individual will need long term care assistance at some point during his or her life. The assistance needed can range from services designed to help a person recover from an illness or operation to memory care for individuals with Alzheimer s or other cognitive impairments. The required care can be provided in many different ways, including informal care by family and friends, and in many different settings, ranging from private homes to assisted living facilities to skilled nursing homes. It can be paid for in many different ways. Examples include care donated by family and friends, personal assets, private health insurance, private long-term care insurance, long-term care benefits provided under life insurance and annuities, Medicare, and Medicaid. Different payers have different requirements for coverage. The cost can be substantial. The table below shows 2016 median costs for different types of long term care. Type of care Median rate Increase from 2015 Compound annual growth rate, 2011-2016* Home health care (hourly rate) $ 20 2.56% 2.13% Adult day health care (daily rate) $ 68-1.25% 2.53% Assisted living facility (monthly rate) $3,628 0.78% 2.16% Nursing home care, semi-private room (daily rate) $ 225 2.27% 3.12% Nursing home care, private room (daily rate) $ 253 1.24% 3.51% Source: Genworth 2016 Cost of Care Survey * Compound annual growth rate for surveys conducted from 2011 to 2016. 5
The tax treatment of premiums for long term care coverage and the long term care benefits can be an important factor in a client s decision on which type of policy to use. Long-term care insurance and life insurance that offers LTC benefits receive favorable income tax treatment. Depending on the type of policy, how it is owned and how the premiums are paid, the premiums may be tax-deductible while benefit payments are not subject to income tax. For 2017, the Eligible LTCi Premiums are: Attained Age Premium Limitation Age 40 or less $ 410 Age 41-50 $ 770 Age 51-60 $1,530 Age 61-70 $4,090 Age 71 and older $5,110 MassMutual offers three types of long term care benefits: the LTCAccess SM Rider (LTCR), available on whole life policies; SignatureCare 500, a stand-alone long term care policy; and CareChoice SM One, a single premium whole life policy with a long term care benefit pool in addition to the death benefit. The tax rules can vary based on the type of product. The LTCR is not considered long term care insurance and receives different income tax treatment than SignatureCare 500 and CareChoice One. This Primer discusses the treatment of LTCi in general, followed by specific information on treatment of policies with the LTCR and treatment of CareChoice One. Eligible Long Term Care Premiums The IRC distinguishes between the actual premium paid for a policy and the LTCi premium that can qualify for favorable income tax treatment. The term eligible long term care premiums means the amount paid during a taxable year for any qualified LTCi contract covering an individual, to the extent such amount does not exceed the amount set by IRC 213(d)(1)(D), 213(d)(10) as adjusted annually for inflation. Qualified Long Term Care Insurance Policies (IRC 7702B) To receive favorable income tax treatment and be considered a qualified long-term insurance contract, a policy must meet specific tax law requirements. These include: Covering only LTC services; Not covering services to the extent that they would be reimbursable by Medicare; Being guaranteed renewable; and Not providing for a cash surrender value or other money that can be borrowed or used as collateral for a loan. IRC 7702B(a)(1) provides that a qualified LTCi contract shall be treated as an accident and health insurance contract. Medical Expense Deduction (IRC 213(a)) Eligible long term care premiums paid on a qualified LTCi contract qualify as a deductible medical care expense. The insurance can cover the individual, his or her spouse and/or dependents. 6
Medical expenses are only deductible to the extent that the total qualifying medical expenses exceed 10% of the taxpayer s adjusted gross income (AGI). IRC 213(f)). Example 1: Ed, age 63, and Ann, age 61, have an adjusted gross income of $75,000, 10% of which is $7,500. Their medical expenses for the year include premium payments on qualified LTCi policies. Although the actual premium may be greater, the only amount they can use to calculate any medical expense deduction is the eligible LTCi premium of $4,090 per person. Their total qualified LTCi premiums and their other medical expenses of $4,300 produce total medical expenses of $12,480. This exceeds the 10% AGI threshold by $4,980 ($12,480-$7,500 = $4,980). Their medical expense deduction is $4,980. It must then be added to Ed and Ann s other itemized deductions, such as mortgage interest, taxes, and charitable contributions to determine if their itemized deductions exceed their standard deduction. Because the 2017 standard deduction for a married couple filing jointly is $12,700, their other itemized deductions must exceed $7,720 for Ed and Ann to benefit from the medical expense deduction for the LTCi premiums. Amounts Received Under a Qualified LTCi Policy Amounts received under a qualified LTCi contract are treated as reimbursements for expenses actually incurred for medical care (IRC 7702B(a)(2)), and excluded from gross income. IRC 105(b). The result is the same whether the contract reimburses actual long term care expenses (a reimbursement contract) or pays a per diem amount toward long term care (an indemnity contract). However, if the per diem benefit exceeds the per diem limit provided under IRC 7702B(d) ($360 in 2016), the excess is taxable income to the extent it exceeds actual long term care expenses. A contract can provide for a full refund of all premiums upon complete surrender or cancellation, with no reduction for benefits that may have already been paid. This feature is often referred to as a full refund of premium option, and is usually offered by way of a rider. 1 Any refund received on a complete surrender or cancellation of the contract is includible in gross income to the extent that any deduction or exclusion was allowable with respect to the premiums. IRC 7702B(b)(2)(C). Because the deduction is subject to the AGI limitation discussed above, no deduction may have been allowable. In that case, none of the refund would be includible in income. 1 Note: A cost may be associated with this rider 7
Medical Care Gift Tax Exclusion (IRC 2503(e)) IRC 2503(e) provides an unlimited gift tax exclusion for amounts paid directly to a provider for medical care for another person. This includes amounts paid for medical insurance on behalf of any individual. Regs. 25.2503-6. For a qualified LTCi contract, the exclusion is limited to the eligible long term care premium amount based on the insured s age. IRC 213(d)(1)(D), 213(d)(10). Taking advantage of this exclusion requires that the medical care provider must be paid directly. For an insurance policy, this means that the donor must send the premium payment directly to the insurer. Practice tip: Increasing life expectancies mean many adults may be faced with caring not only for their children, but for their aging parents. LTCi can allow members of this sandwich generation to provide for their parents long term care expenses. If a parent owns the LTCi policy and the child pays the premium directly, the eligible long term care premium qualifies for the medical care gift tax exclusion under IRC 2503(e). The annual gift tax exclusion under IRC 2503(b) can be applied to the balance of the premium, if any. In addition, if the parent qualifies as a dependent, the expenses can qualify for the medical expense deduction discussed above. Example 2: Carol wants to purchase LTCi for her mother, Dorothy, age 69. The annual premium is $4,500. If Dorothy owns the policy, and Carol pays the insurance company directly, the gift tax consequences are as follows: The amount of the gift is $4,500. Of that amount, $4,090 (the eligible LTCi premium based on Dorothy s age) qualifies for the medical care gift tax exclusion. The $410 balance qualifies for the annual gift tax exclusion ($14,000 in 2017). This leaves Carol with a remaining annual gift tax exclusion amount for her mother of $13,590, which she can use to help her mother in other ways. Health Savings Accounts (IRC 223) A health savings account (HSA) allows individuals who have high-deductible health plans (HDHPs) to save for health care expenses pre-tax. Amounts paid or distributed out of an HSA used exclusively to pay qualified medical expenses of an account beneficiary are not includible in gross income. IRC 223(f)(1). Qualified medical expenses are amounts paid by an account beneficiary for medical care (as defined in 213(d)) for themselves, their spouse, and their dependents. They do not include expenses compensated or reimbursed by insurance or otherwise. Premiums paid for a qualified LTCi contract are specifically permitted as qualified medical expenses. IRC 223(d)(2)(C)(ii). 8
In Notice 2004-50, 2004-33 IRB 196, the IRS clarified the rules for using HSAs to pay for LTCi premiums and qualified long-term care services. A-41 states that although HSA distributions to pay or reimburse qualified LTCi premiums are qualified medical expenses, the exclusion from gross income is limited to the eligible LTCi premiums. Any excess premium reimbursements are includible in gross income. For individuals who are not disabled and have not reached age 65, the excess may also be subject to the 20% penalty tax under IRC 223(f)(4). Example 3: John s LTCi premium is $4,200. Because he is 64 and not disabled, his eligible LTCi premium for 2017 is $4,090. He can pay $4,090 of the premium directly from his HSA or reimburse himself from the HSA and exclude it from his gross income. If he pays or reimburses the entire premium from his HSA, $110 will be included in his gross income and subject to the 20% penalty tax. If he were at least 65 or disabled, the penalty tax would not apply. In A-40 of Notice 2004-50, the IRS pointed out that an account beneficiary may pay qualified LTCi premiums with distributions from an HSA, even if contributions to the HSA are made by salary reduction through a 125 cafeteria plan (also known as a flexible savings account or FSA). IRC 125(f) provides that the term qualified benefit under a 125 cafeteria plan shall not include any product which is advertised, marketed or offered as LTCi. IRC 223(d)(2)(C)(ii) provides that the payment of any expense for coverage under a qualified LTCi contract is a qualified medical expense for HSA purposes. Where an HSA offered under a cafeteria plan pays or reimburses individuals for qualified LTCi premiums, IRC 125(f) is not applicable because it is the HSA that is offered under the cafeteria plan and not the LTCi. Similarly, A-42 of the Notice clarified that distributions from an HSA for qualified long term care services are excluded from income. IRC 106(c) provides that employer-provided coverage for long term care services provided through a flexible spending or similar arrangement are included in an employee s gross income. The IRS stated that IRC 106(c) applies to benefits provided by a flexible spending or similar arrangement but not to distributions from an HSA, which is a personal health care savings vehicle used to pay for qualified medical expenses through a trust or custodial account. This treatment does not depend on whether the HSA is funded by salary-reduction contributions through a 125 cafeteria plan. Can Trusts and Other Third Parties Own LTCi and Life Insurance Policies Providing LTC Benefits? While third-party ownership for LTCi policies may not be available in all states, some insurers allow ownership of a qualified LTCi contract by a third party. Trusts can own life insurance policies that provide LTC benefits. Trust ownership of a qualified LTCi policy presents a unique wealth transfer planning opportunity. IRC 7702B does not address third party ownership, neither prohibiting it nor specifically allowing it. However, a reasonable argument can be made that third party ownership was contemplated. IRC 7702B(d) addresses aggregate payments in excess of limits. Its thrust is to tax per diem or indemnity benefits to the extent they exceed the greater of total qualified LTC expenses or the per diem 9
limitation ($360 in 2017). IRC 7702B(d)(3) provides aggregation rules, stating For purposes of this subsection... all persons receiving periodic payments... with respect to the same insured shall be treated as one person, and... the per diem limitation... shall be allocated first to the insured and any remaining limitation shall be allocated among the other such persons... Because LTC benefits are always paid to the policyowner, such aggregation rules would be unnecessary if third party ownership was not allowed. If the trust that owns the policy is a grantor trust, the policy should be treated as owned by the grantor. When the grantor is the insured, the question of third-party ownership should not arise. Under the grantor trust rules found in IRC 671-679, the grantor is treated as the owner of all or part of the trust and thus is taxed on the income of the trust in proportion to his or her ownership. In other words, the trust and the grantor are treated as the same taxpayer for income tax purposes. The IRS took this position in Rev. Rul. 85-13, 1985-1 CB 184, and has followed it in numerous private letter rulings (PLRs). This strengthens the proposition that amounts received by the trust under the contract should be treated as amounts received for personal injuries and sickness and as reimbursement for expenses actually incurred for medical care. Therefore, the amounts received by the grantor trust should be income tax free. However, if the policy is owned by someone who does not stand in the shoes of the insured (e.g., where children own a policy on a non-dependent parent), then receipt of the LTC benefit may very well be subject to income tax. Grantor trust ownership of a policy offering LTC benefits presents a unique wealth transfer planning opportunity. For example, the insured may pay the LTC expenses from personal assets, thereby depleting her personal taxable estate while allowing any LTCi benefits to be retained by the irrevocable trust. Income Tax Treatment of Trusts Owning LTCi Policies and Life Insurance Offering LTCi Benefits The income tax treatment of policies that are owned by someone other than the insured, such as a trust, varies between LTCi policies, including hybrid policies such as the CareChoice One, and policies that offer an accelerated death benefit, such as the whole life policies with the LTCR. The tax treatment of polices with an accelerated death benefit is discussed in a subsequent section. Because MassMutual LTCi benefits are paid to the insured or as directed by the insured or the insured s legal representative, this presents some interesting opportunities and challenges. If the insured intends to pay LTC expenses from other resources and not use LTCi benefits, trust ownership of an LTCi contract may be an effective wealth preservation/transfer strategy. As LTCi benefits, the amounts received by the trust should be income tax free under IRC 104(a)(3) as amounts received for personal injuries and sickness and as reimbursement for expenses actually incurred for medical care. Some states provide an income tax deduction or credit for LTCi premium payments. An unfunded trust that pays no income tax cannot receive these tax benefits, but an insured who pays the premium directly to the insurance company may, depending on state law. If the trust is a grantor trust, the premium payment could still qualify for a state tax benefit. Practice tip: Assuming the issuer allows for third-party ownership of a stand-alone LTCi policy, presumably a policy can be transferred from one owner to another. While there is no published guidance, a reasonable argument can be made that the value of the policy on transfer is the replacement value of the LTCi policy (i.e., the single premium necessary to replace the coverage on the insured assuming current age and underwriting class). 10
Practice tip: For many years, the testamentary credit shelter trust has been a standard element in estate planning for married persons. These trusts are created upon death and funded to the extent of the decedent s available applicable exclusion amount. Where a surviving spouse is the beneficiary of a funded credit shelter trust, the trustee often has authority to make distributions for the spouse s health, education, maintenance and support (HEMS). The trust can apply for and own an LTCi policy with a full refund of premium insuring the spouse. Should the spouse ever go on claim, the trust has the LTCi benefits to pay for her or his care while retaining the opportunity to recover all premiums paid for the policy upon the death of the insured if no claim is ever filed. Estate Tax Treatment of Trusts Owning LTCi and Life Insurance Policies Providing LTC Benefits If the insured intends to pay LTC expenses from other resources and not use LTC benefits available under a LTCi policy or life insurance policy that provides LTC benefits, trust ownership of a policy offering LTC benefit may be an effective wealth preservation/transfer strategy. If the goal is for the trust to be excluded from the insured s estate, the trust must be drafted and administered carefully to accomplish that goal. The trust must be irrevocable for the trust assets to be excluded from the grantor s federal taxable estate. The grantor helps finance the purchase of the LTC benefits by making gifts to the trust. To qualify for the gift tax annual exclusion ($14,000 in 2017), the trust must provide for Crummey withdrawal powers, allowing beneficiaries to withdraw the cash or assets transferred to the trust. In theory, if the insured pays the premiums directly to the insurance company, that payment should qualify for the gift tax annual exclusion. If the trust has the usual Crummey provisions and the insured is a beneficiary of the trust (but not the grantor), and the trustee can satisfy a demand by distributing cash or assets in kind, including interests in the insurance policies, then direct payment of premiums may qualify for the annual exclusion. For an irrevocable life insurance trust (ILIT), a Tax Court Memorandum decision, Est. of Turner v. Com r, TC Memo 2011-209, and several PLRs are often cited for this proposition: Whole life PLRs; 8044080, 8015133, 8008040 Term PLRs; 7826050, 7935091, 7947066 Group term PLRs; 8143045, 8006109 Split dollar life insurance PLRs; 8051128, 8103069 The same reasoning should apply to an irrevocable trust that owns a qualified LTCi policy. The key is that the trustee must have the authority to distribute the insurance or interests in the insurance policies to any beneficiary who makes a withdrawal demand. Another option is for the grantor to make an additional gift or loan to the trust to provide the cash to satisfy a demand. Many trusts have this specific provision. A grantor s transfer of assets into a trust while retaining certain rights and interests will cause the value of those assets to be included in the grantor s gross estate for estate tax purposes. See IRC 2036 (transfers with certain life interests retained), 2037 (transfers with a reversionary interest retained), and 2038 (transfers with a right retained to alter, amend or revoke). 11
Because benefits paid under an LTCi policy are paid to the policyowner, the trust will receive the benefits if the insured goes on claim. Where a trust owns a qualified LTCi policy and the insured directs that the amounts received by the trust are to be used to cover his or her long term care expenses, then he or she has a retained interest, and as such, the value of the assets inside the trust as of the date of death will be included in the gross estate for estate tax purposes. Consequently, this strategy should be contemplated only where the insured can easily cover his or her long term care expenses without the insurance. Alternatively, the trust can be given discretion to make distributions to trust beneficiaries, who in turn can take advantage of the medical care gift tax exclusion under IRC 2503(e) to cover the grantor s LTC expenses. However, there is a risk associated with this. If the facts and circumstances support the determination that there is a prior arrangement that distributions to beneficiaries will be used to cover the grantor s LTC expenses, then the IRS may apply the step-transaction doctrine and conclude that the grantor retained an interest in the trust assets. This would cause the trust assets to be included in the grantor s estate. Another alternative is for Trustee to loan LTCi funds to a grantor-insured to cover expenses. Legal formalities, such as a note, should be followed. The loan can be paid off from the insured s estate. Employer-provided LTCi (IRC 105, 106, 162) Any employer-sponsored plan that provides coverage under a qualified LTCi contract is treated as an accident and health plan. IRC 7702B(a)(3). An accident and health plan is an arrangement that provides benefits for employees, their spouses and their dependents in the event of personal injury or sickness. Regs. 1.105-5, 1.106-1. Accident and health plans: Can include retirees. Rev. Rul. 62-199, 1962-2 CB 38; May cover one or more employees; different plans are permitted for different employees or classes of employees; may be either insured or non-insured; do not need to be in writing; and employee s rights to benefits under the plan do not need to be enforceable. Regs. 1.105-5. Practice tip: A plan must be formulated as a program for actions to achieve an end. Ordinarily, a definite program to provide LTCi coverage includes certain features reflecting the plan s purpose. For example, such a plan could state that its purpose is to qualify as an accident and health plan for federal tax purposes and that the benefits payable are eligible for income tax exclusion. Even though the Code does not require a plan to be in writing, it is advisable to document the plan using at least a corporate resolution and provide notice to participating employees. If the business is not a corporation, an adoption agreement should be included in its business records. If the employer is not directly or indirectly a beneficiary under the policy, it may deduct the LTCi it pays as an ordinary and necessary business expense under IRC 162(a), if it can be shown that: 1 the premiums were paid in consideration of personal services actually rendered by the employee; and 2 the total amount paid the employee, including the premiums, was not unreasonable compensation for his services. Rev. Rul. 58-90, 1958-1 CB 88. 12
An employer cannot deduct the premium payments as an ordinary and necessary business expense if it owns the contract. Practice tip: Reasonable compensation is not easily defined and is heavily dependent upon all the facts and circumstances of each situation. Factors to consider in determining whether compensation is reasonable include: the employee s qualifications; the nature, extent and scope of the employee s work; the size and complexities of the business; a comparison of salaries paid with gross income and net income; the prevailing general economic conditions; comparison of salaries with distributions to stockholders; the prevailing rates of compensation for comparable positions in comparable enterprises; the salary policy of the taxpayer as to all employees; and compensation paid in prior years. See Owensby & Kritikos, Inc. v. Comm., 60 AFTR2d 87-5224 (CA5, 1987). In general, IRC 106(a) and Reg. 1.106-1 provide that gross income of an employee does not include employerprovided coverage under an accident and health plan covering the employee, the employee s spouse and the employee s dependents. There is apparently no limit on the amount of this exclusion. Under IRC 105(b), an employee may exclude amounts received through employer-provided coverage paid to reimburse expenses incurred by the employee for long term care of the employee, the employee s spouse, or the employee s dependents. Amounts excluded from gross income under IRC 105(b) or IRC 106(a) are also excluded from income tax withholding under IRC 3401. Additionally, amounts paid to reimburse expenses incurred by the employee for long term care of the employee, the employee s spouse, or the employee s dependents, are also excluded from FICA and FUTA taxes under IRC 3121(a) and 3306(b). For the exclusions available to plans for employer-provided coverage and/or medical expense reimbursement to apply, an accident and health plan (including employer-provided LTCi) must provide benefits for employees as an incident of the employment relationship. This means a bona fide employeremployee relationship must exist so the employer can deduct the premium payment and so the employee can exclude the premium payment from gross income. Benefits for owner-employees. If the plan provides benefits for owner-employees primarily because of their ownership interest, then the exclusions under IRC 105(b) and IRC 106 are not available. The keys are determining whether an accident and health plan is for an owner or for an employee are whether: the plan s expected benefits are paid with respect to the individual s capacity as an employee of the business; and whether there is any rational basis other than ownership to differentiate that individual from other employees. A rational basis for differentiation has been found where a plan was established for an owner-employee (or group of owner-employees) who was a key person in performing executive or management decisions. American Foundry v. Comm., (1976, CA9) 37 AFTR 2d 76-1373, 536 F2d 289, 76-1 USTC 9401, rev g on this issue 59 TC 231 (1972), acq 1974-2 CB 1. Stating in the resolution adopting the plan that the plan is providing benefits to the individual in their capacity as an employee should reinforce this. 13
S Corporation shareholder-employees. S Corporation employees who own more than 2% of the S Corporation are treated as self-employed persons for purposes of employee benefits, including accident and health plans. This means that the S Corporation cannot deduct the premiums for an owneremployee as contributions to an accident and health plan and that the individual cannot exclude an S Corporation s payment of premiums from income. The tax treatment of accident and health insurance premiums paid by an S Corporation for an employee who owns more than 2% of the S Corporation is discussed in a subsequent section. Benefits for corporate directors. Directors of a corporation are treated as self-employed individuals, not as employees of the corporation. A corporation s payment of LTCi premiums for a director is an addition to the director s fees. The premiums are deductible by the corporation under IRC 162 and includible in the recipient director s gross income under IRC 61. The premiums are not excludable from the recipient director s gross income under IRC 106. If all the requirements of IRC self-employed health insurance deduction are met, the director may deduct the cost of the premium as a self-employed health insurance deduction. The deduction is limited to the eligible LTCi premiums. Rev. Rul. 61-146, 1961-2 CB 25, provides that the IRC 106 exclusion applies to an employer s reimbursement of an employee for individual accident or health insurance (including LTCi) premiums paid by the employee to an insurer if (1) the employer has an accident and health plan under which it permits such reimbursements and (2) any reimbursement is for premiums actually paid by the employee. The exclusions from gross income under 106(a) or 105(b) do not apply to reimbursements by an employer to employees for salary reduction amounts used to pay for accident or health insurance premiums. Rev. Rul. 2002-3, 2002-3 IRB 1. Practice tip: An insured long term care expense reimbursement plan that qualifies as an accident and health plan within the meaning of IRC 105(b) and 106(a) can be a very attractive executive fringe benefit. The employer can provide this benefit to a named executive or to a select group of executives. The plan can be designed to cover not only the executive, but also the executive s spouse and dependents. Employer contributions are generally deductible as an ordinary and necessary business expense. The premium payments are excluded from the executive s compensation while the benefits paid under the LTCi contract are income tax free. Practice tip: LTCi needs continue and may become more important after retirement. Employers may consider offering continued coverage through an employer-sponsored LTCi plan to their retirees. Employer contributions to accident and health plans for a retired employee are excludable from the retiree s income under IRC 106 and the benefits received are non-taxable under IRC 105 (assuming the coverage is attributable to the previous employment relationship). See Rev. Rul. 62-199, 1962-2 CB 38. Practice tip: Contributions by an employer to an accident and health plan (including a plan to provide LTCi), which was adopted during the employee s employment and continues to provide benefits to the spouse and dependents after the employee s death, are excludable from gross income under IRC 106. Rev. Rul. 82-196, 1982-2 CB 53. Practice tip: A tax-exempt organization (also known as a non-profit) can provide an LTCi plan to select key executives who receive the same tax advantages as executives of for-profit organizations. Because the tax-exempt organization generally does not pay income taxes, it would not receive any income tax benefits. 14
Practice tip: A professional corporation (PC) is a personal service corporation, taxed at a flat rate of 35% if it is a C Corporation. IRC 11(b)(2). This means that it does not benefit from graduated corporate income tax rates. However, a PC may provide LTCi to certain key executives with the same tax advantages outlined earlier. Because of the flat rate structure, many PCs elect to be S Corporations. There are very different tax consequences if an S Corporation pays LTCi premiums for its shareholder-employees. The planner should confirm the entity s classification for federal tax purposes. Special Rules for Certain S Corporation Owner-Employees Special rules govern the tax treatment of employee benefits provided to S Corporation employees who own more than 2% of the S Corporation s stock. IRC 1372. The same rules apply to members of LLCs taxed as S Corporations. For this purpose, 2% shareholder means any person who owns (or is considered as owning under the attribution rules of 318) on any day during the taxable year of the S Corporation more than 2% of the outstanding stock of such corporation or stock possessing more than 2% of the total combined voting power of all stock of such corporation. Under the family attribution rules of IRC 318, an individual is considered to own any stock owned directly or indirectly by his or her parents, spouse, children and/or grandchildren. Thus, a spouse of a 2% S Corporation shareholder is deemed to be a 2% shareholder for fringe benefit purposes, even though he or she may not actually own any shares. Practice tip: The tax treatment of LTCi premiums for limited liability company (LLC) members depends on how the LLC is classified for federal income tax purposes. An LLC is an unincorporated business entity that can elect its federal tax classification under the check-the-box regulations. Reg. 301.7701-3. These regulations provide that a single-member LLC is taxed as a sole proprietor unless it elects to be taxed as a C Corporation or as an S Corporation. A multiple-member LLC is taxed as a partnership, unless it elects to be taxed as a C Corporation or as an S Corporation. The planner should always ask how the LLC is classified for federal tax purposes. Rev. Rul. 91-26, 1991-1 CB 184, outlines the tax treatment of employee fringe benefits such as accident and health insurance (including qualified LTCi) provided for S Corporation shareholder-employees as consideration for services provided. The ruling states that the employee fringe benefits are treated like partnership guaranteed payments under IRC 707(c), discussed below. The resulting tax treatment is: 1 The accident and health insurance premiums (including eligible LTCi premiums) are deductible by the corporation as salary and wages under IRC 162. 2 The premiums are includible in the recipient shareholder-employee s gross income under IRC 61. 3 The S Corporation must file a Wage and Tax Statement (Form W-2) for each 2% shareholderemployee. The W-2 must include the cost of accident and health insurance premiums (including LTCi premiums) in the shareholder-employee s wages. 4 The premiums are not excludable from the recipient shareholder-employee s gross income under IRC 106. 15
5 If the requirements for the self-employed health insurance deduction are met (see below), the shareholder-employee may deduct the cost of the premium to the extent permitted by the deduction. 6 The S Corporation cannot treat the premiums it paid as a reduction in S Corporation distributions to the shareholder-employee. Although Rev. Rul. 91-26 requires the inclusion of amounts paid by an S Corporation for accident and health insurance covering a 2% shareholder in the shareholder-employee s income, the IRS has clarified that such payments are not wages for FICA (Social Security and Medicare) tax purposes. See Announcement 92-16, 1992-5 IRB 53. Notice 2008-1, 2008-2 IRB 251, clarified that the selfemployed health insurance deduction under IRC 162(l) requires the existence of a plan established by the S Corporation. The Notice provides that a plan is established by the S Corporation if premiums for the coverage are either paid directly by the S Corporation or reimbursed to the employee on proof of payment to the S Corporation. For the 2% shareholder to qualify for the deduction, (1) the S Corporation must report the insurance premiums paid or reimbursed on the employee s Form W-2 in the year the premiums were paid and (2) the 2% shareholder-employee must include these amounts in gross income. See also IRS Publication 535, which can be downloaded from the IRS website (www.irs.gov). Example 4: In 2017, Jim, an S Corporation shareholder-employee who is age 55, has a distributive share of the corporation s profits of $30,000. The S Corporation also pays for his LTCi policy in the amount of $2,000, which is included on his W-2 along with his salary of $30,000 for total wages of $32,000. He has no other income for the year. In calculating his tax for the year, his gross income of $62,000 is reduced by his eligible LTCi premium ($1,530), resulting in adjusted gross income of $60,470. His other allowable deductions and credits are then applied to his AGI in calculating his taxes due. Coverage purchased by an S Corporation for employees not owning any stock and for shareholder-employees owning 2% or less of the outstanding stock or voting power are subject to the same rules as any other bona fide employer-employee situation. Changes made under the Affordable Care Act may subject arrangements where an S Corporation pays or reimburses premiums a 2% shareholder for individual health insurance coverage to the excise tax imposed under 4980D for failure to meet certain group health plan requirements. The tax is $100 per day per individual for each day of noncompliance. Because LTCi premiums are considered health insurance coverage, the excise tax may apply to the payment of LTCi premiums as well. In Notice 2015-17, 2015-10 IRB 845, the IRS stated that it, the Department of Treasury, Department of Labor, and Department of Health and Human Services are considering providing guidance on how those group health plan requirements apply to the payment or reimbursement of 16
accident and health insurance premiums by S Corporations for 2% shareholders. Notice 2015-17 states that the 4980D excise tax will not be applied until such guidance is issued. It also states that the IRS and Treasury are considering whether additional guidance is needed on the federal tax treatment of these arrangements. Until additional guidance provides otherwise, taxpayers may continue to rely on Notice 2008-1 concerning the tax treatment of the arrangements for all federal income and employment tax purposes. Special Rules for Partners Rev. Rul. 91-26, 1991-1 CB 184, also covers the treatment of accident and health insurance premiums (including LTCi premiums) paid by a partnership on behalf of a partner. This also applies to members of an LLC that is taxed as a partnership. The payments are treated as guaranteed payments under IRC 707(c) if they are made for services rendered in the capacity of partner and to the extent the premiums are determined without regard to partnership income. Guaranteed payments. The partnership can elect to treat the premiums as guaranteed payments under IRC 707(c). The resulting tax treatment is: 1 As guaranteed payments, the premiums are deductible by the partnership under IRC 162 and includible in the recipient-partner s gross income under IRC 61. 2 The premiums are not excludable from the recipientpartner s gross income under IRC 106. 3 If the requirements for the self-employed health insurance deduction are met, the partner may deduct the cost of the premiums to the extent permitted by the deduction. 4 The partnership must report the cost of accident and health insurance premiums (including LTCi premiums) that are guaranteed payments on its U.S. Partnership Return of Income (Form 1065) and the Schedule K-1s. A partnership is not required to file a Form 1099 or a Wage and Tax Statement (Form W-2) for accident and health insurance premiums that are guaranteed payments. Reduction in distributions to partners. The ruling also allows the partnership to account for the premiums as a reduction in distributions to the partner. In this situation, the resulting tax treatment is: 1 The premiums are not deductible by the partnership. 2 Amounts reported to the partners on their K-1s as shares of partnership income, deduction, and other payment items are not affected by the premium payments. 3 A partner may deduct the premiums paid on the partner s behalf as a self-employed health insurance deduction. Although Notice 2008-1 (discussed above) deals specifically with S Corporations, its requirement should apply equally to partnerships. The partnership must establish a plan for a partner to claim the self-employed health insurance deduction. To be deductible, the premiums for the coverage must either be paid directly by the partnership or reimbursed to the partner on proof of payment to the partnership. To qualify for the deduction, the partnership must report the insurance premiums paid or reimbursed as guaranteed payments on Schedule K-1. The partner must include these amounts in gross income. Similarly, the 4980D excise tax may apply to payments or reimbursements by partnerships for a partner s LTCi premiums. 17
See also IRS Publication 535, which can be downloaded from the IRS web site (www.irs.gov). Example 5: In 2017, Jones has net earnings from his partnership of $130,000. In addition, the partnership pays for his LTCi policies covering him (age 57) and his wife (age 55) in the amount of $4,000. Jones must include this amount in his gross income. They have no other income. In calculating his tax for the year, his gross income of $134,000 is reduced by his eligible LTCi premium ($1,530) plus his wife s eligible LTCi premium (also $1,530), resulting in adjusted gross income of $130,940. Their other allowable deductions and credits are then applied to his AGI in calculating their taxes due. Self-Employed Health Insurance Deduction A self-employed individual can deduct an amount paid during the taxable year for insurance that constitutes medical care for the taxpayer, his or her spouse and dependents. IRC 162(l)(1) (A). For a qualified LTCi contract, the deduction is limited to eligible long term care premiums. IRC 162(l)(2)(C). For 2016, the deduction is claimed on Form 1040, line 29. A taxpayer may claim this deduction even if the taxpayer does not itemize deductions. In addition, the deduction reduces the adjusted gross income used to compute some limitations. This provides self-employed persons with tax treatment for medical insurance equivalent to the treatment of employees. To qualify for the deduction: 1 The taxpayer must either: a. Be self-employed and had net profit for the year reported on Schedule C, Schedule C-EZ, or Schedule F; b. Be a partner with net earnings from selfemployment for the year reported on Schedule K-1; c. Have used an optional method to determine net earnings from self-employment on Schedule SE; or d. Have received wages from an S Corporation in which they were a more-than-2% shareholder with the health insurance premiums shown as wages on Form W-2. 2 The deduction cannot exceed the taxpayer s earned income from the trade or business that maintains the plan providing the insurance. 3 The individual cannot be eligible to participate in any subsidized health plan maintained by an employer of the taxpayer or of the spouse, dependent, or child under 27 at the end of the taxable year. This limit is applied separately to plans that include LTC coverage or are qualified LTCi contracts and plans that do not include LTC coverage and are not LTC contracts. Notice 2008-1, 2008-2 IRB 251, clarified that the selfemployed health insurance deduction under IRC 162(l) is dependent on the existence of a plan established by the S Corporation. Specifically, the Notice provides that a 2% shareholder-employee can deduct health insurance premiums paid by the S Corporation and included in the employee s income as long as premiums for the coverage are either paid directly by the S Corporation or reimbursed to the employee on proof of payment to the S Corporation. 18