Long-term care insurance (LTCI) premium deductions in the business setting can seem confusing. There are three questions your clients want answered:
- Does the business get a deduction if it pays the premium?
- Is the employee taxed on the premium the business pays?
- Will benefits paid by the policy be taxed?
The answer to these questions depends on two questions of your own:
- Is the employee an owner of the business, the spouse or a dependent of an owner?
- Is the business a C corporation (which includes not-for-profit organizations) or is it a “pass-through” entity for tax purposes?
To simplify things, we’ll use the acronym PTB to refer to pass-through businesses (sole proprietorships, partnerships, S corporations and most limited liability companies) and PTO to their owners. Although technically PTOs are not employees, if there’s no difference in the tax treatment, we’ll lump them together into the word “employee.”
Once you know the answers to the second set of questions, it’s easy to answer the questions your clients want answered. Those questions are:
Is it a C corporation or another type of business?
If it’s not a C corporation, it will be one of the PTBs. This means that it “passes through” its taxable income to its owners. PTBs do not pay tax themselves; their owners report the business’ taxable income on their personal income tax returns.
Although you can usually tell what kind of business it is by its legal name, it’s always best to ask the owner (or better yet, the owner’s tax advisor).
THE LTCI BENEFITS ARE NOT TAXABLE JUST BECAUSE THE BUSINESS PAID THE PREMIUMS.
Is the employee an owner of the business?
You’d think it would be easy to answer this question. Either a person is an owner or she’s not. For everything other than S corporations, it is easy. For S corporations, however, if someone owns less than 2 percent of the S corporation’s stock, that person is not an owner for these purposes.
Now that you have the answers to those two key questions, let’s look at the two situations you’ll run into. Almost every client will fall into one of these two.
Situation No. 1: The employee is not an owner or the employee is an owner of a C corporation.
The business may deduct the premium it pays for an LTCI policy covering the employee (including the employee’s spouse and dependents). It doesn’t matter if the premiums are higher than the employee’s age-based limits; they’re still deductible. But see the note about “limited pay” policies later.
Generally, the employee is not taxed on the premiums the business pays—even if those premiums exceed the age-based limits and even if the employer must amortize the premiums instead of deducting them. The LTCI benefits are not taxable just because the business paid the premiums. This assumes, of course, that the policy is tax-qualified and the benefits would not be taxable.
Situation No. 2: The business is a PTB and the insured is a PTO or a PTO’s spouse or dependent.
The business may generally deduct premiums it pays for the PTO’s LTCI (including premiums paid for a spouse and dependents). However, that premium must then be included in the PTO’s income. He then deducts the premiums on line 31 (self-employed health insurance deduction) of his personal income tax return. The age-based limits do apply; however, the 7.5 percent of adjusted gross income (AGI) limit does not apply.
The LTCI benefits are not taxable just because the business paid the premiums (including premiums paid for a spouse and dependents). This assumes, of course, that the policy is tax-qualified and the benefits would not otherwise be taxable.
There are always exceptions. The big exception—the one that trips people up easily—deals with people who own 2 percent or more of an S corporation, who employ their spouse, and want to treat the spouse under the “not-an-owner” rules, which would allow the S corporation to deduct the entire premium without regard to the age-based limits.
Because of a quirk in tax law—the attribution rules in IRC §318—some accountants feel the spouse of the owner of an S corporation is also treated as an owner—even if that spouse is a genuine employee. As long as the spouse’s premium is less than the age-based limits, there’s no problem. But if it’s more, the PTO does not get to deduct the excess as it would have if the spouse had been a “true” employee.
The other situation you need to keep in mind involves limited-pay premiums. Some insurance companies now offer LTCI policies that are “paid up” after a policyholder has paid premiums for a certain period (usually 10 or more years) or until a certain age. When the policy covers nonowners in PTBs or owners in a C corporation (and thus would otherwise be completely deductible by the business), your client’s accountant must decide if those premiums are “prepaid expenses” that must be amortized over the life of the policy, instead of deducted in the year paid.
Issue of discrimination
Finally, can a business “discriminate” in paying LTCI premiums? Another way of asking the same question is whether LTCI carve-out plans are subject to ERISA. The only authoritative language I’ve seen is in the preamble to the ERISA regulations (Federal Register, Nov. 21, 2000, Vol. 65, No. 225, Page 70246):
One commenter requested clarification as to the application of the proposed regulation to ‘‘long-term care benefits.’’
It is the view of the Department that the provision of the types of benefits described by the commenter would not, in and of itself, cause a plan to be treated as a group health plan or a plan providing disability benefits for purposes of this regulation. (Italics provided.)
It’s the phrase “in and of itself” that causes some concern. Keep the chart in this article handy. When you’re puzzling over the taxation of an LTCI policy, ask yourself those two questions: “Is the insured an owner, the spouse or a dependent of an owner?” and “What kind of business is it?”
Walter Bristow, J.D., CLU, ChFC, is an advanced marketing attorney for Genworth Financial. You can reach him at email@example.com.