Kitces: When and how to deduct long-term care insurance
With the 1996 introduction of tax-qualified long-term care insurance under the Health Insurance Portability and Accountability Act and IRC Section 7702B, Congress affirmed that long-term care insurance benefits should be tax-free. Tax benefits for purchased long-term care insurance coverage followed.
However, the evolving landscape of both individual tax deductions and long-term care insurance tax preferences have created myriad options for filers, all of them confusing. What follows is a run-through of the choices, benefits — and indeed, drawbacks — of each.
DEDUCTING INDIVIDUAL PREMIUMS
Under IRC Section 213(d)(1)(D), premiums for long-term care insurance, or LTCI, are deductible along with other individual medical expenses.
To be eligible for deductibility, the LTCI must be tax-qualified coverage as defined under IRC Section 7702B(b), though in practice virtually all LTCI issued today — and really over the past 20 years — is tax-qualified. Non-tax-qualified LTCI is primarily characterized by either not requiring a minimum activities of daily living restriction, or being more lax in the certification requirements to be eligible for claims.
Premiums paid for tax-qualified LTCI are deductible if paid for the individual taxpayer themselves, spouses or any dependent as defined under IRC Section 152. This can include both dependent children and even dependent parents if they otherwise qualify as dependents for tax purposes, and without regard to the must-be-unmarried or income tests that otherwise apply to a qualifying relative dependent.
While premiums are deductible, the amount of the deduction is limited, though.
First and foremost, the standard rule for medical expenses still applies — that is, in order to claim a deduction for both LTCI premiums and all other medical expenses added together, the taxpayer must itemize deductions on Schedule A, and only the portion in excess of 10% of Adjusted Gross Income (AGI) is actually deductible. The ceiling is owed to the expiration of the 7.5%-of-AGI threshold at the end of 2016 under the Affordable Care Act.
Second, in addition to the limitation on total medical expense deductions including LTCI premiums, there is a further limitation on the amount that can be counted as a medical expense.
Under IRC Section 213(d)(10), premiums can only be deducted up to a specific maximum annual dollar amount, which itself is annually indexed for inflation. The LTCI premium deductibility limits for 2017 are shown below, with age thresholds evaluated based on the taxpayer’s age at the end of the tax year:
Example 1. This year, Allen and Jennifer turned ages 62 and 59, respectively. Each recently bought a tax-qualified LTCI policy. Allen’s costs $3,200 per year, and Jennifer’s costs $2,800. As a result, in 2017 Allen will be permitted to deduct $3,200, i.e., the cost of his policy, given it is below the $4,090 threshold, though Jennifer will only be permitted to deduct $1,530 of her premium, which is capped at the up-to-age-59 threshold. This means that in total, the couple can claim $3,200 + $1,530 = $4,730 of LTCI premiums as deductible medical expenses. To the extent that $4,730, when added to other medical expenses, exceeds 10% of the couple’s AGI, the excess above the threshold will be deductible.
Next year when Jennifer turns 60, her deductibility limit will rise to $4,090, which is more than enough for her to deduct her entire premium. Thus, in the future, the couple’s LTCI premium deduction will rise to the full $3,200 + $2,800 = $6,000, which again must be added to other medical expenses to determine how much above the 10%-of-AGI threshold is actually deductible.
Notably, because the couple’s LTCI premiums themselves are less than the $4,090 limit once they’ve reached their 60s, their deductions are still capped at the actual amount of LTCI premiums being paid each year.
As the above example illustrates, even if LTCI premiums have limited deductibility early on, the tax deductions may become more feasible later as the policy owner crossed the deductibility age bands.
In addition, because LTCI premiums are only deductible to the extent that they exceed 10% of AGI, premiums may be partially or fully deductible in some years but not others, simply due to unrelated changes in income that impact the AGI threshold. Conversely, significant shifts in other deductions can also indirect impact LTCI premium deductions, as none of them are deductible until/unless the taxpayer can itemize rather than claiming the standard deduction.
This also means that potential tax reform proposals, which may substantially increase the standard deduction, could also reduce the deductibility of LTCI premiums by making the standard deduction so high that few have enough LTCI premium, medical and other qualifying itemized deductions to reach the threshold.
In addition, some states also provide individuals with a tax deduction or small credit for purchasing an LTCI policy. In some cases, the deduction or credit is only for the first-year premium/purchase; in other scenarios, it is permitted on an ongoing basis as long as premiums continue to be paid. Furthermore, some states have no limits on the amount of LTCI premiums eligible for the deduction or credit, while others conform to the age-based premium limitations. Individuals should check on the rules applicable in their particular state.
PAYING THROUGH BUSINESSES
The rules and limitations on the deductibility of LTCI are substantially different when premiums are paid through a business.
Under the general rules of IRC Section 162, compensation to employees is deductible to the business, which may include LTCI, and the related IRC Section 106 stipulates that payments for “accident and health plans” — which includes tax-qualified LTCI — are not included in the employee’s income either. And under IRC Section 105(b), payments to reimburse medical expenses of an employee are not taxable benefits to the employee, and IRC Section 7702B(a)(2) stipulates that LTCI premiums will be treated as reimbursement for medical expenses. This means that claims from employer-paid LTCI are not treated as taxable benefits.
The end result? Akin to other employee benefits, a business’s payment of LTCI premiums on behalf of employees is a pre-tax expense for the business, without causing income to the employee that receives the coverage or claims benefits against it[Office1] . That said, if the employee also pays some of the premium themselves, it is treated as after-tax, and the out-of-pocket portion will only be deductible or not under the usual individual limitations.
To prevent abuses by owners who may also be employees in their own businesses, tax law also imposes several limitations on the deductibility of LTCI premiums.
In the case of a sole proprietor, IRC Section 162(l) provides that LTCI can be deducted as a self-employed health insurance expense, but the dollar amount of the deduction will be limited to the age-based premium limitations of IRC Section 213(d)(10), as shown in the earlier chart.
However, because the self-employed health insurance deduction is claimed as an above-the-line deduction on line 29 of Form 1040 and not as an itemized deduction, sole proprietors paying for their LTCI are not subject to the 10%-of-AGI limitation.
In the event that the sole proprietor purchases LTCI coverage for both themselves and a spouse, the age-based premium limits apply to both. But if the spouse is a bona fide employee of the business and the policy is purchased and paid for as employee compensation, the full amount of the premium can be deducted as a business expense — and only the owner’s LTCI premiums would face the age-based limitation).
Additionally, LTCI coverage provided to a bona fide employee-spouse, and that also covers the sole proprietor employer, may be fully deductible as employee-family coverage for both — i.e., where the business buys the employee-spouse individual coverage that has a shared-care family rider attached.
Regarding business partnerships or an LLC taxed as such, LTCI premiums paid on behalf of partners may be deductible to the business as guaranteed payments under IRC Section 707(c), but since partners are not treated as employees, the cost of the coverage must then be added back to the partner’s income — which means the net result may shift income among the partners, but doesn’t directly produce any tax savings.
Subsequently, the partners are still treated as self-employed, which means they can personally deduct the LTCI premiums as “self-employed health insurance” coverage on line 29 of Form 1040. As with sole proprietors, the deduction will be limited to the age-based premium restrictions, but as an above-the-line tax deduction, will not face the 10%-of-AGI or itemized deduction threshold requirements.
Example 2. Ashley and Sally are 50/50 members of an LLC that last year produced $200,000 of income, and the two want to purchase LTCI and route it through their business. Ashley is 57 and her LTC premium is $2,700; Sally is 62 and her LTC premium will be $3,700.
Absent the LTCI, their respective income shares as 50/50 partners would be $100,000. However, with the LTCI premiums being deductible as guaranteed, business income is reduced by $2,700 + $3,700 = $6,400 to only $193,600. With their 50/50 shares, this reduces income to $96,800. Then, Ashley and Sally must each include the premiums paid on their behalf in their respective incomes, which brings Ashley’s total income up to $99,500 and Sally’s up to $100,500. Notably, total business income is still $200,000, but Sally’s taxable share is now slightly higher due to the higher LTCI premium.
As a final step, Ashley and Sally may each deduct their LTCI premiums from their tax returns as a self-employed health insurance deduction. Due to her age, Ashley is limited to a deduction of just $1,530 of her $2,700 premium, while Sally is able to claim the entire $3,700 premium, since her age-based cap is as high as $4,090.
To get the favorable treatment for a partnership or LLC — where ultimately, the premiums are at least deductible as self-employed health insurance without the medical expense AGI or itemized deduction thresholds — the premiums must actually be paid by the business. If the business owners pay the premiums directly as individuals, they may still be subject to the standard rules for individual LTCI premiums, including the below-the-line medical expense limitations.
Under IRC Section 1372, a more-than-2% owner of an S corporation is treated as though he/she is a partner in a partnership, which means all the aforementioned rules apply. Premiums paid may be deductible to the business, but must be included in the income of the more-than-2% owner, who may then claim the premium deduction as an above-the-line self-employed health insurance deduction — but only up to the age-based premium limitation.
In order to be treated as a more-than-2% owner, the shareholder must actually own more than 2%. The threshold is met, however, if he/she owns more than 2% on any day of the taxable year. Consequently, even if ownership changes intra-year, being a more-than-2% owner at any point in the year counts for that tax year.
Additionally, the family attribution rules of IRC Section 318 apply when evaluating the more-than-2% ownership requirement. Thus, stock owned by a spouse, children, grandchildren or parents — including indirect beneficial ownership via a trust — also counts toward meeting the 2% ownership threshold.
When it comes to a C corporation, the standard rules for employees continue to apply, including that LTCI is deductible as part of compensation as an accident and health insurance benefit under IRC Section 162, and that the premium payments are not taxable to the employee under IRC Section 106.
Again though, for favorable tax treatment, the premiums must be paid directly by the employer, not via a Section 125 cafeteria plan, as LTCI is explicitly denied favorable treatment under IRC Section 125(f). And if the premiums are paid under a flexible spending account, the premiums become taxable to employees under IRC Section 106(c) — although then at least they could be deducted under the rules for individuals paying LTCI premiums.
In the case of a C corporation, there rules apply equally to owners and other employees, and there’s no less-favorable treatment for employee-shareholders. However, to substantiate the LTCI premiums as an employee compensation business expense under IRC Section 162, the shareholders must actually be employees doing bona fide work, and the compensation — including those LTCI premiums — must be reasonable compensation for the services rendered to maintain deductibility.
LTCI premiums generally are moderate enough that reasonable compensation shouldn’t be an issue, but be wary when trying to allocate deductible LTCI premiums to family-member employees who don’t actually do much of anything for the business, and be cognizant that limited-pay LTCI policies — e.g., 10-pay, five-pay, or single-pay policies — that lump larger premiums into fewer years could potentially run afoul of reasonable compensation, although in practice such policies are rarely even available anymore.
In addition, while LTCI is not subject to non-discrimination testing as an employee benefit — meaning it can be offered selectively to employees, including shareholder-employees — it’s still necessary to substantiate it as employee compensation and not just a shareholder dividend.
As a result, eligibility to participate in the employer’s LTCI employee benefit program should not be based solely on whether the participant is a shareholder; instead, it should be determined based on other factors, such as providing to a class of employees — e.g., officers of the corporation — based on a particular length of service, among other factors.
Beyond the rules for deducting LTCI premiums as an individual or via various types of businesses, there are a few other ways that LTCI coverage can be purchased in a tax-preferenced manner, including via a Health Savings Account (HSA), an annuity 1035 exchange or a hybrid LTCI or annuity policy.
From an HSA
Under IRC Section 223, contributions to an HSA are tax-deductible, the account grows tax-deferred and distributions are tax-free when using for qualified medical expenses. And while the HSA qualified distribution rules generally only apply to medical expenses and not medical insurance, IRC Section 223(d)(2)(C)(ii) explicitly states that tax-qualified LTCI premiums are eligible.
However, since IRC Section 213(d)(10) limits the portion of LTCI premiums that can be treated as medical expenses to the age-based limits, only LTCI premiums up to those age-based limits can be withdrawn tax-free from an HSA as qualified medical expenses. This means that any excess premiums above the age-based thresholds must be paid out of pocket, i.e., not with HSA dollars.
It’s also notable that under IRC Section 223(f)(6), any medical expenses —including LTCI premiums — paid via an HSA cannot also be itemized later as a medical expense deduction. In other words, LTCI premiums up to the age-based limits can be deducted as an individual medical expense or paid for with a tax-free HSA distribution, but never can receive both favorable treatments for the same premium dollar.
Via a 1035 Exchange
The Pension Protection Act of 2006 modified the like-kind exchange rules of IRC Section 1035(a) to allow life insurance and annuity contracts to be exchanged for an LTCI policy. Up until that point, annuity policies could only be exchanged for other annuity policies, and life insurance policies could only be exchanged for other life insurance or annuity policies.
Under the new rules though, an existing life insurance or annuity policy could be 1035 exchanged for a tax-qualified LTCI policy. The existing policy must be a non-qualified annuity or life insurance policy, i.e., not held inside of an IRA or employer retirement plan.
Of course, given that life insurance or annuity policies often accumulate significant cash value, while the premiums on LTCI are far more modest at least on a relative basis, in most cases the exchange would just be a partial 1035 exchange [Office2] of some life insurance or annuity cash value for an LTCI policy.
Fortunately, Revenue Procedure 2011-38 affirms that partial 1035 exchanges are permitted, and when they occur, gains and basis are simply allocated pro-rata between the old and new contracts. Though since an LTCI policy generally has no cash value, the gains allocated to the policy effectively vanish without ever being taxed.
Example 3. Charlie has a $120,000 existing non-qualified annuity contract with a cost basis of only $70,000, and thus an embedded gain of $50,000. He is also purchasing a qualified LTCI policy with a $3,000/year premium. Under the existing 1035 rules, Charlie can fund his LTCI premium with a partial 1035 exchange for $3,000, reducing the cash value of the annuity to only $117,000 and the cost basis to $68,250 — since the transfer is treated as $70,000 / $120,000 *[Office3] $3,000 = $1,750 of basis, and the remaining $1,250 of gain. Thus, after the exchange, Charlie’s embedded annuity gain has decreased from $50,000 to just $48,750, as $1,250 of the gains are shifted to the LTCI policy. Yet since the exchange was tax-free (as a 1035 exchange) and the LTCI has no cash value to liquidate, the $1,250 of gain is simply eliminated.
One major caveat for doing a 1035 exchange to an LTCI policy is that to complete the transaction, the existing annuity or life insurance company must directly assign the policy — or part thereof — to the new LTCI company, which in turn must be capable of accepting, processing and liquidating the assigned share.
In practice, not all LTCI companies have the systems in place to do so, and thus may not be willing to permit or cooperate with a partial 1035 exchange. If the insurance company cannot facilitate the transaction, the opportunity is simply unavailable; it cannot be done by merely taking a distribution and rolling it over to an LTCI policy if the 1035 exchange is not facilitated directly.
For companies that do permit an incoming partial 1035 exchange, the strategy can help to whittle down otherwise taxable gains. This is especially appealing in the case of an appreciated non-qualified annuity, given such annuities remain taxable to the beneficiaries even after death, and do not receive a step-up in basis, providing no other alternative to eliminate the embedded gain.
Via Hybrid Policies
The last option for funding LTCI on a tax-preferenced basis, also introduced as part of the Pension Protection Act (PPA) of 2006, is to do a 1035 exchange from an appreciated life insurance or annuity policy into a hybrid version of a life insurance or annuity policy that includes an LTCI rider.
Specifically, PPA 2006 modified the definition of what constitutes a “like-kind” exchange under IRC Section 1035(b) to stipulate that it’s permissible to exchange into a life insurance or annuity policy that has an LTCI rider, and still be treated as like-kind — as long as the exchange would have otherwise been permitted into a similar policy without such a rider.
The advantage of this strategy is that under IRC Section 72(e)(11)(B), any charges for the LTCI rider against the insurance or annuity policy are not treated as a taxable distribution. By contrast, without these rules, subtracting LTCI premiums from the cash value of life insurance or an annuity would have generally been treated as a taxable withdrawal. Instead, the premiums are simply subtracted from the cost basis of the policy.
Given the premiums subtracted from the hybrid policy already receive preferential treatment, they may not also be claimed as a medical expense deduction under IRC Section 7702B(e)(2). However, claims paid out for the LTCI portion of the policy can also be received tax-free as LTCI benefits — even if they otherwise would have been a taxable distribution from the policy’s cash value.
This is likely to be a more favorable treatment than just taking a taxable distribution from the insurance or annuity policy directly, paying long-term care expenses and trying to claim a medical expense deduction later.
Example 4. Charlie decides that instead of doing partial 1035 exchanges to an LTCI policy from his non-qualified annuity with $120,000 of cash value and a $70,000 cost basis, he will instead do a full 1035 exchange to a hybrid annuity/LTCI policy. After the exchange, his $120,000 is invested into a new hybrid annuity/LTCI policy, and carries over his $70,000 cost basis. Shortly thereafter, his first $3,000 premium is subtracted from the policy’s value, which reduces his cash value to $117,000 and the cost basis to $67,000.
Notably, after the LTCI premium is paid, Charlie still has a $50,000 gain exposure. Unlike the prior scenario of exchanging to an LTCI policy directly, the potential gain is not reduced. But if Charlie subsequently has an LTCI claim and uses the $120,000 to cover his long-term care expenses, he will not owe any taxes on the liquidation of his entire cash value, despite the $50,000 gain, because the LTCI claims are still able to be distributed tax-free. On the other hand, if he never actually has a claim, Charlie or his heirs will still need to contend with the $50,000 embedded gain, plus any subsequent growth that occurs in the future.
Given that LTCI premiums in a hybrid policy are only subtracted from basis — and the embedded gain is only reduced when actual claims are paid — an exchange to a hybrid policy will be most appealing in situations where there is an existing contract with substantial embedded gains, and a relatively high likelihood of actually using the dollars for future claims.
Ultimately, the Internal Revenue Code provides a substantial number of different ways to purchase LTCI with favorable tax treatment.
In general, the most favorable rules encourage a purchase via a business that allows for the full deduction of LTCI premiums without any age-based limits — though that is only available for employees, C corporations and 2%-or-less owners of S corporations.
The next best alternative, which at least maximizes the deduction — albeit subject to the age-based limits — is to claim a deduction for LTCI as a business owner (self-employed, partner or LLC member, or more-than-2% owner of an S corporation), or via an HSA.
After that, the most appealing option that remains is to purchase as an individual, claiming a deduction for only the age-based premium limitation as a medical expense itemized deduction subject to the associated limits.
And in some cases as a last resort, it may be appealing to purchase the coverage either via a direct 1035 exchange or what is often the least favorable — but still better than nothing — treatment of using a hybrid LTCI policy. Though the greater the existing embedded gains, particularly in the case of a non-qualified annuity, the more appealing this strategy may be.
So what do you think? Do you explore tax-preferenced options for purchasing long-term care insurance with your clients? Is the landscape of tax-preferenced options too confusing? Please share your thoughts in the comments below.