Long-term care insurance and tax planning: make the most of tax rules for premiums and benefits.

EXECUTIVE SUMMARY

* Long-term care (LTC) insurance benefits are tax-free to the insured for either reimbursement of qualified expenses or payments up to a per-diem limit indexed for inflation--$270 in 2008.

* Premiums for LTC insurance are tax-deductible according to limits that are also indexed to inflation and increase with the age of the insured. For an individual purchaser, however, premiums, along with other qualified medical expenses, are further subject to the floor of 7.5% of adjusted gross income as an itemized deduction.

* More favorable treatment is available to self-employed persons, who may be able to deduct as a trade or business expense premiums (up to the annual limit) of an LTC plan sponsored by their business for themselves or spouse or dependents.

* A company that pays premiums for nonowner employees is generally allowed still more favorable treatment: deduction without regard to the annual limits. LTC insurance is generally not allowable as part of a "cafeteria plan"; however, premiums up to the eligible amount or LTC expenses may be funded through a health savings account, medical savings account or health reimbursement arrangement.

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The number of baby boomers in or near retirement is rising, and so too is the demand for long-term care (LTC) insurance. Depending on the age of the insured, such coverage can be expensive, but fortunately for them, Congress and some states have provided income tax incentives for the purchase of certain LTC insurance policies--called "qualified" LTC contracts--in IRC [section] 7702B. CPAs who have a command of these rules will be well-placed to provide valuable advice to clients. To that end, this article provides an overview of the income tax treatment for both premiums paid into and benefits received from qualified LTC insurance contracts for individuals (nongroup policies). As you'll see, benefits and premiums can be excluded or deducted from income--within limits--but the crucial question of who pays can make the difference ultimately whether that's true of any, some or all of the cost.

TAXATION OF BENEFITS

The federal income taxation of benefits received under an LTC policy depends on the type of contract. Under a "per-diem," also known as indemnity-based, policy, the insurance company generally pays the same benefit regardless of the insured's actual LTC expenses. These amounts are received income-tax-free up to the greater of (1) costs incurred for LTC services or (2) a daily limit indexed for inflation--$270 per day in 2008. Any excess amount is taxed. (The taxable amount is further reduced by reimbursements received for LTC services, but with a per-diem policy, that reduction often will be zero). See IRC [section] 7702B(d) and Rev. Proc. 2007-66. Under a "reimbursement" policy, the insurer does not pay a set amount. Instead, it pays for LTC expenses incurred, up to the maximum benefit under the contract. All amounts received under a reimbursement policy are income-tax-free. See IRC [section][section] 7702B(a)(2) and 104(a)(3).

TAXATION OF PREMIUMS

The federal income tax treatment of premiums paid into a qualified LTC policy differs not by the type of contract, but by the type of taxpayer (or in some respects, the relationship between the premium payer and insured/policy owner). There are three categories: individual (good), self-employed (better) and employer-employee (best).

Individual (Good). When individuals personally buy LTC insurance (no business is involved in the purchase) that covers themselves, a spouse or a dependent, they can deduct a portion of the premium. See IRC [section][section] 7702B(a)(4), 213(a) and 213(d)(1). Dependents generally include the taxpayer's children and certain relatives (including parents, siblings, aunts and uncles) for whom the taxpayer provides over half the support. See IRC [section] 152. To determine the deductible amount, the individual must consider two limitations: the "eligible long-term care premium" amount and 7.5% of adjusted gross income (AGI).

The eligible LTC premium amount is the maximum portion of the LTC insurance premium that an individual can take into account when calculating the deduction. See IRC [section] 213(d)(1) and Rev. Proc. 2007-66. The eligible amount is dictated by the insured's age (not the taxpayer's) at the close of the taxable year and is indexed for inflation. In 2008, the amounts are:

* Age 40 or less: $310

* 41 through 50:$580

* 51 through 60:$1,150

* 61 through 70:$3,080

* 71 or more: $3,850

Exhibit 1 Deduction for Individuals

In 2008, a client purchases LTC insurance for himself and his spouse,
both age 55, for a total premium of $3,000 a year ($1,500 for each
policy). Given their ages, their eligible LTC premium amounts are
$1,150 + $1,150 = $2,300. The client also has $2,600 of unreimbursed
medical expenses. AGI is $100,000. The deduction calculation is:

unreimbursed medical expenses + eligible LTC premiums - 7.5% of AGI,
or $2,500 + $2,300 - $7,500 = no deductible amount.

The appropriate eligible LTC premium amount is added to other unreimbursed medical expenses, and this total is deductible only to the extent that it exceeds 7.5% of AGI. See IRC [section] 213(a). At first blush, it seems few taxpayers will have enough unreimbursed medical expenses to claim this deduction (see Exhibit 1). But some individuals--retirees, for example--might not have much income in a given year, so 7.5% of their AGI may not be a large number. And other individuals might be paying LTC premiums not just for themselves but also for a spouse and senior generation dependents, any of whom might also have high unreimbursed medical expenses. So the aggregate LTC premiums and expenses might be high enough to exceed 7.5% of their AGI and result in a deduction.

Self-Employed (Better). Self-employed taxpayers generally can deduct as a trade or business expense the LTC premiums paid for themselves, their spouses or dependents pursuant to an employer-sponsored plan. See IRC [section] 162(1). Unlike the deduction for individuals, the deduction for self-employed taxpayers is not subject to the 7.5% of AGI limitation but is generally limited only by the eligible LTC premium amount. Well, there are other minor limits: The deduction is available only to the extent that the taxpayer has earned income from the business providing the coverage (W-2 wages or guaranteed payments), and is not available if the taxpayer is eligible for LTC coverage under a subsidized health plan maintained by his spouse's employer or by his employer, if he works for one in addition to running his own business. The mechanics of these rules mimic those for accident and health insurance for self-employed taxpayers, a feature that, among other things, suggests that it's wise to put the plan in writing. See Notice 2008-1 and Revenue Ruling 91-26; also IRC [section][section] 162(1)(2), 401(c), 707(c), 1372(a), 1402(a), and 7702B(a)(3).

So who is a self-employed taxpayer? Sole proprietors, partners of partnerships, members of limited liability companies taxed as partnerships, and S corporation shareholders who own more than 2% of the corporation are all self-employed taxpayers--but only if they provide personal services to the business. Also, due to ownership attribution rules under IRC [section][section] 1372(b) and 318(a), certain family members of S corporation owners also might be treated as self-employed owners, even if they are merely employees. This is generally undesirable, as treatment for self-employed taxpayers is less favorable than that for employees, as shown in exhibits 2 and 3.

Employer-Employee (Best). The best federal income tax treatment occurs when employers provide LTC coverage to employees (or their spouses and dependents) under an employer-sponsored plan. An employer can deduct LTC premiums it pays on an employee's behalf as long as they are ordinary, necessary and reasonable business expenses; they are not limited to the eligible LTC premium amount (for premiums paid by the employee under an employer-sponsored plan, see discussion of cafeteria plans below). Moreover, the premiums are not included in the employee's income, and the employee can receive the ultimate LTC benefits entirely tax-free. See IRC [section][section] 106(a), 162(a) and 7702B(a)(3), also Treas. Reg. [section] 1.106-1. Clearly, this is an extremely attractive employee benefit (see Exhibit 3).

Unlike self-employed owners of S corporations or partnerships, owners of C corporations are allowed to be treated as employees for this purpose and, therefore, potentially can enjoy the same generous tax treatment. But the fact that C corporation owners can also be employees does not mean they are assured employee treatment with respect to the LTC premiums paid by the business; the corporation's payments must be made pursuant to a plan to benefit the individual because of employment status rather than ownership status. There is no clear-cut formula to follow to prove LTC coverage is based on employment status, so it's often best to describe plan eligibility in a manner that could cover a nonowner employee in addition to shareholders. In fact, it's safer still to cover at least one nonowner employee. See Leidy v. Commissioner, TC Memo 1975-340, affd, 39 AFTR2d 77-877 (4th Cir. 1976); Larkin v. Commissioner, 48 TC 629 (1967), aff'd, 21 AFTR2d 1307 (1st Cir. 1968).

Exhibit 2 Deduction for Self-Employed
Taxpayers

A client is self-employed, and neither the client's employer nor her
spouse's employer provides LTC coverage under a subsidized plan. The
client buys LTC policies for herself and her spouse, both age 55, for
a total premium of $3,000 ($1,500 for each policy).

The client's earned income from the business providing the coverage is
$45,000, and the 2008 eligible LTC premiums (based on each spouse's
age) is the same as in the previous example: $1,150 + $1,150 = $2,300.
The full $2,300 is deductible.

Another caveat arises with "limited-pay" contracts, which provide coverage for the rest of the insured's life after the payment of only, say, 10 annual premiums. IRC [section][section] 419 and 419A impose rather strict limits on the amount an employer can deduct when prefunding welfare benefits (which include LTC). Although it's not entirely clear that these Code sections apply to limited-pay LTC contracts, there's a good chance they do (certain nonguaranteed contracts aren't covered by sections 419 and 419A, but all qualified LTC contracts are guaranteed renewable), so any employer should be prepared to either live within the limits or explain to the IRS why these Code sections don't apply.

Presuming these limits are relevant, an employer can deduct the cost for the current year's coverage, and this would allow LTC premiums to be deducted under a typical pay-as-you-go contract. But with an insured plan, additional deductions for funding welfare benefits for future years is limited to those amounts needed to create a reserve for post-retirement benefits, and only to the extent this reserve is funded on a level basis over the employee's remaining working years. So if an employee has 20 more years to work before retirement, the employer' premium payments under a 10-year limited-pay LTC contract could easily be too large to be fully deductible (although, in this situation, payments under a 20-year limited-pay contract might very well be deductible). Furthermore, claiming a deduction under this post-retirement reserve category introduces nondiscrimination rules and can reduce the contribution limits to qualified retirement plans, so using limited-pay contracts can quickly become complicated.

Problems also can arise with "return of premium" contracts that offer a refund of unused premiums if the policy is canceled. Not only might the refund be taxed--see IRC [section] 7702B(b)(2)(C)--it might also constitute deferred compensation under IRC [section] 409A, which, if violated, carries a 20% penalty.

CAFETERIA PLANS, ALPHABET SOUP, ERISA AND STATE LAW

As if all that weren't enough, there are even more rules CPAs should know when advising clients on LTC insurance, First, LTC insurance cannot be offered as part of a cafeteria plan. See IRC [section] 125(f). As for the "alphabet soup" of medical savings and reimbursement accounts, they basically break down this way: HSAS (health savings accounts), MSAs (medical savings accounts) and HRAs (health reimbursement arrangements) can be used to pay both LTC expenses and LTC insurance premiums (up to the eligible premium amount). FSAs (flexible spending arrangements), however, can be used to pay only for LTC services, not LTC insurance premiums. Also, ERISA rules governing welfare plans generally require that plans be written and that they contain "fiduciary" and "claims procedure" provisions, and potentially "reporting and disclosure" provisions.

Exhibit 3 Deduction for Employer-Paid
Premiums

In 2008, an employer pays premiums for LTC policies (not limited-pay
contracts) covering an employee and his spouse, both age 55, for a
total premium of $3,000 ($1,500 for each policy). Given the age of the
client and the spouse, their eligible LTC premium amounts are $1,150 +
$1,150, or a total of $2,300. Because of the employment status,
however, their ages are irrelevant and the eligible LTC premium amount
is not a limit on deductibility. The employer's deduction is the total
$3,000 premium paid, none of which is included in the employee's
income.

In addition, many states provide their own tax breaks--deductions or credits--so to give their clients the complete picture, CPAs should also become familiar with the specific state laws wherever they practice. Many LTC insurance carriers can provide state-by-state descriptions.

A KEY TO SECURITY

Whether your clients are individuals, self-employed taxpayers or employees, they increasingly will be using LTC insurance as a key risk management tool in their retirement portfolios. Therefore, providing and implementing effective tax planning and management with respect to LTC will have an important impact on your clients' long-term financial security.

AICPA RESOURCES

Articles

* "What Is Long-Term Care and Who Is Responsible for Its Cost?" The Tax Adviser, April 08, page 240

* "LTC Insurance for Owners and Executives' JofA, March 05, page 53

* "A Financially Secure Future," JofA, Dec. 02, page 53

* "Long-Term Care Insurance," JofA, May 02, page 112

Publications

* The CPA's Guide to Long-Term Care Planning (#017259)

* Adviser's Guide to Counseling Aging Clients and Their Families (#091024)

* CPA ElderCare-PrimePlus: A Practitioner's Resource Guide, Third Edition (#022511)

CPE 

Tax, Healthcare and Asset Protection for Aging Clients, a CPE self-study course (#732179)

Conference

AICPA National Conference on Employee Benefits Plans, May 18-20, 2009, Orlando, Fla.

For more information or to place an order or to register, go to www.cpa2biz.com or call the Institute at 888-777-7077.

OTHER RESOURCES

Web sites

* National Clearinghouse for Long-Term Care Information, U.S. Department of Health and Human Services, www.longtermcare.gov/LTC/Main_Site/index.aspx

* National Association of Insurance Commissioners, www.naic.org

Daniel R. Finn, Esq., CLU, is a director in the Advanced Financial Security Planning Division of The Northwestern Mutual Life Insurance Co. His e-mail address is [e-mail].