Taxation of LTCI


For many years the tax treatment of long-term care insurance was in dispute. Some argued that LTCI was a type of health insurance, and consequently premiums were deductible and benefits could be excluded from taxable income. Others rook the position that because LTCI benefits most commonly cover such things as help with ADLs, supervision, and room and board in facilities, rather than medical care, LTCI was nor health insurance, and therefore premiums could not be deducted as medical expenses and benefits had to be considered taxable income. Because long-term care insurance was simply not addressed by Internal Revenue Service regulations, the issue remained unresolved.

This changed with the enactment of the Health Insurance Portability and Accountability Act of 1996 (HIPAA). HIPAA addressed a wide array of health insurance issues, including the tax treatment of LTCI. Essentially, HIPAA established a new class of LTCI policies, federally tax-qualified (TQ) policies, set requirements that must be met for a policy to be tax-qualified, and granted favorable tax treatment to the policies that meet those requirements.

The Tax Status of LTCI Policies

Federally tax-qualified policies now make up a very large majority of the LTCI policies sold and have become the industry standard. The benefits of TQ policies are generally tax-free, and premiums may in some circumstances be partially tax-deductible. (The requirements for TQ status and the tax treatment of TQ policies are discussed later.)

However, not all LTCI policies are tax-qualified. HIPAA allows insurers to continue to market products that do not meet the requirements for TQ status, referred to as nonqualified (NQ) policies. But the owners of these policies do not enjoy the tax advantages that apply to TQ policies. The tax status of NQ policies is "pre-HIPAA" -- that is, their tax status is the same as that which applied to all LTCI policies before HIPAA. In other words, whether benefits are taxable remains unresolved, and premium payments are not tax-deductible.

To be federally tax-qualified, LTCI policies issued on or after January 1, 1997 must meet all HIPAA requirements. However, policies that were issued before that date and so were already in force when HIPAA's long-term care provisions took effect are governed by HIPAA's "grandfather" clause and referred to as grandfathered policies. These policies are deemed tax qualified (that is, the same tax treatment applies to them as to regular TQ policies) even if they do not meet HIPAA requirements. The grandfather clause was included in HIPAA so that large numbers of policyholders would not need to replace their LTCI policies to gain favorable tax treatment. Such a massive replacement would have caused a major disruption in the industry and would not have been in the interest of consumers. An important restriction applies -- an insurer cannot make changes in a grandfathered policy so substantial that the insurer is in effect issuing a new policy that does not meet HIPAA standards. If such changes are made, the policy may lose its grandfathered status.

The Requirements for TQ Status  

The requirements an LTCI policy must meet to be deemed federally tax-qualified are numerous and in some cases complex. We will summarize the most important ones in this section.


The Cover Page

The cover page of a tax-qualified LTCI policy must include certain information:

It must clearly indicate that the policy is intended to be federally tax-qualified. A typical statement would be, "This policy is intended to be a qualified long-term care insurance contract under Section 7702B(b) of the Internal Revenue Code."
 It must notify the insured that for 30 days after delivery he has the right to return the policy for a full refund of all premiums and fees paid, even though the policy has already gone into effect. (This is called the 30-day free look or right to return provision.)
If the policy includes a preexisting condition exclusion, this must be explained on the cover page.


 Covered Services and Benefit Triggers

HIPAA requires that a tax-qualified LTCI policy pay benefits only for "qualified long-term care services." HIPAA defines qualified long-term care services as "necessary diagnostic, preventative, therapeutic, curing, treating, mitigating, and rehabilitative services, and maintenance or personal care services" that are "required by a chronically ill individual" and "provided pursuant to a plan of care prescribed by a licensed healthcare practitioner." Let us examine these terms.

In defining "qualified long-term care services," HIPAA does not name specific services (such as skilled nursing care, assistance with bathing, supervisory care, etc.) but rather deems a service qualified if it has one of several purposes ("diagnostic, preventative, therapeutic," etc.). This purpose-based approach allows for a great deal of flexibility in the care of an individual. Any service that serves one of the purposes approved by HIPAA is acceptable, and benefits may be paid for it. This approach also makes possible the introduction of newly developed services, which is particularly important in an ever-evolving field like long-term care. (If HIPAA had dictated a list of specific long-term care services, new services not on the list would not be reimbursable without a change in the law.)

A chronically ill individual is defined by HIPAA as one who meets the benefit triggers for TQ policies described in earlier. Essentially, a chronically ill individual is a person who is expected to be unable to perform at least two of the standard ADLs without substantial assistance from another person for at least 90 days, or one who suffers a severe cognitive impairment such that substantial supervision is needed to protect her from threats to her health and safety.

There is another requirement a long-term care service must meet to be qualified -- it must be appropriate for the impairment the insured suffers from. HIPAA ensures that services match a person's impairment by requiring that they be "provided pursuant to a plan of care prescribed by a licensed healthcare practitioner." Physicians, registered nurses, and discharge planners at hospitals have used plans of care for years. These professionals look at the underlying cause of a person's need for services, her overall medical condition, and the types of services available. They also consult with her and her family on their care and setting preferences. They then draw on their expertise and experience to summarize the insured's needs and broadly outline the services that can meet those needs. The purpose of a plan of care is to ensure that a person receives safe and appropriate services, which might not occur if she and her family had no professional guidance.

A plan of care should be reviewed and updated frequently. As a person's condition changes, different services are required. Typically, as her physical or cognitive impairment worsens, she needs additional services. On the other hand, in some cases therapy and proper care can lead to a person regaining functional ability so that a reduced level of services is appropriate. For this reason, HIPAA states that insurers must require recertification of an insured's impairment by a licensed health care practitioner every 12 months. (Many insurers review an insured's case more frequently if her condition is one that could change in the near term.)

 HIPAA defines a licensed healthcare practitioner as "any physician (as defined in section 1861(r)(l) of the Social Security Act) and any registered professional nurse, licensed social worker, or other individual who meets such requirements as may be prescribed by the Secretary [of the Treasury]."

Generally, a TQ policy may not make payments to an insured that are not intended to cover qualified long-term care services. However, in the case of nonforfeiture and policy dividends, payments of certain types may be made under certain circumstances.

Finally, a TQ policy may not pay benefits for a service to the extent that Medicare pays benefits for the same service. This rule is intended to prevent insureds from receiving double benefits. However, it does not apply to indemnity or disability policies.


Consumer Protection

HIPAA requires TQ policies to include many of the consumer protection provisions mandated by the NAIC LTCI Model Act and Model Regulation discussed earlier. To mention a few of the most important, a TQ policy must:

be either guaranteed renewable or noncancellable,
include a third-party notification of lapse provision,
offer an inflation protection option,
offer a nonforfeiture option.

Finally, the provisions relating to exclusions must be those described earlier.


 The Tax Treatment of TQ Policies

Benefits

Benefits paid by TQ reimbursement LTCI policies are not considered income for purposes of federal income tax. Benefits paid by TQ indemnity or disability policies (referred to by the IRS as per diem policies because they pay a flat dollar amount per day) may be taxed if they exceed a certain limit ($260 per day in 2007, adjusted annually for inflation). However, if an insured with a per diem policy can furnish proof that her qualified long-term care expenses were greater than this limit, benefit payments up to the actual amount of expenses may be excluded from taxable income, even if they exceed the limit. This rule is based on the principle that LTCI benefits that are not actually spent on long-term care should not be tax-free, but rather treated as ordinary income.

Gary has a TQ reimbursement policy with a daily benefit of $300. He receives benefit amounts ranging from $225 to $300 for different days, depending on the amount of covered expenses he incurs. Since all his benefits go to pay for care, the entire amount each day is tax-free.

David has a TQ policy that pays a daily benefit of$300 on a disability basis. He is paid $300 for every day he meets a benefit trigger of the policy, even though his actual ling-term care expense range from $180 to $240. Only $260 of each daily benefit is tax-free, and the other $40 is taxed as ordinary income.

Robert also has a TQ policy that pays a daily benefit of $300 on a disability basis. He is paid $300 for every day he meets a benefit trigger of the policy, even though his actual expenses range from $200 to $330. For days on which he receives services costing $260 or less, only $260 is tax-free, but if he can show that he received qualified services costing more than $260 on certain days, his benefits for those days are tax-free up to the actual amount of incurred expenses.  

The above rules apply to both individually purchased policies and group coverage.  



Premiums:  Individual Policies

Premiums paid by an individual on a tax-qualified LTCI policy may in certain circumstances be partially tax-deductible. It works like this: A taxpayer may include premiums up to a maximum amount in itemized deductions on Schedule A. This maximum depends on the taxpayer's age at the end of the tax year and is adjusted annually for inflation.

Limits on Tax Deductibility of LTCI Premiums
for 2007 adjusted annually for inflation
Age of the insured at close of tax year
Maximum amout includable for deduction:
40 and under
$290
41 - 50
$550
51 - 60
$1,110
61 - 70
$2,950
71 and over
$3,680


If LTCI premiums (up to the allowed maximum) and other deductible medical expenses add up to more than 7.5 percent of the taxpayer's adjusted gross income (AGI), the amount in excess of 7.5 percent of AGI is deductible from taxable income.

Gloria is 57. In 2007 she pays an annual premium of$1,250 on a tax-qualified LTCI policy. She had $4,000 in deductible medical expenses that year, and her adjusted gross income was $35,000. At her age, she can add $1,110 of her LTCl premium to her deductible medical expenses for a total of $5,110. This amount exceeds 7.5 percent of her AGl ($2,625) by $2,485. Therefore, $2,485 is deductible from taxable income.

For the self-employed, premiums are treated somewhat differently. The same age-based maximums listed in but a self-employed person may exclude the full amount of premiums up to these maximums from taxable income (unlike an employed person, who may only deduct any amount that, together with other deductible medical expenses that exceeds 7.5 percent of adjusted gross income).

In addition, a growing number of states offer credits or deductions on state income taxes for LTCI premiums.


Premiums: Employer-Sponsored Coverage.

As a general rule, employers paying premiums or portions of premiums for TQ long-term care insurance on behalf of their employees may deduct their payments. The premium payments must be deemed reasonable and ordinary business expenses, but meeting this test is relatively easy, and the deduction is unlikely to be challenged as long as the long-term care insurance is offered as an employee benefit.

Employees do not have to include as taxable income any premium payments made on their behalf by their employer. The tax treatment of premium payments made by employees themselves for employer-sponsored coverage is the same as for individual policies -- that is, premiums may be partially deductible in certain circumstances, according to the rules explained above.

There is an exception for employees who are self-employed owners. A self-employed owner is someone who is both an owner and an employee of the same business, such as a partner in a law firm. Unlike other employees, a self-employed owner may not exclude from her taxable income LTCI premium payments made by her employer on her behalf. However, a self-employed owner can take a deduction for a portion of such premium payments; the rules are similar to those for the self-employed, described above.