Stanley I Strouch is Chairman and CEO of Creative Insurance Planning, an independent brokerage agency which services the life and health insurance needs of independent agents.  Stanley worked in the legal department of New England Life Insurance Company, was its National Director of Advanced Sales, then worked for Aetna and in the mid-'80s as Vice President of Health Operations, was in charge of the development of Aetna's long-term care products.

Stanley authored LISI's Long Term Care – Information EVERY Planner Needs to Know (Estate Planning Newsletter # 1019).

Stanley has prepared for LISI members an extensive special report on the tax treatment of Long-Term Care insurance.

EXECUTIVE SUMMARY:

The 1996 Health Insurance Portability and Accountability ACT, HIPAA, clarified the tax treatment of employer paid LTCI by adding Code Section 7702B to the Internal Revenue Code.  This section provides among other things that for purpose of the Internal Revenue Code

• a qualified long- term care insurance contract shall be treated as an accident and health insurance contract,

• amounts received under a qualified long-term care insurance contract shall be treated as amounts received for personal injuries and sickness and shall be treated as reimbursement for expenses actually incurred for medical care as defined in section 213(d),

• any plan of an employer providing coverage under a qualified long-term care insurance contract shall be treated as an accident and health plan with respect to such coverage,

• amounts paid for a qualified long-term care insurance contract shall be treated as payments made for insurance for purposes of section 213(d) (1)(D).

This article examines the relevant tax issues for both tax qualified and non-tax qualified long-term care purchased by individuals and businesses.

FACTS:

Tax Treatment for Individuals

Individuals have two potential income tax deductions for LTCI premiums:

1. the self-employed health insurance deduction under IRC Section 162(l) and
    
2. itemized medical expense deduction under IRC Section 213.

Self-employed Health Insurance Deduction

CODE SECTION:

162(l) permits a self-employed individual to deduct the "applicable percentage" of LTCI premiums for "medical care for the taxpayer, his spouse and dependents."

7702 B (a) (1) states that a qualified LTCI is an accident and health insurance contract.

162(l)(2)(C) states that a qualified LTCI policy is a medical care insurance policy, but that in applying the applicable percentage, "only eligible long term care premiums…shall be taken into account.

162 (l) (1) (B) defined the applicable percentage as 60% in 2001, 70% in year 2002, and 100% in year 2003 and thereafter.

213(d) (10) lists five different age-based eligible long-term care premiums that are subject to annual cost of living adjustments.

Based on Rev. Proc. 2005-50 the eligible premiums for 2006 are:

Age	Amount
40 or Younger	$280
41 through 50	$530
51 through 60	$1,060
61 through 70	$2,830
71 or older	$3,530

Example 1 James is 65 and self-employed.  His LTCI premium is $3,740.  In 2006, he can claim a self-employed health insurance deduction of $2,830.

Example 2 Both James and his wife age 59 purchased a qualified LTCI policy.  The premium for her policy is $2,540. James can deduct $2,830 for his policy and $1,060 for his wife's policy as a self-employed health insurance deduction.

Recap:

The self-employed health insurance deduction is available for premiums paid for (1) a qualified LTCI policy or policies that insure a self-employed taxpayer, his or her spouse and dependants, but only for premiums that do not exceed the eligible premium for each person.  As noted below, the balance of the eligible premium may be deductible as an itemized medical expense.

The self- employed health insurance deduction is a deduction from gross income in determining the taxpayer's adjusted gross income.  This means that a self-employed taxpayer can claim the self-employed health insurance deduction whether he or she itemizes deductions or claims a standard deduction.  On the other hand, the medical expense deduction under IRC Section 213 is limited to taxpayers who itemize their deductions.

Limitations:

The self-employed health insurance deduction is subject to two further limitations.

1.     The deduction cannot exceed the taxpayers earned income from the business "with respect to which the plan providing the medical care coverage is established."

2.     If the taxpayer is eligible to participate in a subsidized LTCI plan of another employer the deduction is not available.

Itemized Medical Expense Deduction

Code Section 213(a) permits individual taxpayers who itemize their deductions to deduct their, their spouse's and their dependents "medical care" expenses that in total exceed 7 ½% of adjusted gross income.

Code Section 213(d)(1)(D) states that the term "medical care" includes "amounts paid….for any qualified long-term care insurance contract," but limits the deduction to "only eligible long term care premiums".

In the case of a self-employed individual, deductible medical expenses for LTCI premiums are limited to the balance of the eligible premiums that were not deducted as self-employed health insurance.  In the case of individuals who are not entitled to any self-employed health insurance deduction, the entire eligible premium constitutes a medical care expense under IRC Section 213(a).

Example:  The total premium for James and his wife's policies is $6,280. In 2006, they can deduct $3,890 under IRC Section 162(l). If James and his wife itemize their deductions, the balance of the eligible premium, $2,390, may be deductible if their total medical expenses including the $2,390 long term care premium exceeds 7 ½% of adjusted gross income.

LTCI Premiums Paid By Business

The tax treatment of employer paid long-term care is different for C Corporations, S Corporations, and Partnerships.

There are three tax issues to examine for each type of business entity.

1.     Are the premiums deductible by the business entity?

2.     Is the premium paid by the entity taxable to the insured?

3.     Are the benefits received under the long-term care contract received tax- free?

C Corporations

Are the employer's premium payments taxed to employee?

No! IRC Section 106 provides that long- term care premiums paid by the employer are not included in an employee's income.  Regulation, 1.106-1, provides that an employee's gross income does not include contributions his employer makes to an "accident or health plan". The regulations provide that the employer may contribute to an accident and health plan by paying the premium or a portion of the premium on a policy of accident or health insurance covering one or more of his employees.  Section 7702 B (1) treats employer paid long- term care insurance as medical insurance.  As such, the premiums paid by the employer are not included in the employee's income.

Is the employer entitled to deduct the long-term care premium?

Yes!  The employer is allowed a deduction for the long-term care premiums paid on behalf of its employees under IRC Section 162(a).  The regulations to Section 162 provide,  "Amounts paid or accrued within the taxable year for dismissal wages, unemployment benefits, guaranteed annual wages, vacations, or a sickness, accident, hospitalization, medical expense, recreational, welfare or similar benefit plan, are deductible under section 162(a) if they are ordinary and necessary expenses of the trade or business."

Are the benefits received under the long-care contract excluded from income?

Yes!  The tax treatment of benefits received under a long-care contract where the premium is paid for the employer is governed by IRC section 105. Section 105 is an inclusion section of the Code. Section 105(a) states that unless otherwise provided in this section, any benefits received by an employee through accident or health insurance for personal injuries or sickness is included in gross income to the extent such amounts are attributable to contributions by the employer that were not includible in the employees gross income.  Since the premium that the employer paid for an employee's long- term care contract is not included in the employee's income, it would appear under Section 105(a) that the benefits under the long- term care contract are included in the employee's income.

Section 105(b) however provides that gross income does not include benefits paid to reimburse the taxpayer for expenses incurred by him for the medical care (as defined in section 213(d)).    Section 213(d) was amended in 1996 to include benefits and premiums paid for qualified long- term care contracts.  Thus, benefits received by the employee under a long- term care contract, where the employer pays the premium, are excluded from income.

Is the tax treatment different if "the plan" only covers highly compensated employees or owner-employees?

Sections 162 and 106 do not have any limitation for plans that only cover highly compensated employees, or owners. Section 105, however, provides there must be a plan and the plan must be for employees. The Regulations in Section 1.105-5 provide that "a plan may cover one or more employees, and there may be different plans for different employees or classes of employees.  An accident or health plan may be insured or noninsured, and it is not necessary that the plan be in writing or that the employee's rights to benefits under the plan be enforceable."

Even though the above stated regulation seems to indicate that the plan need not be in writing, we suggest there be a written plan and also a corporation resolution adopting the plan.

Even if the board adopts a written plan, if the plan only covers stockholder- employees the IRS may challenge the deduction and exclusion from income,.  The issue is whether the stockholder-employee is covered as an employee or as a stockholder.  If the plan is deemed to cover the participants as stockholders then the transaction in all likelihood will be treated as a dividend.  This means that the premium is not deductible to the corporation and the premiums or benefits are includible in the gross income of the shareholder.

The courts have approved plans which cover a class of employees that is based on factors other than being a stockholder. The most successful classification is officers of the corporation.  Bogene, Inc v Comm., TC Memo 1968-147; E.B. Smith v Comm., TC Memo 1970-243; Arthur R. Seidel v Comm., TC Memo 1971-238: and Nathan Epstein v Comm., TC Memo 1972-53.

If the owners want a plan that covers only employee owners, they must develop a classification that is not based solely on stock ownership.  For example, the classification can cover all officers, or all senior officers.   A non-owner employee may need to be covered under the classification, but the added cost  will assure the desired tax treatment.

Partnerships

For employees, other than partners, the tax treatment of partnership paid long term care premiums is the same as for a C corporation.  Partners, however, are treated differently.  There are really two issues:

1.     How does the partner treat the premium paid by the partnership?

2.     How is this tax treatment reflected on the individual and partnership return?

Revenue Ruling 91-26 discusses health insurance premiums paid for by partnerships or S corporations. With respect to a partnership there are two ways the partnership can account for the premium payment:

1.     The premium is paid for services rendered in the capacity of a partner without regard to partnership income, a guaranteed payment under IRC Section 707(c), or

2.     The premium is treated as a reduction of a partner's share of profits.

Where the premium payment is treated as a guaranteed payment it is deductible by the partnership under section 162, and includable in the recipient-partner's gross income under section 61.

The Revenue Ruling also held that the premium is not excludable from the recipient-partner's gross income under section 106, but the partner may deduct the cost of the premiums to the extent provided by section 162(l).  The deduction under section 162(l) is equal to the eligible premium.

Another way the partnership can account for the long-term care premiums paid on behalf of a partner is to treat the premium payment as a reduction in distributions to the partner.  Under this scenario, the premium is not deductible by the partnership, so distributive shares of partnership income and deduction are not affected by payment of the premium.  A partner may deduct the cost of the premium paid his behalf to the extent allowed under section 162(l).

S Corporations

Code Section 1372 provides that, for purposes of applying the income tax provisions of the Code relating to employee fringe benefits, an S corporation shall be treated as a partnership, and any person who is a "2-percent shareholder" of the S corporation shall be treated like a partner of a partnership.

Under Revenue Ruling 91-26, accident and health insurance premiums (which includes long-term care premiums) paid by an S Corporation on behalf of a two-percent shareholder-employee is treated like guaranteed payments under section 707(c).  Therefore, the premiums are deductible by the corporation under section 162 and includable in the recipient-shareholder's gross income under section 61.

Further, the premiums are not excludable from the recipient-shareholders gross income under section 106, but the two-percent shareholder may deduct the premium as a self employed individual as provided in section 162(l).

ERISA Considerations:

I believe that an employer paid long-term care plan is an employee welfare benefit plan and within the scope of the Employee Retirement Income Security Act (ERISA).  However, if the business has less than 100 employees, the ERISA are listed below:

The Establishment by Written Plan

Section 402 of ERISA requires that every employee benefit plan be established and maintained pursuant to a written instrument. This written instrument must provide for one or more named fiduciaries that have authority to control and manage the plan.  This document should be kept with the records of the company.

Summary Plan Description

The administrator of the plan (usually the employer) must provide a Summary Plan Description to each participant.

Select Group Exemption

Plans maintained by an employer, primarily to provide benefits for a select group of management or highly compensated employees for whom benefits are paid through insurance policies paid for by the employer, are exempt from reporting and disclosure requirements.  The plan documents have to be made available to the Secretary of the Labor if they are requested.

Reporting Requirements

Fully insured plans with fewer than 100 participants are exempt from annual reporting of Form 5500.  Plan that cover 100 or more employees come under the full requirements of ERISA.

Non-Tax Qualified Long Term Care Insurance Contract

Is a tax-qualified long-term care plan the best plan for your clients?  Are you meeting your professional responsibility by only recommending a tax-qualified plan?  Have the insurance companies so conditioned us that we automatically believe that a tax qualified plan is a better plan than a non-tax qualified plan?

The primary reason, and perhaps the only reason, to recommend a tax-qualified long-term care plan is that the benefit payments are guaranteed to be tax-free.

However, the tax status of the benefits is only one of many factors to consider when recommending a long-term care plan, and in fact, is probably one of the least important.  The most important consideration is how the insured qualifies for benefits.  What good is it to have a long term care policy where the benefits are guaranteed to be tax-free, but the insured may not qualify for benefits?

Before 1996, the year HIPPA was passed, there were three ways an insured could qualify for benefits under most long-term care plans.

1.     The insured was unable to perform two out of six activities of daily living without   human assistance or continual supervision;

2.     The insured was "cognitively impaired";

3.     The insured's physician certifies that the care or service was medically necessary.

With the passage of HIPPA, Code Section 7702(B) provides that a tax-qualified long-term care insurance policy must provide "qualified benefits" for a chronically ill individual.  A chronically ill individual is defined as:

1.     An individual who is unable to perform two out of six daily activities of living for a period of at least ninety days due to a loss of functional capacity, without substantial assistance from another individual, certified by a health practitioner, or

2.     The insured requires substantial supervision to protect him or her from threats to health and safety due to severe cognitive impairment.

The new benefit triggers are substantially more restrictive than the pre-HIPPA benefit triggers.

Why did Congress pass a law that makes it more difficult for an insured to qualify for benefits?  Perhaps the insurance companies lobbied Congress.  With respect to long-term care, HIPPA was anti-consumer and pro-insurance company.  In my opinion, the insurance companies were the primary beneficiaries of the legislation.  They can offer for sale a "Congressionally approved" more restrictive long-term care plan, at the same or higher premium than the pre-HIPPA plans.

After HIPPA, all of the long-term care insurance companies introduced a tax-qualified long-term care plan to comply with the new law.  Many of the companies said that the tax- qualified policy was the only type of long-term care policy entitled to the tax breaks, and that the primary reason they introduced the tax-qualified policy was to meet the requirements of the new law.  Most of the major companies only sell the tax-qualified plan.

It is my understanding that before HIPPA, many long-term care claims resulted from the medical necessity benefit trigger.  HIPPA eliminates the medical necessity benefit trigger and makes it more difficult to qualify under the other two benefit trigger tests.  Since it is more difficult to qualify for benefit, you would expect claim experience under the new policies to be much better than under the pre-HIPPA policies.  Did the insurance companies reduce the premium?  No, and in fact, many companies increased premiums under the guise of new plan benefits.  In effect, HIPPA resulted in a substantial rate increase by most companies.

Benefit Triggers:

Although everyone likes tax breaks, the most important feature of a long-term care policy is the benefit triggers.  The tax issues are discussed below:

Other than the financial strength of the company, why would anyone buy a long-term care policy that pays benefits on a restricted basis?

As discussed above, the non-tax qualified long-term care plan typically has three benefit triggers.  However, the benefit triggers may differ by companies, and therefore you should carefully review the policy.  There are only five companies that will issue a non-tax qualified long-term care policy:  Bankers Life and Casualty, Mutual of Omaha Insurance Company, Penn Treaty Network America, Physicians Mutual Insurance Company and United of Omaha Life Insurance Company.

Some companies have different benefit triggers for Facility Care and Home Care.  Some companies have a triple benefit trigger for Facility care and a double benefit trigger for Home Health Care (a double trigger eliminates the medical necessity trigger).  The preferred non-qualified plan is a plan that offers the three benefit triggers for both Facility Care and Home and Community Based Care.

Tax-qualified plans are more restrictive:

The first restriction of a tax-qualified plan is that a health provider must certify that the condition resulting in the insured being unable to perform two out of the six activities of daily living will last at least ninety days.  This may not be particularly onerous but, nonetheless, this restriction does not exist in the non-qualified plan.

An often-overlooked restriction of the qualified plan is the requirement of SEVERE cognitive impairment versus "cognitive impairment" for the non-tax qualified plan.

The problem is that "severe" is not defined in the policy.  Therefore, it is completely discretionary for the insurance company to define when and how coverage will be instituted.  Definitions that are unclear or, not defined, may lead to questionable coverage.  The issue may become particularly taxing if Alzheimer's or other form of senile dementia affects a loved one.  At what point does the individual reach the severe stage?

Finally, and most importantly, under a tax qualified plan the insured must be sicker, (chronically ill) to qualify for benefits.  Under a non-tax qualified plan if the insured's physician using standard medical practices says the insured needs "covered care", the care may be paid for up to the daily benefit.  The medically necessary trigger applies even if the insured can perform all the activities of daily living and is not cognitively impaired.  The medical necessity trigger is essential to provide full and adequate coverage.

A reasonable expectation of people who buy a long-term care policy is that benefits are paid when they get sick.

However, a tax-qualified plan may not work this way.  An insured can be sick enough or be functionally disabled to require care, but not sick enough to satisfy the chronically ill benefit trigger of a tax qualified plan.

For example, as people age they naturally become frail, and although they may be able to do many of the activities of daily living as defined in a tax-qualified policy, they may need help with activities like grocery shopping, cooking, managing medication, etc.  Since the insured is not chronically ill, no benefits are paid under a tax-qualified plan.  Benefits may, however, be paid under a non-tax qualified policy that has a medical necessity benefit trigger for home and community based care.

Let's look at another situation.  Assume an insured, age 72, has a hip replacement.  Full recovery is expected within eight weeks.  Rarely will a doctor certify that this insured is chronically ill.  If, however, the insured's doctor certifies that the insured needs care, under the "medically necessary" trigger, benefits will be paid subject to satisfying the elimination period.  If the policy does not have the "medical necessary" benefit trigger no benefits will be paid.

Please note if Medicare provides coverage, even a non-tax qualified plan will not provide benefits because there is no duplication of coverage.

Tax Issues:

Many insurance companies and industry commentators have stated that the policy owner will have adverse tax results if the policy is not tax-qualified.  There are really three different tax issues:

1.     Is the benefit received under a long-term care plan excluded from gross income?

2.     Is the premium deductible?

3.     If an employer pays the premium, is that amount excluded from the employee's income?

Are long-term care benefits excluded from gross income?

Clearly, if the policy is a tax-qualified plan the benefits are tax-free.  Benefits received under a non-tax qualified plan should also be received tax-free.  Many companies and commentators have given different opinions.  Although every one is entitled to an opinion, they are wrong.  Mary Oppenheimer, the Assistant Chief Counsel in the IRS's Office of Employee Benefits and Exempt Organizations responded to a letter from George R. Nethercutt, a State of Washington congressional representative.  Congressman Nethercutt asked several questions about the federal income tax treatment of benefits received form "Non-tax Qualified Long Term Care Policies.

In the response to Nethercutt, Ms. Oppenheimer stated,

"If the insurance contract does not meet the requirements of section 7702B, it is necessary to examine additional Code sections to determine whether the … benefits may be excluded from income…  If an individual, rather than an employer, purchases an A&H policy, section 104(a)(3) excludes from gross income amounts received through the policy."  The response goes on to say that "unlike qualified LTC plans, polices that do not meet the requirement of section 7702B are not statutorily defined in the Code and must, therefore meet the requirements of…104(a)(3) in order for the… benefits to be excluded from income.  As a general rule, to meet the requirement …of 104(a)(3) benefits must be received though a plan that constitutes an A&H insurance arrangement and must be payable for personal injuries or sickness.  Determining whether a NTQ policy meets the requirements necessitates a detailed analysis of the specific provisions of each insurance policy." 

The policies of reputable companies offering a non-qualified plan should qualify as an A&H arrangement.

Although the letter does not directly say all NTQ policies meet the definitions of an A&H policy, the letter is very strong indication that a typical NTQ long-term care policy will qualify as an A&H policy under section 104(a)(3), and thus the benefits will be excluded from income.

Additionally, the companies that only issue tax qualified long term care plans say that payments under a NTQ long-term care plan are included in income because the IRS requires the insurance companies to report payments under long term care policies on Form 1099.

This analysis is specious and a scare technique by the companies.

Ms. Oppenheimer states,

 "Insurers are required to report all LTC benefits that are paid.  This reporting requirement is mandatory under section 6050Q(a) of the Code.  However, the fact that all LTC benefits must be reported does not necessarily mean that all LTC benefits are taxable…In addition, LTC benefits from NTQ policies that satisfy the definition of A&H insurance and are amounts received for personal injuries or sickness are also not taxable."

The letter to the Congressman further states, even though the insurance company files the Form 1099-LTC,

‘the instructions to the form indicate that the payer, the insurance company, is not required to determine whether any benefits are taxable..."

Rather, the policyholder determines whether to report the amounts that appear on their copy of the Form 1099.

The final question addressed in the letter to the Congressman was

"Does the IRS currently lack clarification from Congress in regard to congressional intent of the tax status of benefits on NTQ LTC insurance plans?"

 Ms. Oppenheimer's response was

"In enacting section 7702B, the Congress wanted to provide a safe harbor for qualified LTC insurance contracts so that taxpayers could be sure that the benefits from such contracts are non-taxable.  However, the Congress did not specify how NTQ LTC insurance contracts should be treated.  Nevertheless as previously discussed, existing Code provision can be used to analyze the taxability of these benefits and to the extent that a taxpayer has difficulty making a determination, a definitive answer is available from the IRS through a private letter ruling process."

The letter from Ms. Oppenheimer is a clear indication that the benefits from a NTQ LTC policy will be excludable from income under Section 104(a)(3).

Are the premiums for a non-tax qualified long term care plan deductible if:

1.     The employer pays the premium?

2.     The individual policy owner pays the premium?

If the employer pays a long-term care premium on a policy for an employee, the premium payment is deductible under IRC Section 162.

 The regulations to Section 162 provide:

"Amounts paid or accrued within the taxable year for … sickness, accident hospitalization, medical expense are deductible under Section 162(a) if they are an ordinary and necessary expense of the trade or business.' 

It would appear that the business could deduct the premium for both a tax-qualified, and a non-tax-qualified policy.

With respect to self-employed individuals, and more than two-percent owners of pass through entities, no portion of a NTQ long-term care premium is deductible.  All of the relevant code sections, IRC 162(l) and 213(d) specifically refer to a long-term care policy as defined in section 7702B.  Thus, if the policy is a NTQ policy no deduction is allowed.

Even if the deduction is disallowed for the people referred to in the above paragraph, what is the economic loss?  With respect to self-employed and more than 2% owners of pass through entities, the amount of the deduction is the eligible premium.

With respect to an individual that itemizes deductions, the medical expense deduction is limited to total medical expenses that exceed 7.5% of adjusted gross income.  In determining medical expenses, a portion of the long-term care premium is an eligible medical expense.  When allowable medical expenses including a portion of the long-term care premium exceed 7.5% of adjusted gross income, the excess over 7.5% is deductible.

How many people do you know have medical expenses that exceed 7.5% of adjusted gross income?  Since the deductibility issue for most individuals is a non-issue, the decision on whether to purchase a tax-qualified or non-tax-qualified policy should be based on other criteria.

If the employer pays the premium, is the amount of the premium included in the taxpayer's income?

Code Section 106 is the applicable section of the code dealing with this issue.  It provides that gross income does not include amounts paid by his employer to an accident and health plan.  Section 7702B treats tax-qualified long-term care insurance as medical insurance.  Thus, if the policy is tax-qualified, it is clear that the premium payments by an employer are excluded from gross income.

The answer is unclear for a non-tax qualified plan.  The conservative approach is that the premium is included in income, because there is no specific section of the Code that provides for non-recognition of income.

However, it could be argued that an employer sponsored long-term care plan is an "accident and health policy" under IRC Section 106.

Even if the premium is taxable to the employee, it is better than purchasing the policy personally.  Let us assume that the premium is $1,000 and the employee is in a 28% tax bracket.  The cost to the employee is $280.  This is a lot better than paying the $1,000 if he purchased the policy personally.  If the employee includes the premium in income, he is deemed to have paid for the policy personally so that the benefits are income tax free under Section 104.

Conclusion:

As a professional, you have an obligation to explain the difference between a tax-qualified plan and non-tax qualified plan.  Let the client decide which plan he or she wants.

If you agree that the benefits received under a non-tax qualified plan will be excluded from gross income, then you should recommend that your client purchase a non-tax-qualified plan.  Even if the entire premium is tax deductible, which is not the current law, the additional benefit triggers under the non-tax qualified policy may more than offset the deductibility of the premium.

Remember, the value of the deduction is based on your income tax bracket.  If you are in a 30% tax bracket and the premium is $3,000, the deduction saves you $900.  Should your client purchase a product with inferior benefit triggers to obtain the small tax savings?

HOPE THIS HELPS YOU HELP OTHERS MAKE A POSITIVE DIFFERENCE!

Stanley Strouch