long-term care income taxation: stand-alone vs hybrid...

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Situation: In recognition that the government cannot cover the costs for long-term care services through entitlement programs such as Medicare and Medicaid, Congress passed the Health Insurance Portability and Accountability Act (the “Act”)1 in 1996. The Act included tax incentives to encourage people to take responsibility for their own long-term care needs. At the time of the Act’s passage, stand-alone long-term care products dominated the market. Since the passage of the Act, carriers have introduced a variety of products that combine long-term care coverage as part of a life insurance or annuity contract … referred to as hybrid products. More recently, hybrid life insurance products with long-term care or chronic illness riders have proven to be the most popular products in the marketplace. However, the increased variety of long-term care policy designs has contributed to a degree of confusion concerning their income tax treatment. This Counselor’s Corner addresses some of the tax implications associated with long-term care policies.

Solution: The starting point for determining the tax treatment of long-term care products begins with an understanding of the provisions contained in IRC § 7702B. Section 7702B is the Internal Revenue Code section enacted as part of the 1996 legislation that spell out the requirements that a long-term care insurance policy must meet to receive favorable tax treatment. Section 7702B provides favorable tax treatment only to “qualified long-term care contracts,” or so-called “tax-qualified” policies. So before digging into the nitty-gritty tax details, we must first distinguish between tax-qualified and non-tax qualified policies.

What Is A Tax-Qualified Long-Term Care Policy? Following are the pertinent conditions that must be met for a contract to be considered tax-qualified (it should be noted that for purpose of meeting the below requirements, a long-term care rider on a life insurance or annuity contract is treated as a separate contract):

▪ The contract must be guaranteed renewable and only provide coverage for qualified long-term care services.

▪ Individuals receiving services must be certified by a licensed health care practitioner as unable to perform two out of six activities of daily living (ADLs2) that are expected to last for a minimum of 90 days or suffer from a severe cognitive impairment requiring substantial supervision.

▪ Services must be provided pursuant to a plan of care prescribed by a licensed health care practitioner. ▪ The contract must not pay or reimburse expenses reimbursable under title XVIII of the Social Security Act

or would be so reimbursable but for application of deductible or coinsurance amounts.

1 Long-term care is not confined to the elderly. According to a 2010 NPR report adults under the age of 65 have been one of the fastest growing long-term care population over the past 10 years, accounting for 14% of the nursing home residents. “A New Nursing Home Population: The Young.” www.npr.org/2010/12/09. 2 Activities of daily living are defined as eating, toileting, transferring, bathing, dressing, and continence.

Counselor’s Corner

Long-Term Care Income Taxation: Stand-Alone vs Hybrid, Individual vs Business

▪ Benefit payments can be made on a per diem or other periodic basis without regard to the expenses incurred. Consequently, reimbursement and indemnity forms of long-term care insurance can meet the tax-qualified contract requirements.

▪ The contract cannot provide cash surrender value or other money that can be paid, assigned, pledged, or borrowed, other than as a refund of no more that the aggregate premiums paid on the death of the insured or on a complete surrender or cancellation of the contract.

▪ The contract must satisfy specified consumer protection provisions.

In general, tax-qualified long-term care policies are restrictive in terms of when benefits kick in. They cannot be used for short-term stays, as the individual must need care for at least 90 days in order to receive benefits. In addition, the individual must be unable to perform at least two of the ADLs or suffer from a severe cognitive impairment. In contrast, non-tax qualified long-term care policies are less restrictive. For example, some policies include a “medical necessity” trigger, which means benefits can begin if the doctor states that they are necessary, without the need to meet 90 days or the need for assistance with a specific number of ADLs. While non-tax qualified policies may appear to be more attractive, the vast majority of policies purchased are tax-qualified. Consequently, most of the discussion in this Counselor’s Corner will focus on the nitty-gritty tax ramifications of tax-qualified policies. Tax Treatment of Individual Purchases of Stand-Alone Long-Term Care Policies. Treatment of Premium Payment. Section 7702B provides that premiums on a stand-alone tax-qualified policy paid by an individual are considered medical expenses. However, the amount of long-term care premium treated as a medical expense is limited to the eligible premium as defined by IRC § 213(d). The maximum deductible amount for each individual is based on the attained age of the individual at the close of the tax year. The deductible maximums are indexed, increasing each year for inflation. The portion of the premium that exceeds the eligible premium is not included as a medical expense.

2017 Deductible Limit Based On Taxpayer’s Age At End of Tax Year (indexed for inflation)

40 or less $410

41 but not more than 50 $770

51 but not more than 60 $1,530

61 but not more than 70 $4,090

71 or over $5,110

Individual taxpayers can treat eligible premiums paid for themselves, their spouse and any tax dependent as a medical expense. The total eligible long-term care premium is then added to other qualified medical expenses and the portion of that total which exceeds 10% of the taxpayer’s adjusted gross income is deductible as an itemized deduction. In addition, HSA distributions up to the age based limits are income tax-free. In contrast, premiums on a stand-alone non-tax qualified policy are not deductible. Treatment of Benefit Payments. The tax treatment of amounts received for long-term care paid from a stand-alone tax-qualified policy are basically the same whether the policy is a reimbursement or indemnity policy. Specifically, benefits received as reimbursement from a stand-alone tax-qualified policy purchased by an individual are not taxable and therefore excluded from gross income. Likewise, benefits paid under an indemnity or cash style tax-qualified policy are not taxed unless they exceed the greater of the cost of the qualified long-term care received or the daily per diem limit (the 2016 limit is $340 per day). Finally, stand-alone non-tax qualified long-term care benefits are not currently taxed as income. However, it remains possible that benefits from a non-tax qualified policy could become taxable in the future. Tax Treatment of Business Purchases of Stand-Alone Long-Term Care Policies. Section 7702B also set forth the tax treatment of employer paid long-term care insurance. The tax consequences of a business using its cash flow to fund the purchase of a personally owned stand-alone tax-qualified long-term care policy depends on the type of business entity and whether the person covered is an owner of the business.

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The following chart describes the tax consequences of a stand-alone tax-qualified policy where various business entities fund the purchase of a personally owned policy.

Business Tax Treatment of Stand-Alone Tax- Qualified Long-Term Care Insurance

Business Entity Insured Business Tax Personal Tax

Sole Proprietor Owner Cash flow of business used to purchase owner’s personally

owned policy is included in the owner’s gross income.

Premium -100% of the eligible age based premium is deductible.3

Benefits - Income tax free to the same extent as a personal

purchase.

Partnership/ LLC

Owner

Cash flow of business used to purchase an owner’s personally owned policy is included in the

owner’s gross income.



purchase.

Employee non-owner

100% of premium is deductible. Business can selectively choose

who to cover and how much they pay.

Premium – None of the premium is considered taxable income.


purchase.

S Corporation More than 2% Owner4

Cash flow of business used to purchase an owner’s personally owned policy is included in the

owner’s gross income.



purchase.

Employee non-owner & < 2%

owner4

100% of premium is deductible. Business can selectively choose




purchase.

C Corporation/ Personal Service Corporation

Owner or Employee

100% of premium is deductible. 5 Business can selectively choose




purchase.

3 Section 162(l) provides special rules for deductibility of health insurance premiums for self-employed individuals. Partners in a partnership, owners of an LLC taxed as a partnership and shareholders of an S corporation who owner more than 2% of the corporation are treated as self-employed individuals for this purpose. Unlike the personal purchase of a long-term care policy, the self-employed taxpayer (or partner or over 2% S shareholder) does not need to meet the 10% itemized deduction threshold in order to take the eligible age base premium deduction. However to avoid the itemized limitations the premiums for the partner or more than 2% S shareholder must be paid by the business (If paid by the individual they will be limited as an itemized deduction). Furthermore, this section permits a self-employed individual to deduct the eligible age based premiums paid for spouses, tax dependents, and children under the age of 27. However, a self-employed individual may not deduct premiums in any calendar month in which s/he his/her spouse is eligible to participate in a long-term care plan that the employer pays all or part of the premium. Of course, if the self-employed’s spouse happens to be an employee of the sole proprietorship, then 100% of the premium is deductible by the business and not taxable to the employee/spouse; the same as employees in other business entity. 4 The family attribution rules of IRC § 318 apply when determining whether a person is more than a 2% owner. 5 Premiums paid for spouses are also 100% deductible. Note: there is no age based limit to the business deduction.

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Tax Treatment of Individual Purchases of Hybrid Life and Long-Term Care Policies. Like stand-alone products, long-term care riders on life insurance products may be classified as tax-qualified or non-tax qualified. A tax-qualified rider is intended to meet the requirements of a qualified long-term care contract for purposes of IRC § 7702B, thus providing income tax advantages similar, but not the same as stand-alone policies. Treatment of Premium Payment. Although eligible long-term care premiums for a stand-alone tax-qualified policy may be deductible by an individual to the extent the amount exceeds 10% of the taxpayers adjusted gross income, IRC § 7702B(e) prohibits a deduction for the long-term care portion of the premium payments on hybrid policies (tax-qualified and non-tax qualified) when the charge for the rider are made against the cash value of the life insurance policy. Most hybrid life insurance policies today treat the charge for the long-term care benefit as a charge against the cash value, thus preventing a deduction for premium payment. Since most hybrid long-term care policies treat the charge for the long-term care benefit as a charge against the cash value of the policy the question becomes whether this cost is considered a taxable distribution. The answer differs depending on whether the rider is tax-qualified or non-tax qualified. With a tax-qualified rider, the charges are not considered taxable distributions, even if the policy is a MEC (modified endowment contract). However, the cost for the rider reduces policy owner’s basis/investment in the contract (but not below zero). Even though the rider charge is not taxable, tax reporting is still required. In contrast, with a non-tax qualified rider the charges are considered distributions each year. Therefore, taxation depends on whether the policy is a MEC, whether there is remaining tax basis in the policy and whether there is gain in the policy. Where the policy is not a MEC the monthly charges reduce the cost basis of the policy. When basis is zero, the monthly charges are reported as taxable income. Where the policy is a MEC and there is no gain in the policy at the time the charge is taken, the cost basis of the policy is reduced. If there is gain in the policy at the time the charge is taken, the monthly charge is reported to the extent of the gain in the policy. Treatment of Benefit Payments. The tax treatment of amounts paid for long-term care expenses from a rider qualifying under IRC § 7702B are basically the same whether the policy is a reimbursement or indemnity policy. Specifically, benefits received as reimbursement from policy purchased by the insured individual are not taxable and therefore excluded from gross income.6 Likewise, benefits paid under an indemnity or cash style tax-qualified policy are not taxed unless they exceed the greater of the cost of the qualified long-term care received or the daily per diem limit (the 2017 limit is $360 per day). Tax Treatment of Hybrid Life and Long-Term Care Policies Owned by Third-Party (Trust or Business). The implications of third-party ownership of a policy with a long-term care rider are not entirely clear. Section 7702B does not address the situation. Thus, there is a tax risk that such ownership could result in taxable benefits (this is the case whether the benefit is a reimbursement or indemnity style rider). In fact, in business ownership situations IRC § 101(g)(5), which addresses taxation of payments received for chronic illness, provides that amounts received by a business are taxable for income tax purposes. Where the policy is owned by a trust transfer tax risks (estate, gift and generation skipping) exist, in addition to the risks that the benefit may be subject to income tax.

Treatment of Benefit Payments for Insureds with Multiple Policies. If there is more than one policy on the insured (regardless of ownership), long-term care benefit payments must be aggregated according to IRC § 7702B(d)(3)to determine taxability. Under the aggregation rule, the benefits received from all sources on an insured are aggregated. To the extent the amounts exceed the tax law limits (per diem or

6 Amounts received from a qualified long-term care policy are treated as amounts received for personal injuries and sickness and are treated as reimbursements for expenses actually incurred for medical care. IRC §104(a)(3)

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This material has been prepared to assist our licensed financial professionals and clients’ advisors. It is designed to provide general information in regard to the subject matter covered. It should be used with the understanding that we are not rendering legal, accounting or tax advice. Such services must be provided by the client’s own advisors. Accordingly, any information in this document cannot be used by any taxpayer for purposes of avoiding penalties under the Internal Revenue Code. Insurance policies contain exclusions, limitations, reductions of benefits and terms for keeping them in force. Policies and or features may not be available in all states.

Securities and Insurance Products: Not Insured by FDIC or Any Federal Government Agency. May Lose Value.

Not a Deposit of or Guaranteed by Any Bank or Bank Affiliate.

©2017 Diversified Brokerage Services, Inc. 5501 Excelsior Blvd., Minneapolis, MN 55416-5153 www.DBS-LifeMark.com

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actual expenses) the excess benefit amount is taxable as ordinary income to the recipient. For purposes of the aggregation rules, the limits are first allocated to the amounts received by the insured and any remaining limitation is allocated among the other policy owners. Benefit Payments from Hybrid Products Covering Chronic Illness or Critical Illness. Many hybrid products allow for the acceleration of death benefit to pay expenses incurred by a chronically ill or critically ill insured. The tax treatment of chronic illness riders that accelerate death benefit to pay expenses are governed by IRC § 101(g). This section provides that where the policy is owned by the insured the benefits shall generally be income tax-free to the same extent as long-term care benefits. However, where an employer owns the policy the benefit is taxable as income to the employer. Finally, critical illness riders that allow the owner to accelerate a portion of the death benefit if the insured is diagnosed with one of several critical illnesses specified in the contract is not mentioned in either IRC § 101(g) or § 7702B. However, several private letter rulings indicate that the benefits may be received tax-free as accident and health benefit under IRC §104(a)(3).7 Summary. With the increase in popularity of life insurance products providing living benefits for long-term care it is important to be aware of the variation in tax consequences.

7 PLR 200339015, PLR 200339016, PLR 200627014, and PLR 200903001.

long-term care income taxation: stand-alone vs hybrid...

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