Tax Advantages of LTCI
Pre-Tax Premiums & Tax-Free Benefits
Disclaimer: The following information is not intended for use as specific legal or tax advice and may not be relied on for purposes of avoiding any federal tax penalties. Neither Wolf & Associates nor its representatives are authorized to give legal or tax advice. Individuals are advised to consult with their own personal legal or tax advisor.
Tax-Qualified (TQ) Long-Term Care Insurance (LTCI) qualifies as an accident and health plan under IRC Sections 105(b) and 106(a). As such, it has unique tax treatment. Premiums for TQ LTCI can be funded pre-tax and the benefits are also received from the policy are tax-free.*1
Long-Term Care Insurance policies have the potential for pre-tax funding. These funding paths include:
The first three of these paths to pre-tax funding are subject to IRS Age-Based premium limits (see infographic on page 4). However, LTCI premium deductions taken as a business expense can be potentially fully deductible.
When TQ LTCI is funded on a pre-tax basis through a business, attention should be given to appropriate plan documentation (the specifics of the plan design and on what employment basis is the plan is offered), and individuals should consult their tax advisors about “reasonable compensation” justifications.
NOTE: Some states may also have State Income tax deductions or credits.
NOTE: In a Life/LTC Hybrid policy, ONLY the Long-Term Care portion of the policy premium can be funded pre-tax or deducted (this occurs only when the LTC premium can be separated from the life insurance premium – usually this is a small portion of the whole premium). The life insurance premium is not able to be paid pre-tax.
Tax-Free Benefits
Benefits received under a Tax-Qualified Long-Term Care Insurance contract are treated as reimbursements for medical care expense incurred and are not taxed (IRC Sec. 7702B(a)(2)). Just as health insurance benefits are not taxed, TQ LTCI benefits are also not taxed.1 The potential for pre-tax funding or deduction of the premium does not impact the tax-free nature of the benefit.
This tax-free treatment of the benefit applies whether the insurance reimburses actual Long-Term Care expenses or pays a per diem amount toward Long-Term Care needs. However, the tax-free treatment of a per diem benefit (one that pays the full benefit regardless of expenses incurred) is capped each year by the IRS. If the insurance pays a per diem benefit that exceeds the per diem limit provided under IRC Section 7702B(d)(4) ($420 in 2023), the excess is treated as taxable income to the policyholder unless the policyholder’s actual Long-Term Care expenses are equal to or exceed the per diem benefit paid.
Aged-Based vs Full Deductions
When deducting TQ LTCI premiums, deductibility can either be “Age-Based” (subject to annual IRS deduction caps according to the individual’s attained age within that tax year) or “Full” (not limited to an “Age-Based" cap on the deduction). Age-based deductions apply to Itemized Medical Deductions, HSA or HRA account reimbursements, and Self-Employed Medical Deductions. On the other hand, Full deductions may be available for owners of C-Corporations, for LTCI policies funded by a business, for W-2 Non-Owner Employees, and potentially for LTCI policies offered to W-2 Spouses of Sole Proprietors. Care should be taken in justification and documentation of these offerings.
NOTE: The term “Full” used within this article is to be interpreted simply as the lack of a deduction cap associated with an individual’s age. For all other justifications the individual should consult their legal or tax advisor.
Itemized Medical Expense (“Age-Based” Deduction)
For individuals, premiums paid for TQ LTCI are deductible (subject to IRS age-based tables) as an itemized medical expense deduction to the extent that when added to all other unreimbursed medical expenses the total exceeds 7.5% of the taxpayer’s Adjusted Gross Income (AGI) in 2023 (IRC § 213(a)).2 Since many purchasers of TQ LTCI are unable to itemize medical expenses when they are healthier in their 50's and 60's, they may not qualify for this deduction. That said, as age increases and medical conditions and expenses accumulate, this allowable deduction may become more meaningful.
HSA LTCI Funding (“Age-Based” Deduction)
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. Each year the HSA account owner is allowed to make contributions up to IRS caps. For individual HSA accounts (the high deductible medical plan only covers the individual), the account owner can contribute $3,850 in 2023. For Family HSA accounts (the HDHP covers a family and not just one individual), the account owners can contribute $7,750 in 2023. In both cases if the account owner is age 55 or older, that individual can contribute an extra $1000.3
Any amount paid or distributed out of an HSA, that is used exclusively to pay qualified medical expenses for the account beneficiaries (the owner or the owner's spouse and tax dependents), is not taxable income IRC § 223(f)(1). The term “qualified medical expenses” includes premiums paid for a Tax-Qualified LTCI contract, subject to IRS age-based tables, for the account beneficiary, their spouse, and their dependents.?
NOTE: In Notice 2004-50, 2004-33 IRB 196, Q&A 41, the IRS clarified that although distributions from a Health Savings Account (HSA) to pay for Tax-Qualified Long-Term Care Insurance premiums are qualified medical expenses, and therefore excluded from gross income is limited to the eligible (age based) LTCI premiums. Any excess premium reimbursements are considered taxable income and for individuals who have not reached age 65, may also be subject to the 20% penalty under IRC § 223(f)(4).
NOTE: In Notice 2004-50, Q&A 40, the IRS pointed out that an account beneficiary may use distributions from an HSA to pay for qualified LTCI premiums, 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 Long-Term Care insurance. 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. When 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”.
NOTE: Health Reimbursement Accounts may also reimburse for premiums paid for TQ LTCI. Employers pay for HRAs. However, if an HRA is provided through salary reduction or a cafeteria plan “IRC Sec. 125”, the LTC insurance premiums cannot be paid on a pre-tax basis from that HRA.
Self-Employed Medical Deduction (“Age-Based” Deduction)
Owners of Partnerships or S-Corps, Sole Proprietors, or LLCs (filing a tax return as any of the previous) can claim Self-Employed medical deductions for TQ LTCI. When a business owner(s) (>2% shareholder - if the entity has stock) purchases a TQ LTCI policy for themselves (and their spouse), the deduction is subject to IRS age-based deduction limits. These owner(s) are treated as self-employed individuals and can thus deduct LTCI premiums subject to IRS age-based tables. The premium flows through as income to the owner and is deducted by the owner as a self-employed medical deduction. This deduction is an adjustment to income taken on the 1040 (Section 1, line 17).?
Business Expensing LTCI (“Full” Deduction)
C-Corporations Owners & Non-Owners
A C-Corporation may deduct an owner’s full premium under section 162 for the owner and spouse of the owner. These Qualified LTCI policy premiums are excludable from owner’s gross income (IRC § 106(a)). Additionally, a C-Corporation with retained earnings may be able to use part of these earnings to purchase LTCI for a Key Executive or Owner, potentially avoiding accumulated earning tax.?
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W-2 Non-Owner Employees
When an employer funds premiums for a W-2 non-owner employee (an employee who earns less than 2% of the company’s stock) of any entity type, the premiums are “fully” deductible but must be justified as “reasonable compensation”. In the case of W-2 non-owner employees, the business may deduct the Long-Term Care Insurance as an ordinary and necessary business expense under IRC § 162(a). Employer-paid TQ LTCI policy premiums are excludable from an employee’s (non-owner employee) gross income (IRC § 106(a)).
W-2 Employee Spouses of Sole-Proprietors
Exceptions to age-based premium limits may exist when a Sole Proprietor or LLC (taxed as a SoleProprietor) offers this benefit to a “legitimate” W-2 employee spouse (a “legitimate” employee is one who receives compensation for services rendered to the business). Since Sole-Proprietorships do not have stock, stock attribution rules (IRC Sec 318) do not apply. Therefore, this creates a potential for a W-2 employee spouse (who is not considered to be self-employed) to be offered a benefit that is 100% deductible to the Sole Proprietor.
The amount of the premium (when added to other amounts paid to the W-2 employee spouse) cannot exceed reasonable compensation to the W-2 employee spouse. Reasonable compensation may include justifications for current and past services rendered as an employee, severance, or postretirement benefits (IRC § 162). In the case where the benefit is offered to the W-2 employee spouse only (and not to other employees), care should be taken in documenting the justification for this offering and the basis on which the W-2 employee is specified as a class of employees. It is advisable to appropriately define such a “class” by legitimate discriminatory classifications (income, title, tenure). By doing so, it is possible to offer the benefit (on a reasonable basis) solely to the W-2 employee spouse (in their role as an employee); and separate the W-2 employee spouse from other employees who do not receive coverage.
NOTE: In the case of a contributory plan, where the employee is contributing to the premium, only the employer-paid premiums are excludable from gross income. This exclusion can apply to coverage provided to an employee’s spouse and tax dependents before and after death, as well as to retired former employees and to employees on layoff.
NOTE: The business (or business owner) cannot retain any beneficiary interest in the policy without possibly enabling the Internal Revenue Service to treat the policy as a “Welfare Benefit Fund” under IRC Sec. 419, and challenge at least a portion of the deduction.
NOTE: An employer cannot provide Long-Term Care coverage as part of a cafeteria plan (IRC Sec. 125(f)).
Reasonable Compensation (Employer-Provided LTCI)
Employer deductions for owner or non-owner benefits can be claimed provided that the amount of the premium, (when added to other amounts paid to the shareholder/employee) does not exceed reasonable compensation to the shareholder as an employee of the corporation. Reasonable compensation may include justifications tied to current and past services rendered as an employee, as well as severance or as part of a post-retirement benefit (IRC § 162).
There are no formal guidelines to reasonable compensation and is not easily defined, but instead relies heavily on the facts and circumstances of each situation. Accordingly, the employer or business owner should consult with their tax advisor for specific guidance. This is usually subjective reasoning to some degree, but still follows some basic principles tied to other compensation and the value of the services rendered to the business.
NOTE: Reasonable compensation may include (but not limited to): the employee’s qualifications; the scope of the employee’s work; a comparison of salaries (base salary and/or bonus) to comparable other positions or at other employers; and compensation paid in prior years. See Owensby & Kritikos, Inc. v. Comm., 60 AFTR2d 87-5224 (CA5, 1987).
Plan Documentation (Employer-Provided LTCI)
IRC sections 105, 106, & 162 allow for employer-provided health and accident "plans". Although the tax code does not require that a “plan” be in writing, it is advisable to document an offering of employer-provided Long-Term Care Insurance (LTCI) as a Corporate Resolution (for Corporations) and/or an Employee Benefit Memorandum. Despite the Long-Term Care Insurance itself being a formalized plan, the documentation should formalize the nature of the plan, including how it is funded and for whom (e.g., owner only or non-owner employees).
The goal of a documented “plan” is to demonstrate that the benefit is offered (on a reasonable basis) to certain employees (or in some cases solely to the employee/owner) in their role as an employee and not any other role (i.e. for owners it is not offered for their role as owner). (IRC § 162(a)); it should also separate the “class” of employees who receive the benefit from those that do not.
When the benefit is offered to a “class” of W-2 employees and/or to an owner/employee(s), it is important to carefully document the justification for this offering and the basis on which the employee is specified as a “class” of employees. It is advisable to appropriately define such a “class” by legitimate discriminatory employee classifications (income, title, tenure).
NOTE: Rev. Rul. 58-90, 1958-1 CB 88 under IRC § 106 reinforced that in order for deductions to be legitimate it must be shown
(1) that the premiums were paid as a benefit for services rendered by the employee in their role as an employee (defined by legitimate discriminatory classes), and
(2) that the total amount paid to the employee, including premiums, was not unreasonable compensation for their services.
About David
David Wolf is the president and owner of Wolf & Associates , a Long-Term Care planning firm in Spokane, WA.?Wolf & Associates has specialized solely in Long-Term Care Planning since 1988.?David’s expertise in Long-Term Care Insurance planning with business owners and executives has gained him national recognition in his field.??He has been quoted by the Wall Street Journal, Forbes, Money Magazine, and others.?His depth of knowledge in the Long-Term Care Insurance industry has made him a recognized leader and speaker.??David’s practice niche is working with financial advisors to assist their clients in planning for aging, potential frailty, and protecting the ones that they love.
1 Tax-free benefits are capped at $420/day in 2023.
2 https://www.irs.gov/taxtopics/tc502(accessed 1.16.23)
3 https://www.fidelity.com/learning-center/smart-money/hsa-contribution-limits (accessed 1.16.23)
4 IRC section 7702B(b)). IRC § 223(d)(2)(C)(ii). HSA funding limits
5 https://turbotax.intuit.com/tax-tips/home-ownership/ deducting-health-insurance-premiums-if-youre-selfemployed/L6bRhLaVE (accessed 1.16.23)
6 https://www.upcounsel.com/tax-on-retained-earnings-ccorp (accessed 1.16.23)