Advanced Underwriter. Qualified Long Term Care Insurance (LTCi) A Tax Primer. Advanced Underwriter. Volume 6, Issue 2. Tax Planning Strategies

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1 Advanced Underwriter Volume 6, Issue 2 Advanced Underwriter Qualified Long Term Care Insurance (LTCi) A Tax Primer Tax Planning Strategies FOR PRODUCER AND PROFESSIONAL ADVISOR USE ONLY. NOT FOR USE WITH THE PUBLIC.

2 Estate and Business Planning Department Joshua A. Hazelwood Vice President JD, LL.M Albert R. Kingan AVP JD, LL.M, CLU, ChFC Patrick F. Olearcek AVP JD, CLU, ChFC Marc Belletsky JD, CLU, ChFC Steven A. Brand M.T., ChFC, CLTC Todd L. Janower JD, LL.M, CLU, ChFC Richard C. Martin JD, LL.M, CFBS CLU, ChFC, CFP 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 The MassMutual Estate and Business Planning 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 for each of our clients. Our areas of focus include the following: Business Succession Planning Estate Planning Charitable Giving Arrangements Employee Benefit Arrangements Please call , extension with any questions. The information provided is not written or intended as specific tax or legal advice and may not be relied on for purposes of avoiding any federal tax penalties. MassMutual, its employees and representatives are not authorized to give tax or legal advice. Individuals are encouraged to seek advice from their own tax or legal counsel. Individuals involved in the estate planning process should work with an estate planning team, including their own personal legal or tax counsel.

3 Qualified Long Term Care Insurance (LTCi) A Tax Primer Updated By Bruce A. Tannahill, JD, CPA/PFS, CLU, ChFC, AEP Qualified Long Term Care Insurance (LTCi) reimburses the cost of Qualified LTC services, which include necessary diagnostic, preventive, therapeutic, curing, treating, mitigating and rehabilitative services, as well as maintenance or personal care services that are required by a chronically ill individual, in connection with a plan of care prescribed by a licensed health care practitioner. IRC 7702B(c)(1). A chronically ill individual is one who has been certified within the previous 12 months by a licensed health care practitioner as (1) being unable to perform (without substantial assistance) at least two activities of daily living for at least 90 days due to a loss of functional capacity, (2) having a similar level of disability as determined under regulations prescribed by the Secretary of the Treasury in consultation with the Secretary of Health and Human Services or (3) requiring substantial supervision to protect such individual from threats to health and safety due to severe cognitive impairment. Activities of daily living are eating, toileting, transferring, bathing, dressing and continence. IRC 7702B(c)(2). Key Concept: Eligible LTCi Premiums A key to an understanding of the tax treatment of LTCi is noting the distinction the Internal Revenue Code (IRC) makes between the actual premium paid for a policy and the eligible LTCi premium. 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. The Eligible LTCi Premiums in 2015 are (Rev. Proc , IRB ): Attained age Limitation on premiums Age 40 or less $ 380 Age $ 710 Age $1,430 Age $3,800 Age 71 and older $4,750 Medical Expense Deduction (IRC 213(a)) For individuals, premiums paid for medical care insurance are deductible as a medical expense itemized deduction to the extent that when added to all other unreimbursed medical expenses the total exceeds 10% of the taxpayer s adjusted gross income (AGI) (7.5% of AGI through 2016 if the taxpayer or taxpayer s spouse attains age 65 before the close of the taxable year. IRC 213(f)). For income tax purposes, eligible long term care premiums paid on a qualified LTCi contract qualify as a medical care expense. The insurance can cover the individual, his or her spouse and/or dependents. 1

4 Example: Ed, age 63, and Ann, age 61, have an adjusted gross income of $75,000 in 2015, 10% of which is $7,500. Among their medical expenses for the year are 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 his eligible LTCi premium of $3,800 plus her eligible LTCi premium of $3,800. They have other medical expenses in the amount of $4,500. For tax purposes, their total medical expenses are $12,100, which exceeds the 10% AGI threshold by $4,600 ($12,100-$7,500 = $4,600). Their medical expense deduction is $4,600. Amounts Received Under a Qualified LTCi Amounts received under a qualified LTCi contract are treated as reimbursements for expenses actually incurred for medical care (IRC 7702B(a)(2)), and as such are 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 an indemnity contract pays a per diem benefit that exceeds the per diem limit provided under IRC 7702B(d) ($330 in 2015), the excess is taxable income to the extent it exceeds actual long term care expenses. Medical Care Gift Tax Exclusion (IRC 2503(e)) IRC 2503(e) provides a gift tax exclusion for amounts paid to a provider of the medical care for another person. This unlimited exclusion from the gift tax includes amounts paid for medical insurance on behalf of any individual. Regs However, in the case of a qualified LTCi contract, only eligible long term care premiums based on the insured s age can be taken into account. IRC 213(d)(1)(D), 213(d)(10). To take advantage of this exclusion, the medical care provider must be paid directly, and in the case of an insurance policy, the premium payment must be sent directly to the insurer. Practice tip: Because of increasing life expectancies, many adults may be faced with caring not only for their children, but for their aging parents. This sandwich generation can anticipate providing for their parents long term care expenses through LTCi. If a parent owns this type of contract insuring himself, and the child pays the premium directly, the portion of the premium equal in amount to 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. 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. * Any refund 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). *Note: A cost may be associated with this rider. 2

5 Example: 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 transfer tax consequences are as follows: The amount of the gift is $4,500, $3,800 (the eligible LTCi premium based on Dorothy s age) qualifies for the medical care gift tax exclusion, and the balance of $700 qualifies for the annual gift tax exclusion ($14,000 in 2015). This leaves Carol with a remaining annual gift tax exclusion amount of $13,200, which she can use to help her mother in other ways. Health Savings Accounts (IRC 223) A health savings account (HSA) is a savings vehicle established to set aside tax-deductible funds that can be used to pay for health care expenses income tax-free. HSAs allow individuals who have high-deductible health plans (HDHPs) to save pre-tax money for health care expenses. Any amount paid or distributed out of an HSA, which is used exclusively to pay qualified medical expenses of any account beneficiary, are not includible in gross income. IRC 223(f)(1). The term qualified medical expenses means amounts paid by such beneficiary for medical care (as defined in section 213(d)) for such individual, the spouse of such individual and any dependent of such individual, but only to the extent such amounts are not compensated for by insurance or otherwise. This includes premiums paid for a qualified LTCi contract (as defined in section 7702B(b)). IRC 223(d)(2)(C)(ii). In Notice , IRB 196, Q&A 41, the IRS clarified 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 and for individuals who have not reached age 65, may also be subject to the 10% penalty under IRC 223(f)(4). Also, in Notice , Q&A 40, 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 Section 125 cafeteria plan. IRC 125(f) provides that the term qualified benefit under a Section 125 cafeteria plan shall not include any product which is advertised, marketed or offered as LTCi. However, for HSA purposes, 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. Where an HSA that is offered under a cafeteria plan pays or reimburses individuals for qualified LTCi premiums, IRC 125(f) is not applicable because it is the HSA and not the LTCi that is offered under the cafeteria plan. 3

6 Finally, Notice , Q&A 42, clarified that distributions from an HSA for qualified long term care services are excluded from income. IRC 106(c) provides that employerprovided coverage for long term care services provided through a flexible spending or similar arrangement are included in an employee s gross income. IRC 213(d)(1) (C) provides that amounts paid for qualified LTC services are treated as being for medical care, and IRC 223(f)(1) provides that amounts paid or distributed out of an HSA used to pay for qualified medical expenses are not includible in gross income. Qualified medical expenses are amounts paid for medical care (as defined in section 213(d)) for the account beneficiary, his or her spouse and dependents. Although IRC 106(c) applies to benefits provided by a flexible spending or similar arrangement, it does not apply 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, whether or not the HSA is funded by salary-reduction contributions through a Section 125 cafeteria plan. Third-Party Owned LTCi 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 person other than the insured. Because benefits are generally paid to the contract owner, this presents some interesting opportunities and challenges. Where a need for long term care is anticipated, but the intent is to pay the expenses from other resources, trust ownership of an LTCi contract may be an effective wealth preservation/ transfer strategy. The amounts received by the trust under the contract are treated as amounts received for personal injuries and sickness and are treated as reimbursement for expenses actually incurred for medical care. IRC 7702B(a)(2). As such, these amounts should be income tax-free under IRC 104(a)(3). The trust must be irrevocable, if the corpus is to be excluded from the individual s federally taxable estate. The grantor helps finance the purchase of the LTCi by making cash gifts to the trust. A gift in trust is a gift of a future interest. Consequently, in order to qualify these premium gifts for the annual gift tax exclusion ($14,000 in 2015), the trust must provide for Crummey withdrawal powers; that is, beneficiaries must be given a right to withdraw the cash transferred to the trust. After a contribution is made to the trust, the beneficiary must be given notice of his or her withdrawal right (Crummey power), along with a reasonable period of time in which to exercise it, generally 30 days or more. It is recommended that the beneficiary be notified in writing. In some states, individuals are offered an income tax deduction or credit for LTCi premium payments. An unfunded trust that pays no income tax cannot realize these tax benefits, but an insured who pays the premium directly to the insurance company may. In theory, if the insured pays the premiums, that payment should qualify for the gift tax annual exclusion. If the trust has the usual Crummey provisions, and the trustee can satisfy any 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. In the context of an irrevocable life insurance trust (ILIT), several old private letter rulings (PLRs) are often cited for this proposition even where the policies have no cash values: Whole life PLRs; , , Term PLRs; , , Group term PLRs; , Split dollar life insurance PLRs; ,

7 IRS Private Letter Rulings (PLRs) are opinions rendered by staff of the IRS relating to a specific case. These opinions do not set legal precedent but do provide some insight concerning the IRS attitude toward the relevant tax issue. PLRs cannot be relied on as can published rulings. But, in many of those PLRs, the trust did have some cash. The same reasoning should apply to an irrevocable trust that owns a qualified LTCi policy. The theory that direct premium payments for ILIT-owned policies qualify for the gift tax annual exclusion is analogous to an outright gift of a life insurance policy or paying the premium on a policy owned by the beneficiary. These gifts qualify for the annual exclusion whether the policyowner is an adult or minor (or a UTMA/UGMA custodianship), and whether or not the policy has any cash value. Reg (c) Ex.6; Rev. Rul , CB 113; Rev. Rul , CB 300. 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 in them. Where the grantor transfers assets into a trust while retaining certain rights and interests, the value of those assets will be included in his/her 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). Benefits paid under an LTCi policy are paid to the owner; i.e., 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. IRC 7702B is silent on the question of third party ownership; that is, the statute does not prohibit third party ownership, but neither does it specifically allow for third party ownership. However, a reasonable argument can be made that third party ownership was contemplated in light of IRC 7702B(d), which addresses aggregate payments in excess of limits. The thrust of this subsection is to tax per diem or indemnity benefits to the extent they exceed the greater of total qualified LTC expenses or the per diem limitation ($330 per day in 2015). IRC 7702B(d)(3) provides aggregation rules, and reads in pertinent part as follows: 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... 5

8 Because LTC benefits are always paid to the policyowner, such aggregation rules would be unnecessary in the absence of third party ownership. IRC 7702B(a)(1) provides that a qualified LTCi contract shall be treated as an accident and health insurance contract. IRC 7702B(a)(2) provides that amounts received under a qualified LTCi 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)). This provision of the Code borrows language from IRC 104(a)(3) and IRC 105(b), indicating that the tax treatment of payments under a qualified LTCi contract is determined by referring to the statutory provision conferring the exclusion and its regulations and rulings. Amounts received by a taxpayer under accident or health insurance for personal injuries or sickness generally are excluded from gross income to the extent that the amounts received are not attributable to medical expenses that were allowed as a deduction for a prior taxable year. IRC 104(a)(3). The use of a grantor trust should facilitate this. Under the grantor trust rules found in IRC , 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. 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. On the other hand, 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 income taxable. Trust ownership of a qualified LTCi policy presents a unique wealth transfer planning opportunity. However, the concept is complex, and requires careful examination of a variety of issues. Practice tip: Assuming the issuer allows for third-party ownership, then 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). 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 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. 6

9 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 , Retirees can be included. Rev. Rul , CB 38. A plan may cover one or more employees, and there may be different plans for different employees or classes of employees. An accident and health plan may be either insured or non-insured, and it is not necessary that the plan be in writing or that the employee s rights to benefits under the plan be enforceable. Regs 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. To accomplish this, it is advisable to document the plan using at least a corporate resolution, with notice to participating employees, even though the Code does not require a plan to be in writing. Where the employer is not directly or indirectly a beneficiary under the policy, the amount it pays as premiums on the LTCi contract may be deducted by the employer as an ordinary and necessary business expense under IRC 162(a), if it can be shown (1) that the premiums were paid in consideration of personal services actually rendered by the employee, and (2) that the total amount paid the employee, including the premiums, was not unreasonable compensation for his services. Rev. Rul , CB 88. An employer cannot deduct the premium payments as an ordinary and necessary business expense when 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 (CA5, 1987). In general, IRC 106(a) provides that gross income of an employee does not include employer-provided coverage under an accident and health plan covering the employee, the employee s spouse and the employee s dependents. Under IRC 106(a), an employee may exclude premiums for LTCi coverage that are paid by the employer. Apparently, there is no limit on the amount of this exclusion. Also, under IRC 105(b), an employee may exclude amounts received through employer-provided coverage if those amounts are paid to reimburse expenses incurred by the employee for long term care of the employee, the employee s spouse, or the employee s dependents. To the extent amounts are excluded from gross income under IRC 105(b) or IRC 106(a), they are also excluded from income tax withholding under IRC

10 In addition, 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). If the exclusions available to plans for employer-provided coverage and/or medical expense reimbursement are to apply, an accident and health plan (including employerprovided LTCi) must provide benefits for employees as an incident of the employment relationship. In other words, a bona fide employer-employee relationship must exist for the employer to be able to deduct the premium payment and for the employee to be able to exclude the premium payment from gross income. If a 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 key in determining whether an accident and health plan is for an owner or for an employee is whether the plan s expected benefits are to be 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. Such a rational basis for differentiation has been held to exist 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 , 536 F2d 289, 76-1 USTC 9401, rev g on this issue (1972) 59 TC 231, acq CB 1. Stating the individual s capacity as an employee in the resolution adopting the plan should reinforce this. Practice tip: In Rev. Rul , CB 296, the IRS has outlined 20 separate factors to consider in making a determination whether a bona fide employer-employee relationship exists. No one factor is given greater weight than any other factor, and all of the factors do not have to be satisfied. However, analysis of each of these factors in light of all the facts and circumstances presented leads to a conclusion of whether a bona fide employeremployee relationship exists. Practice tip: Directors of a corporation are not employees of the corporation, but are treated as self-employed individuals. If the corporation pays the LTCi premiums for a director, these payments are an addition to the director s fees. As such, 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; however, provided all the requirements of IRC 162(l) are met, the director may deduct the cost of the premium to the extent provided by IRC 162(l). This is the self-employed health insurance deduction, which is limited to the eligible LTCi premiums. Rev. Rul , 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 of premiums actually paid by the employee. 8

11 However, the exclusions from gross income under Sections 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 , IRB 1. Practice tip: An insured long term care expense reimbursement plan (qualifying as an accident and health plan within the meaning of IRC 105(b) and 106(a) is a unique and 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, and 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 , 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 , CB 53. Practice tip: A tax-exempt organization (TEO) (also known as a non-profit) is an employer, and as such, can provide an LTCi plan to select key executives with the same tax advantages. Practice tip: A professional corporation (PC) is a personal service corporation, and as such, is taxed at a flat rate of 35%. IRC 11(b)(2). In effect, this means that the benefit of the graduated corporate income tax rates is not available. However, a PC may provide LTCi to certain key executives with the same tax advantages outlined earlier. On the other hand, because of the flat rate structure, many professional corporations elect treatment as an S Corporation, with very different tax consequences. The planner should ask the entity s classification for federal tax purposes. The tax treatment of the refund of premium is prescribed in IRC 7702B(b)(2)(C). Any refund of premium on a complete surrender of the policy or upon death of the insured is income taxable to the extent that any deduction or exclusion was allowable with respect to the premiums. If employerpaid premiums have been excluded from the employee s income under IRC 106(a), the refund of premium will be income taxable to the beneficiary. Presumably, a taxable refund of premium payable upon death of the insured employee will be income in respect of a decedent (IRD) under IRC

12 Example: Barbara s employer, XYZ, Inc., provides her with LTCi coverage under a properly implemented plan. Over a period of years, XYZ has paid cumulative total premiums of $25,000 for the qualified long term care policy with a full refund of premium option. Barbara has named her husband, Bob, beneficiary of this refund of premium. Because Barbara did not include any of these premium payments in her current gross income, at her death, Bob will receive the $25,000 refund of premium as taxable income. Practice tip: A split-premium LTCi arrangement may be an attractive executive fringe benefit. The employee owns the contract and the employer pays the premiums for the base coverage, which is excluded from the employee s gross income under IRC 106(a). The employee pays for the full refund of premium rider. Presumably, the refund of premium payable upon death of the insured will be income taxable to the extent of any premium exclusions. The balance of the refund should be income tax-free. Practice tip: Split-premium is simply a method of dividing premiums between two premium payers. Split-premium LTCi plans are remarkably simple to structure. The most common splits are along the lines of the various elements of the contract the premium, the benefit amount, the elimination period, the benefit period and any riders. For example, a split-premium plan can include: Percentage split: This straightforward approach simply calls for the long term care premium payment to be divided between the employer and the employee by some mutually agreeable percentage, 50/50, 60/40, eligible long term care premium/balance of actual premium. Benefit split: The employer decides what benefit he is willing or able to provide. The employee then decides what additional coverage he or she wants to buy. Of course, the insured cannot exceed the benefit issue limits of the insurance company to which he is applying, but he is able to fill in any gaps that may exist in his coverage. Elimination period split: By this method, the employer pays for a long elimination period. The employee is allowed to buy down the elimination period by paying the difference in premium between the period chosen by the employer and the one he or she desires. Benefit period split: This method takes into account two different benefit periods for a prospective client. One benefit period will be short (e.g., two or three years); the other will be long (e.g., six years or lifetime). Normally, the shorter benefit period will have a premium significantly lower than the longer benefit period. The employer will pay for the shorter benefit period and the employee will pay the difference between the short and the long benefit period. Rider split: The employer pays the premium for the base LTCi policy for the employee. The employee pays the additional premium needed to buy whatever riders are wanted. 10

13 A basic rule of thumb: Any premium paid by the employer is generally a deductible expense, and is excluded from the employee s gross income. Any premium paid by the employee is after-tax and can be treated as an unreimbursed medical expense (limited to an amount no greater than the eligible long term care premium). With the exception of the refund of premium, the benefits of the LTCi policy are generally income tax-free. The terms of the splitpremium arrangement plan should be detailed in the resolution adopting the plan. An exception to the IRC 106 exclusion is prescribed in IRC 105(h). If the plan is a self-insured medical reimbursement plan that favors highly compensated employees, all or part of the employer-paid amounts must be included in the employee s wages subject to federal income tax withholding. However, these amounts, other than payments for specific injuries or illnesses, can be excluded from the employee s wages subject to Social Security, Medicare, and federal unemployment taxes. A self-insured plan is a plan that reimburses employees for medical expenses (including long term care expenses) not covered by an accident or health insurance policy. A highly compensated employee for this exception is any of the following individuals: 1 One of the five highest paid officers. 2 An employee who owns (directly or indirectly) more than 10% in value of the employer s stock. 3 An employee who is among the highest paid 25% of all employees, other than those who can be excluded from the plan. Additionally, contributions to the cost of LTCi cannot be excluded from an employee s wages subject to federal income tax withholding if the coverage is provided through a flexible spending or similar arrangement. IRC 106(c). This is a benefit program that reimburses specified expenses up to a maximum amount that is reasonably available to the employee and is less than five times the total cost of the insurance. However, these contributions can be excluded from the employee s wages subject to Social Security, Medicare, and federal unemployment taxes. In addition, LTCi is not a qualified benefit that can be offered through a cafeteria plan. IRC 125(f). * Refunds of Premium (IRC 7702B(b)(2)(C)) Under a qualified LTCi contract, the only insurance protection provided is coverage of qualified long term care services. The contract cannot provide for a cash surrender value or other money that can be paid out, with the exception of refunds of premiums. During the existence of the contract, all refunds of premiums are to be applied either as a reduction in future premiums or to increase future benefits. And if there is a refund of premium upon surrender or cancellation of the contract, such a refund shall be includible in gross income to the extent that any deduction or exclusion was allowable with respect to the premiums. * Note: There may be implications under the Employment Retirement Income Security Act ( ERISA ) depending on how LTCi policies are made available to employees and whether such an arrangement constitutes an employee benefit plan under ERISA. Employers should consult their own tax and legal advisors for further information on potential ERISA implications. 11

14 The LTCi planning community continues to debate the tax treatment of the refund of premium payable upon the death of the insured. The context in which this question most often arises is where the coverage is an employer-provided fringe benefit. Any plan of an employer providing coverage under a qualified LTCi contract shall be treated as an accident and health plan with respect to such coverage. IRC 7702B(a) (3). Consequently, under a properly implemented plan, an 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 under IRC 162(a). The premium payments are excluded from the executive s compensation under IRC 106(a). The benefits paid under the LTCi contract are income tax-free under IRC 105(b). If the full refund of premium rider is attached to the policy, the question becomes whether the refund of premium payable upon death of the insured is includible in gross income. One side in the debate insists that the refund of premium is always income tax-free on the death of the insured; whereas the other position is that the refund of premium is included in gross income to the extent of any deduction or exclusion that was taken with respect to the premiums. The genesis of the debate is in the language of IRC 7702B(b)(2)(C), which reads as follows: (C) Refunds of premiums. Paragraph (1)(E) shall not apply to any refund on the death of the insured, or on a complete surrender or cancellation of the contract, which cannot exceed the aggregate premiums paid under the contract. Any refund on a complete surrender or cancellation of the contract shall be includible in gross income to the extent that any deduction or exclusion was allowable with respect to the premiums. IRC 7702B(b)(1)(E) (referenced in the first sentence of this paragraph) provides that all refunds of premiums, and all policyowner dividends or similar amounts, under such contract are to be applied as a reduction in future premiums or to increase future benefits. Much (probably too much) is read into the absence of the word death from the second sentence of IRC 7702B(b) (2)(C). Because death appears in the first sentence and not in the second, the interpretation advanced is that the intent of this second sentence is to exclude the refund of premium from gross income upon the death of the insured. The semantics of this sound-bite interpretation seem to ignore the logical inference that the insurance carrier cancels the policy upon the death of the insured. Additionally, the interpretation that the refund of premium is always income tax-free upon the death of the insured sidesteps the broadly inclusive operation of IRC 61 and the principles of the tax benefit rule. 12

15 Except as otherwise provided, gross income means all income from whatever source derived. IRC 61(a). Additionally, all exclusions from income taxation are narrowly construed. See Commissioner v. Jacobson, 336 US 28, 49 (1949). The type of except as otherwise provided exclusion clearly contemplated by the Code is illustrated by IRC 101(a), which exempts from gross income the death proceeds of a life insurance policy that has not violated the transfer for value rule of IRC 101(a)(2). Another example of the exclusionary language contemplated by the Code is IRC 106(a), which excludes from gross income employer-provided coverage under an accident or health plan. Nowhere is there a statutory exclusion from gross income of the refund of premium. The absence of a word hardly rises to this except as otherwise provided model. A more reasonable interpretation of IRC 7702B(b)(2)(C) is within the context of the tax benefit rule. The tax benefit rule is essentially one of judicial origin and development, which the courts and the IRS continue to apply and interpret in new factual circumstances. The tax benefit rule provides that where an item deducted in one year is subsequently recovered, that recovery must be included in income except to the extent that no tax benefit resulted from the prior deduction. In other words, the recovery of a prior year s tax benefit is includible in income. Accordingly, the rule is one of both inclusion and exclusion. It benefits the government by including amounts in income that otherwise might be excluded. It benefits the taxpayer by limiting the inclusion to the amount of deduction for which the taxpayer obtained a prior tax benefit. As traditionally applied, the tax benefit rule provides that deductions taken in earlier years must be restored to income if and when the deducted amount is recovered. In theory, the recovery in the later year stands in the place of that portion of the gross income that was not taxed in the earlier year. Application of the rule is limited to cases in which the deduction and recovery are so interrelated that they are considered integral parts of essentially one transaction. The language of IRC 7702B(b)(2)(C) expands the application of the tax benefit rule from just deductions to include exclusions. Where the premiums have been excluded from the taxpayer s gross income, clearly he or she has derived a tax benefit. When these excluded amounts are later recovered upon payment of the refund of premium, it stands to reason that they should be included in gross income under the tax benefit rule. Practice tip: In an employer-provided LTCi plan, the employer should not be named beneficiary of the refund of premium. The employer s deduction is conditioned on it not being a beneficiary under the policy, either directly or indirectly. See Rev. Rul , CB 88. The employer will likely not be able to deduct the premium payments where it is named beneficiary of the refund of premium. Additionally, where an employer extends money to an employee with an expectation that that money will be returned at some time in the future, there is the appearance of a loan, which raises concerns with the below-market loan rules under IRC

16 Salary Reduction Arrangements (IRC 125(f)) The purchase of a qualified LTCi policy cannot be financed through a salary reduction arrangement. A salary reduction arrangement is an agreement under which a participant elects to reduce compensation or to forgo an increase in compensation and to have such amounts contributed, as employer contributions, by the employer on his or her behalf. Prop. Reg (r). In other words, an employer-provided benefit in lieu of salary or other compensation is a salary reduction arrangement. An accident or health plan funded pursuant to a salary reduction is subject to the rules under IRC 125. See Notice , IRB 93. A qualified LTCi contract shall be treated as an accident and health insurance contract. IRC 7702B(a)(1). IRC 125(f) specifically excludes any product which is advertised, marketed, or offered as LTCi from the definition of qualified benefits that can be offered through an IRC 125 cafeteria plan. Section 125 is the exclusive means by which an employer can offer employees an election between taxable and non-taxable benefits without the election itself resulting in inclusion in gross income by the employees. Prop. Regs (b)(1). An employer can assist in the purchase of a qualified LTCi policy through a payroll deduction arrangement, in as much as the employee is paying for the policy with after-tax dollars. Welfare Benefit Funds In general, a welfare benefit fund is a means of funding an employee welfare benefit plan. Welfare benefit plans include benefits for sickness, accident, disability, death, unemployment, vacation, training programs, day-care centers, scholarship funds, prepaid legal services, and holiday and severance pay. A welfare benefit fund allows an employer to prefund an employee welfare benefit plan by making deposits into the fund and using those deposits to purchase the welfare benefits at a later date. One method of funding welfare benefits is through a welfare benefit trust, which holds the funds from which welfare benefits will be paid. There are two types of welfare benefit trusts: a taxable or non-exempt welfare benefit trust and a non-taxable or exempt welfare benefit trust (more commonly referred to as a voluntary employees beneficiary association, or VEBA). Two questions: (1) Can a welfare benefit trust own an LTCi policy, and if so, what are the implications? (2) Can a welfare benefit fund pay for qualified long term care services? The first question arises most often within the context of an S Corporation. Apparently, it is possible for a welfare benefit trust (whether it is tax-exempt under IRC 501(c)(9) or taxable under IRC 419(e)) to own an individual LTCi contract. However, there is no tax advantage. In fact, the arrangement adds a level of complexity and invites IRS scrutiny. Promoters of placing a LTCi policy in a welfare benefit trust are trying to achieve for the S Corporation shareholder-employees the same tax advantages of an employer-provided LTCi arrangement. The assertion is that by placing the LTCi policy in a welfare benefit trust, the full premium is deductible by the business entity. They argue that the premium payment does not have to be included in the shareholder-employee s income, because he or she does not own the policy. If the taxpayer goes on claim, the benefits should be paid by the LTCi policy to the welfare benefit trust, which in turn distributes these benefits to the taxpayer income tax-free. The tax law does not support this conclusion. 14

17 Rev. Rul , CB 184, outlines the tax treatment of LTCi in the S Corporation environment. IRC 7702B(a) (1) provides that a qualified contract shall be treated as an accident and health plan. Under IRC 1372, accident and health insurance premiums (including qualified LTCi premiums) paid by an S Corporation on behalf of a 2% shareholder-employee as consideration for services rendered are treated like guaranteed payments under IRC 707(c). Therefore, the premiums are deductible by the corporation under IRC 162, and includible in the recipient shareholderemployee s gross income under IRC 61. The premiums are not excludable from the recipient shareholder-employee s gross income under IRC 106; however, provided all the requirements of IRC 162(l) are met, the shareholderemployee may deduct the cost of the premium to the extent provided by IRC 162(l). This is the self-employed health insurance deduction, which appeared on the 2013 Form 1040 (an above-the-line deduction), which is limited to the eligible LTCi premium. As a general rule, contributions to any employer-funded welfare benefit fund are deductible subject to the limitations prescribed in IRC 419 and 419A. However, the availability of any statutory exclusion from gross income with respect to contributions to or the payment of benefits from the welfare benefit fund is determined by the statutory provision conferring the exclusion and its regulations and rulings, not by whether an individual is eligible to participate or by the permissibility of the benefit paid. See Reg (c) (9)-6(b). This same principle should apply to a taxable welfare benefit trust. The presence of the VEBA or a welfare benefit trust does not seem to require special treatment. In other words, even if the welfare benefit trust owns the LTCi policy, it appears that the trust is acting as an agent for the 2% shareholder, and consequently he or she must include the premium payment in gross income. The answer to whether a welfare benefit fund can pay for qualified long term care services requires an examination of IRC 106(c). IRC 106(c)(1) provides that the gross income of an employee shall include employer-provided coverage for qualified long term care services to the extent that such coverage is provided through a flexible spending or similar arrangement. IRC 106(c)(2) defines a flexible spending arrangement (FSA) as a benefit program that provides employees with coverage under which (1) specified incurred expenses may be reimbursed (subject to reimbursement maximums and other reasonable conditions), and (2) the maximum amount of reimbursement which is reasonably available to a participant for such coverage is less than 500% of the value of the coverage. In the case of an insured plan, the maximum amount reasonably available is determined on the basis of the underlying coverage. The statutory definition of a flexible spending arrangement given in IRC 106(c)(2) is similar to the definition given in Proposed Regulation (a). Under these proposed regulations, to qualify as an FSA, a benefit program must: (1) provide employees with coverage which reimburses specified, incurred expenses (subject to reimbursement maximums and any other reasonable conditions); and (2) limits the maximum amount of reimbursement that is reasonably available to an employee for a period of coverage to an amount not substantially in excess of the total salary reduction and employer flex-credit for such participant s coverage. A maximum amount of reimbursement is not substantially in excess of the total salary reduction and employer flex-credit if such maximum amount is less than 500% of the combined salary reduction and employer flex-credit. A single FSA may provide participants with different levels of coverage and maximum amounts of reimbursement. 15

18 A flexible spending arrangement is an employer-sponsored benefit program that provides covered employees with a method to pay for covered expenses (e.g., medical, dental or dependent care) with pre-tax dollars. A covered employee contributes to one or more FSAs (e.g., a medical FSA or a dependent care FSA) through a salary reduction arrangement. Contributions to an FSA are not subject to federal income tax or social security tax, and in many cases, also escape state and local income taxes. This occurs because contributions to an FSA reduce an employee s gross income dollar-for-dollar. The end result of an FSA is that a covered employee reduces the out-of-pocket cost for covered expenses due to the income tax and social security tax savings. There is nothing in the published guidance that provides a good explanation of how to measure the IRC 106(c) ratio of the maximum amount of reimbursement which is reasonably available to a participant for such coverage compared to 500% of the value of the coverage. With an insured plan, an obvious approach is to look at the ratio between the annual premium (i.e., the value of the coverage) and the annual benefit paid under the policy (i.e., the amount reasonably available based upon the underlying coverage). A self-employed individual (as defined in IRC 401(c)(1)) can deduct an amount paid during the taxable year for insurance that constitutes medical care for the taxpayer, his spouse and dependents. On the other hand, a welfare benefit fund makes available for reimbursement only those amounts contributed to the participant s account, plus any interest that may be credited to the account. Thus, the account balance (i.e., the amount reasonably available for reimbursement) is less than 500% of the amounts contributed (i.e., the value of the coverage). Apparently, a welfare benefit fund falls within the definitions of a flexible spending arrangement provided in IRC 106(c) (2) and Prop. Reg (a). Practice tip: The report of the Joint Committee on the Health Insurance Portability and Accountability Act of 1996 (HIPAA) notes that expenses for long term care services cannot be reimbursed from an FSA. It goes on to state that HIPAA does not otherwise modify the requirements relating to FSAs. These requirements include a requirement that a health FSA can only provide reimbursement for medical expenses (as defined in IRC 213) and cannot provide reimbursement for premium payments for other health coverage and that the maximum amount of reimbursement under a health FSA must be available at all times during the period of coverage. Practice tip: Under Prop Reg (k)(4) (upon which taxpayers may rely), a health FSA is not permitted to reimburse expenses for LTCi premiums or for long term care services for the employee or the employee s spouse or dependents. 16

19 Practice tip: Contributions made to a single employer 419 plan to fund post-retirement medical benefits for a key employee reduce on a dollar-for-dollar basis the maximum amount that the employer can contribute to a defined contribution qualified retirement plan on behalf of that key employee. It is unclear whether the section 415(c) limit acts as a cap on deductible contributions to the single employer 419 on behalf of participating key employees. Health Reimbursement Arrangements (HRAs) A health reimbursement arrangement (HRA) is an employer-sponsored health care option that allows employees to pay for medical costs using a pool of employer-provided funds. HRAs reimburse employees for qualified medical expenses they have incurred, up to a maximum amount per coverage period. The IRS outlined the requirements for an HRA in Notice , IRB 93. An HRA is an arrangement that: (1) is paid for solely by the employer and not provided pursuant to a salary reduction election or otherwise under an IRC 125 cafeteria plan; (2) reimburses the employee for medical care expenses (as defined by IRC 213(d)) incurred by the employee and the employee s spouse and dependents (as defined in IRC 152); and (3) provides reimbursements up to a maximum dollar amount for a coverage period and any unused portion of the maximum dollar amount at the end of a coverage period is carried forward to increase the maximum reimbursement amount in subsequent coverage periods. To the extent that an HRA is an employer-provided accident or health plan, coverage and reimbursements of medical care expenses of an employee and the employee s spouse and dependents are generally excludable from the employee s gross income under IRC 106 and 105. Assuming that the maximum amount of reimbursement, which is reasonably available to a participant under an HRA, is not substantially in excess of the value of coverage under the HRA (which means that the maximum reimbursement is not more than 500% of the employer contribution), an HRA is a flexible spending arrangement (FSA) as defined in IRC 106(c)(2) and Prop. Reg (a). As a practical matter, an HRA will be classified an FSA. Specifically, Prop. Reg (k) (4) provides that a health FSA is not permitted to reimburse expenses for LTCi premiums or for long term care services for the employee or the employee s spouse or dependents. Self-Employed Health Insurance Deduction (IRC 162(l)) A self-employed individual (as defined in IRC 401(c)(1)) 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). However, in the case of a qualified LTCi contract, only eligible long term care premiums shall be taken into account. IRC 162(l)(2)(C). Generally, this self-employed health insurance deduction is available to sole proprietors, partners in a partnership, and 2% shareholders in an S Corporation. 17

20 18 A self-employed person can deduct 100% of accident and health plan expenses by hiring his or her spouse as an employee and providing family accident and health coverage for the employee-spouse. Practice tip: A limited liability company (LLC) is an unincorporated business entity that can elect its classification for federal tax purposes under check-the-box regulations. Reg A single-member LLC is taxed as a sole proprietor, unless it elects treatment as a C Corporation or as an S Corporation. A multiple-member LLC is treated like a partnership, unless it elects treatment as a C Corporation or as an S Corporation. The planner should always ask how the LLC is classified for federal tax purposes. The insurance plan must be established under the trade or business. The deduction cannot exceed that income earned by the taxpayer from the trade or business with respect to which the plan providing the coverage is established. IRC 162(l)(2)(A). The self-employed health insurance deduction is actually an adjustment to income (much like a deductible contribution to an IRA) and is taken on Line 29 of the 2014 IRS Form 1040 (the individual income tax return). This is also referred to as an above-the-line deduction. Although the allowable deduction reduces adjusted gross income, it is not allowed as an expense when calculating net earnings subject to self-employment tax. IRC 162(l)(4). Also, any amount paid by a taxpayer that is allowed as a deduction under these rules cannot be taken into account in computing the amount allowed to the taxpayer as a medical expense deduction. IRC 162(l)(3). The deduction is not available to a self-employed individual for any calendar month in which he is eligible to participate in any subsidized health plan maintained by any employer of the self-employed individual or his or her spouse. IRC 162(l). This rule is applied separately to plans that include coverage for qualified long term care services or are qualified LTCi contracts and plans that do not include such coverage and are not such contracts. IRC 162(l)(2)(B). Practice tip: A self-employed person can deduct 100% of accident and health plan expenses by hiring his or her spouse as an employee and providing family accident and health coverage for the employeespouse. The employer-spouse is then covered by the plan as a member of the employee s family. If the employee-spouse is a bona fide employee under the common law rules, the cost of the coverage is fully deductible by the employer-spouse and excludable from the employee-spouse s gross income. Rev. Rul , CB 91. See Ralph E. Frahm et ux. v. Commissioner, TC Memo Practice tip: Because of the definition of a 2% shareholder given in IRC 1372, the spouse of a 2% S Corporation shareholder is deemed to be a 2% shareholder for fringe benefit purposes, even though she or he may not actually own any shares. Consequently, the planning opportunity outlined in Rev. Rul is not available in the S Corporation environment.