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Tax-Qualified LTCI Plans

Tax incentives make these plans attractive to business owners.

By Jon L. Stotesbery, CLU, CSA, CLTC

In 1996, with the passage of HIPAA, Congress formally defined long-term care insurance for income-tax purposes. Although the LTCI tax clarification was only a small part of an act that dealt with a number of health insurance-related issues, it had a huge impact on how LTCI is marketed today, particularly in the business sector.

HIPAA created a new tax code for LTCI, and specifically laid out the requirements for favorable tax treatment of premiums and benefits for what would be known as “tax-qualified” LTCI policies. The lion’s share of the LTCI tax incentives was directed at businesses, making this coverage an increasingly popular fringe benefit for business owners.

We need a solid understanding of the tax implications of this coverage in various planning scenarios to advise our business-owner clients properly.

Premiums for tax-qualified LTCI policies are treated as accident and health insurance premiums (IRC Section 7702B(a)(1)). As such, they are subject to a deduction based on who or what entity is claiming them. Also, premium deductibility is subject to the dollar limits on the table above, based on attained age before the close of the tax year being reported.

Tax-qualified LTCI premiums are deductible personal medical expenses for those who itemize (IRC Section 213). Normal thresholds apply for this LTCI premium deduction, i.e., only unreimbursed medical expenses in excess of 7.5 percent of adjusted gross income are deductible.

PREMIUMS FOR TAX-QUALIFIED LTCI POLICIES ARE TREATED AS ACCIDENT AND HEALTH INSURANCE PREMIUMS

Case studies
Let’s use several case studies to illustrate the tax treatment of tax-qualified LTCI premiums in the business market.*

Sole Proprietors
Case study: Bill Walker, age 62 and a self-employed business owner, purchases a tax-qualified LTCI policy with an annual premium of $2,800. Walker’s unreimbursed medical expenses for this year (excluding the LTCI premium) are $5,000. His adjusted gross income is $50,000.

Business deduction: If the premium is paid by the business, Walker may deduct 100 percent of the eligible premium as an above-the-line business expense on his Form 1040. From the chart above, we see that a 62-year-old is allowed to deduct up to $2,600 of qualified LTCI premium for the 2004 tax year. Thus, in this scenario, $2,600 is deductible as a business expense. (The LTCI premium would still be subject to self-employment tax, however.)

Personal deduction: In this scenario, the medical expense threshold is $3,750 (7.5 percent of Walker’s $50,000 adjusted gross income). Since his unreimbursed medical expenses, excluding the remainder of the eligible LTCI premium, are $5,000, that threshold has already been met.

Therefore, the remaining eligible premium of $200 ($2,800 total premium less $2,600 eligible premium) that was not deducted as a business expense, may be deducted personally.

Partnerships
Case study: Brian Orton, age 57 and a greater-than-2-percent owner of a partnership, purchases a tax-qualified LTCI policy with an annual premium of $1,800. Orton’s unreimbursed medical expenses for this year (excluding the LTCI premium) are $1,000. His adjusted gross income is $60,000.

Business deduction: The partnership can pay the entire premium and deduct it as a business expense. The premium is considered a guaranteed payment to Orton. As such, it is added to his K-1 income and reported to the IRS on Forms K-1 and 1065. He can then deduct 100 percent of the eligible premium on his 1040 under the rules for health insurance costs for self-employed persons. Thus, in this scenario, $980 would be treated as a reduction to his adjusted gross income.

Personal deduction: If Orton deducts 100 percent of the eligible premium, i.e., $980, the remaining $820 of eligible premium ($1,800 total premium less $980 eligible premium) may be deductible personally since it was not deductible as a business expense.

Orton’s medical expense threshold is $4,500 (7.5 percent of his $60,000 adjusted gross income). His unreimbursed medical expenses, along with the remaining eligible LTCI premium, total $1,820, which is less than the $4,500 threshold required. Thus, the remaining eligible LTCI premium of $820 that was not used to reduce his adjusted gross income could not be deducted personally.

S corporations
Case study: Don Watson, age 68 and a greater-than-2-percent owner of an S corporation, purchases a tax-qualified LTCI policy with an annual premium of $3,600.Watson’s unreimbursed medical expenses for this year (excluding the LTCI premium) are $5,500. His adjusted gross income is $65,000.

Business deduction: The S corporation can pay the entire premium and deduct it as a business expense. The premium is considered a guaranteed payment to Watson. As such, it is considered part of his shareholder’s salary and is reported to him on his W-2, as well as to the IRS on the corporation’s return, Form 1120S. He can then deduct 100 percent of the eligible premium on his Form 1040 under the rules for health insurance costs for self-employed persons. Thus, in this scenario, $2,600 would be treated as a reduction to his adjusted gross income.

Personal deduction: If Watson deducts 100 percent of the eligible premium, i.e., $2,600, the remaining $1,000 of eligible premium ($3,600 total premium less $2,600 eligible premium) may be deductible personally since it was not deductible as a business expense.

In this scenario, Watson’s medical expense threshold is $4,875 (7.5 percent of his $65,000 adjusted gross income). Since his unreimbursed medical expenses, excluding the remainder of the eligible LTCI premium, are $5,500, that threshold has already been met. Thus, the remaining eligible premium of $1,000 that was not used to reduce his adjusted gross income may be deducted personally.

C corporations
Case study: Gerry Gray, age 59 and the majority owner of a C corporation, purchases a tax-qualified LTCI policy with an annual premium of $2,650. Gray’s unreimbursed medical expenses for this year (excluding the LTCI premium) are $3,000. His adjusted gross income is $90,000.

Business deduction: The C corporation can pay the entire premium and deduct it as a business expense. In addition, the entire premium, not just the eligible premium, is excluded from Gray’s income.

Personal deduction: Premiums for tax-qualified LTCI provided through a C corporation are excluded from Gray’s taxable income. This is true even though the premium is in excess of what might have been deducted had it been purchased through one of the other business entities discussed above.

POLICYHOLDER AGE 2004 ELIGIBLE PREMIUM LIMITS
40 or under $260
41 through 50 $490
51 through 60 $980
61 through 70 $2,600
71 or older $3,250

(*Kibble & Prentice does not offer legal and/or tax advice. The tax implications suggested in the case studies above are based on our understanding of the HIPAA regulations. Business owners are urged to review these plans with their legal/accounting advisors prior to implementation.)

Jon Stotesbery, CLU, CSA, CLTC, is with Kibble & Prentice, a Seattle-based corporation focused on the unique financial needs of affluent individuals, families and businesses. He is an MDRT producer. You may reach him at 206-676-5674.


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