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Charitable Contributions for High-Income Taxpayers

  • Written by Sidney Kess, CPA, J.D., LL.M.

mug sid kessThe government views those with income of $200,000 or more as “high-income taxpayers,” and charitable contributions are a popular write-off for this group of individuals. For 2015 (the most recent year for which statistics are available), the average charitable contribution deduction for those with adjusted gross income (AGI) of $200,000 to under $250,000 was $11,370. For those with AGI of $250,000 or more, the average deduction was $16,580. In this period of tax uncertainty resulting from Congressional goals of tax reform, what can high-income taxpayers do to maximize their tax-advantaged giving opportunities?

Tax Rules for Charitable Contributions

High-income taxpayers should understand the basic charitable contribution rules for federal income tax purposes, which are fairly straightforward (Code Sec. 170):

• A taxpayer must itemize deductions. No above-the-line deduction for non-itemizers is allowed.

• Donations must go to an IRS-recognized charity, which can be found in Publication 78 online (https://www.irs.gov/charities-non-profits/organizations-eligible-to-receive-tax-deductible-charitable-contributions).

• A taxpayer must follow substantiation rules, with may include obtaining written acknowledgments from the charity and qualified appraisals from outside appraisers.

• Cash donations are limited to 50% of adjusted gross income. Donations of appreciated property usually are limited to 30% of AGI (with the exception of donations of conservation easements explained later). Deductions in excess of these limits can be carried forward for up to five years.

• The deduction for charitable contributions is subject to the phase-out of itemized deductions for high-income taxpayers. This means that the tax write-off for contributions can be reduced by as much as 80%.

Conservation Easements

Conservation easements are a type of special arrangement to let taxpayers have their cake and eat it too. Property owners can give away interests, take a tax deduction, and continue to enjoy the property.

To be deductible, the donation must be a contribution of a qualified real property interest (i.e., a restriction granted in perpetuity on the use which may be made of the real property) to a qualified organization exclusively for conservation purposes (Code Sec. 170(h) and Reg. §1.170A-14). The types of conservation contributions include:

• Preservation of land areas for outdoor recreation by, or the education of, the general public.

• Protection of a relatively natural habitat of fish, wildlife, or plants, or similar ecosystem.

• Preservation of open space (including farmland and forest land).

• Preservation of a historically important land area or a certified historic structure (such as a building façade).

Donations of conservation easements are limited to 50%of AGI minus the deduction for other charitable contributions. Any excess amount can be carried forward for up to 15 years. For donations by farmers and ranchers, the AGI limit is 100%, rather than the usual 50%, with the same 15-year carryover.

However, the IRS has made syndicated conservation easements a reportable transaction that must be disclosed on a taxpayer’s return and may invite IRS scrutiny (Notice 2017-10, IRB 2017-4, 544). For more details about conservation easements in general, see the IRS’s Conservation Easement Audit Technique Guide (https://www.irs.gov/pub/irs-utl/conservation_easement.pdf).

Qualified Charitable Distributions

An IRA owner who is at least age 70½ has an additional way to give to charity. They can make a qualified charitable distribution (QCD) of up to $100,000 annually from the IRA (Code Sec. 408(d)(8)). The distribution is not taxed, and can be counted toward a required minimum distribution (RMD). But no charitable contribution deduction can be taken; no double tax break is allowed.

QCDs are restricted to regular IRAs. They cannot be made from IRA-type accounts, such as SEP-IRAs or SIMPLE-IRAs.

Donor-Advised Funds

A donor-­advised fund is a fund or account in which a donor can advise but not dictate how to distribute or invest amounts held in the fund (Code Sec. 170(f)(18)). Usually, a taxpayer giving cash or property to a donor-advised fund can take an immediate tax deduction even though the funds have not yet been disbursed to a charity.

Donor-advised funds from some major brokerage firms and mutual funds have minimum contribution amounts and fees.

Business Donations

High-income taxpayers may own businesses that can make donations.

• For C corporations, donations are limited to 10% of taxable income.

• For owners of pass-through entities, their share of the businesses’ donations is reported on their personal returns.

Usually, donations of inventory are deductible to the extent of the lesser of the fair market value on the date of the contribution or its basis (typically cost). If the cost of donated inventory is not included in your opening inventory, the inventory's basis is zero so no deduction can be claimed. However, businesses that donate inventory for the care of the ill, the needy, or infants, an enhanced deduction is allowed (Code Sec. 170(e)(3)).

Leave-based donation programs. Companies may have programs that enable employees to donate their unused personal, sick, or vacation days, with this time used by other employees in medical emergencies or disasters. Donated leave time is taxable compensation to the donors, subject to payroll taxes. Employees cannot take any charitable contribution for their donations.

A special rule applies for donations to benefit victims of Hurricane Harvey. The IRS has guidance (https://www.irs.gov/pub/irs-drop/n-17-48.pdf) on the tax treatment of these leave-based donation programs. Employees are not taxed on their donations for this purpose, and no employment taxes are owed on employee contributions for this purpose. Employer can then donate the amount of these donations to a charity providing relief to victims of Hurricane Harvey and claim a tax deduction for this action. Employer donations to tax-exempt organizations must be made before January 1, 2019.

Other Rules

There are many variations on charitable giving, each with special tax ramifications. Some examples:

• Donations of appreciated property held more than one year are deductible at the property’s fair market value on the date of the contribution. Potential capital gain is never recognized.

• Donations can be arranged through special trusts, such as charitable remainder trusts. The donor (and spouse) can enjoy the property for life (or a term of years), with the remainder passed to a named charity. The donor can take a current deduction for the present value of the remainder interest. Another trust option is the charitable lead trust.

• Wealthy individuals can set up their own private foundations to further their philanthropic goals. Special tax rules apply to these foundations.

Year-End Tax Planning

At present, it is uncertain whether there will be any changes in the rules for charitable contributions and, if so, when they will become effective. Likely, the charitable contribution rules for 2017 will be unchanged. However, a decline in tax rates would mean that tax value of donations would be reduced. For example, a $1,000 donation for someone in the 39.6% tax bracket saves nearly $400 in federal income taxes. If the rate for the same taxpayer declines to 25%, the savings would be only $250.

Conclusion

While high-income taxpayers may continue to be generous donors, regardless of tax breaks for giving, thought should be given now to making donations before the end of the year. Review charitable giving to year-to-date and project the tax savings for additional gifts that can be made by December 31, 2017. Allow sufficient time when making donations that require qualified appraisals and legal documentation.

Death of an Employee: Tax Ramifications

  • Written by Sidney Kess, CPA, J.D., LL.M.

mug sid kessWhen an employee dies, family members, co-workers and others may experience profound loss. For the family and the company, there are important tax considerations that arise. Here are some of the issues of note.

Retirement Benefits

If a deceased employee was a participant in a company’s qualified retirement plan, benefits are paid to the designated beneficiary. This is usually a surviving spouse if there is one. If an employee had wanted benefits to be payable to someone other than a surviving spouse, the surviving spouse would have had to consent in writing to this arrangement (Code Secs. 401(a)(11)(F) and 417(a)). The plan administrator should have a record of who was designated as the beneficiary or what happens if there is no such beneficiary (e.g., the beneficiary predeceased the employee).

The person inheriting retirement benefits is not immediately taxed on the inheritance (Code 102). However, when benefits are distributed to the beneficiary, they become taxable to the same extent that they would have been taxable to the employee.

A surviving spouse can roll over the benefits to his/her own account. This allows the surviving spouse to name his/her own beneficiary and to postpone required minimum distributions until age 70½.

A non-spouse beneficiary may direct the trustee of the plan to transfer inherited funds directly to an IRA set up for this purpose. The account should be titled: [Beneficiary’s name], a beneficiary of [employee’s name]. While the non-spouse beneficiary must take distributions over his/her life expectancy (Table I in the appendices to IRS Publication 590-B), this avoids an immediate distribution of the entire inheritance. Generally, distributions must begin by the end of the year following the year of death. However, under a five-year rule, no distributions are required until the end of the fifth year following the year of death, at which time the entire account must be withdrawn.

If the deceased employee’s estate paid federal estate tax, then a beneficiary can claim a miscellaneous itemized deduction for the portion of this tax when benefits are included in his/her income (Code Sec. 691(c)). It is not subject to the 2%-of-adjusted-gross-income floor that applies to most miscellaneous itemized deductions; it is subject to the phase-out for high-income taxpayers.

COBRA Coverage

Under federal law, if the employer has 20 or more full- and part-time employees for at least half of the business days during the previous year and has a group health plan, COBRA coverage (a continuation of the company health plan) must be offered to a surviving spouse and a dependent child (Consolidated Omnibus Budget Reconciliation Act of 1985). A number of states have “mini-COBRA,” which requires the offer of continuing coverage by smaller firms.

The employer must notify the qualifying beneficiary (spouse/dependent child) within 14 days the plan received notice of the qualifying event (the death of the covered employee) about COBRA. This notice of election must spell out what it means and how to make it. What it means is that the qualifying beneficiary can continue the same or reduced coverage for up to 36 months. This election is voluntary, so if the spouse has access to better or less costly coverage elsewhere (e.g., through the Medicare for the spouse; through the children’s health insurance program [CHIP] for the child), making the election may not be advisable. The qualifying beneficiary must pay the cost of coverage, plus an administrative fee up to 2% (unless the company voluntarily pays for some or all of this coverage).

COBRA does not apply to:

• Health savings accounts (HSAs) (discussed later), even though coverage under a company’s high-deductible health plan (HDHP) is subject to COBRA

• Disability insurance for short-term or long-term disability

• Long-term care insurance

Life Insurance

Insurance on the life of an employee is payable at death to the beneficiary of the policy. Depending on the type of coverage, this may be the surviving spouse, the company, or anyone else. As a general rule, the receipt of insurance proceeds payable on account of the death of the insured is tax-free (Code Sec. 101).

Group-term life insurance. Typically proceeds are payable to the surviving spouse or the employee’s child. If the employee has not designated a beneficiary, proceeds are payable according to state law. In order of precedence, this is usually a current spouse, but if there is none, then to children or descendants. If none, then to parents, and then to the employee’s estate.

Key person insurance. This is coverage owned by the company and is designed to provide a financial backstop needed during a replacement period for the deceased employee.

Insurance under buy-sell agreements. If the deceased employee is an owner and there is a buy-sell agreement that has been funded by life insurance, the proceeds are paid out to the company if the company owned the policy (an entity purchase buy-sell agreement), or to co-owners if they owned the policy (a cross purchase buy-sell agreement).

Workers’ Compensation

If an employee dies because of a work-related injury or illness, a death benefit is payable to eligible dependents (usually a surviving spouse and minor children, but to others if there is no spouse or minor child). The receipt of these benefits is tax-free (Code Sec. 104(a)(1)).

The amount of the benefit varies from state to state. For example, in New York the death benefit is two-thirds of the deceased spouse’s average weekly wage for the year before the accident (but not more than a maximum amount adjusted annually), or less if there is no surviving spouse, children, grandchildren, grandparents, siblings, parents, or grandparents. In addition, there may be a payment for funeral expenses.

When there is a work-related death covered by workers’ compensation, this usually becomes the sole remedy against the employer. However, an action against the employer may not be barred in some situations (e.g., death because of toxic substances, defective products, intentional actions by the employer).

FSAs

If the deceased employee had been contributing to a flexible spending account for health care or dependent care costs, contributions cease at death. The executor can continue to submit claims for reimbursement for eligible expenses incurred before death; these reimbursements are tax-free. The plan administrator can provide details about the deadline for these submissions.

Restricted Stock and Stock Options

What happens to restricted stock and stock options when an employee dies varies greatly from company to company. Unvested grants may vest upon death. For example, the terms of a stock option plan may immediately vest any unvested grant, allowing the estate of the deceased employee to exercise the options within a set period.

Nonqualified stock options become part of the deceased employee’s estate. If the executor exercises them, income is taxable to the estate (Form 1099-MISC is issued to the estate). There is no withholding required. Similarly, any restricted stock released to the estate becomes taxable to it (assuming that the employee did not make a Sec. 83(b) election); there is no withholding required.

Special Benefits

In addition to what the law requires, some companies may offer families of deceased employees special benefits. For example, Google pays 50% of a deceased employee’s salary to a surviving spouse or domestic partner for 10 years (http://money.cnn.com/2012/08/09/technology/google-death-benefits/index.html). The company also pays each dependent child a monthly amount until age 19, or 23 if a full-time student.

Conclusion

Families must present death certificates to the company in order to receive any employment-related benefits on behalf of the deceased employee. They should also work with the company to undo other entanglements, such as company credit cards and company vehicles.

Tax Advantages for Working Children

  • Written by Sidney Kess, CPA, J.D., LL.M.

mug sid kessWith summertime approaching, many children will be getting jobs during their school break. Others will continue at their part-time jobs throughout the summer months. What does a child’s work mean to the child and his or her family from a tax perspective?

Tax Considerations for Children

A child can earn for the year up to the amount of the standard deduction for his or her filing status. For 2017, this amount is $6,350 for a single individual (Rev. Proc. 2016-55, 2016-45, 707). Thus, a child can earn over $18 per hour (based on a 35-hour week for 10 weeks) without any income tax on the earnings. The “kiddie tax,” which subjects a child’s income over a threshold amount to the tax rates of the parent, only applies to unearned (investment) income and not to earned income (Code Sec. 1(g)). A child who expects to owe no federal income tax can file an exemption from income tax withholding on Form W-4, Employer’s Withholding Allowance Certificate. This exemption can be used only if the child had no tax liability in the prior year and expects none this year.

Of course, exemption from income tax withholding has no effect on Social Security and Medicare taxes (FICA). A child must still pay these taxes on any amount of earnings (unless the child works for a parent’s company as explained later). Thus, the child’s wages are reduced by 7.65% for FICA taxes.

The child can use his or her earnings to fund an IRA or Roth IRA. The contribution limit for 2017 is $5,500 (Code Sec. 219; Notice 2016-62, IRB 2016-46, 725). If the child opts to use a traditional IRA, then earnings up to $11,850 ($6,350 + $5,500) are tax-free. The contribution need not be made by the child, who can save or spend his or her earnings. The contribution can, for example, be made by a parent or grandparent, to the child’s account up to the lesser of the child’s earnings or $5,500. If it becomes necessary to tap into the IRA in order to pay for higher education, the distributions are taxable, but there is no 10% early distribution penalty in this case (Code Sec. 72(t)(2)(E)).

Usually, because of the long savings horizon until retirement and the child’s low income, it may be better to contribute to a Roth IRA (Code Sec. 408A). No deduction can be claimed for the donation, but earnings become tax-free. If the child does not want to be saddled with investment decisions or risk any losses, contributions can be made to a myRA, which is like a mini-Roth IRA. More information about myRAs can be found through the Treasury (https://myra.gov/).

The child cannot claim the retirement saver credit, which allows taxpayers to double dip (i.e., get a tax break for the contribution and a tax credit) (Code Sec. 25B). The credit is barred to anyone who can be claimed as another taxpayer’s dependent.

Tax Considerations for Parents

The fact that a child works and earns money does not prevent the parent from claiming a dependency exemption for the child ($4,050 in 2017). As long as the child is under age 24 and a full-time student, and the child does not provide more than half of his or her support, has the same principal place of abode and is a member of the parent’s household (when not away at school or for other temporary purpose) the exemption can be claimed (Code Sec. 152(c)).

If child support is being paid on behalf of this child, working at a summer job usually does not affect the amount of payments. However, parents should check their divorce or other relevant agreement to determine whether a child’s working has any impact on child support.

Putting Your Child on the Payroll

It can be a win-win situation for a parent who owns a business and hires his or her child for the summer. The child earns income and gains work experience. The parent gains a tax advantage and enjoys the additional help.

The parent can deduct wages paid to a child as a business expense. A deduction is allowed only if the compensation is reasonable for the work performed. It is advisable to document the hours worked and the type of services performed by the child in case the IRS questions the parent’s return. For example, in one case where a parent with a tax preparation business used her three children to do clerical work, she was denied a deduction for payments because she did not issue them paychecks and could not show any correlation between work performed and the amount of the payments (Ross, TC Summary Opinion 2014-68).

If the parent is a sole proprietor or a partnership in which each parent is a partner, wages paid to a child under age 18 are exempt from FICA (Code Sec. 3121(b) (3)(A)). Wages paid to a child under age 21 are exempt from FUTA (federal unemployment tax) (Code Sec. 3306(c) (5)). These exemptions do not apply if the parent’s business is incorporated or if the parent’s business is a partnership where each partner is not a parent of the child.

Other issues

The earnings of a child can impact financial aid received for higher education. The Free Application for Federal Student Aid (FAFSA) allocates half of a student’s income for the upcoming college year. Income includes money from working (other than work-study income) and withdrawals from IRAs. A parent’s income contribution ranges from 22% to 47%. The FAFSA for the school year between July 1, 2017, and June 30, 2018, can be submitted any time between October 1, 2016, and June 30, 2018. The income reported on the 2017-2018 FAFSA is 2015 income (i.e., the 2015 income tax return).

Also consider that the financial aid formula requires a child to use 20% of his or her assets; parents are only required to use 5.64% of their assets. However, “protected assets,” such as funds in IRAs and Roth IRAs, do not factor into this computation.

Conclusion

For students and parents, now is the time to think about summer employment. Companies are filling their openings now and families should plan accordingly.



Executive Editor Sidney Kess is CPA-attorney, speaker and author of hundreds of tax books. The AICPA established the Sidney Kess Award for Excellence in Continuing Education in his honor, best-known for lecturing to over 700,000 practitioners on tax. Kess is senior consultant for Citrin Cooperman and is consulting editor to CCH.

Key Tax Laws by Birthday

  • Written by Sidney Kess, CPA, J.D., LL.M.

mug sid kessMany of the tax rules for individual taxpayers depend on age. Attaining a birthday may entitle an individual to a special tax break or end entitlement to another. Here is a rundown of key birthdays and what they mean for federal income taxes. It should be noted that some apply on the date of the birthday, some rules apply when the birthday is achieved as of the close of the taxable year, and some apply with respect to the half-year birthday.

Age 13

The dependent care credit can be claimed for a child who has not attained age 13 (Code Sec. 21(b)(1)(A)). This means that expenses up to this birthday can be taken into account for the year in which this birthday occurs.

Age, however, is disregarded if the child is a dependent who is physically or mentally incapable of self care (Code Sec. 21(b) (1)(B)).

Age 17

A tax credit of up to $1,000 can be claimed for a child under the age of 17 (Code Sec. 24(c)(1)). If they turn 17 during the year, no credit is allowed for that year; the credit is not prorated for this purpose. There is no age exception for a disabled child (Polsky, CA-3, USTC ¶ 50,506).

Age 18

A contribution of up to $2,000 can be made annually to a Coverdell Education Savings Account (ESA) until a child attains age 18 (Code Sec. 530(b)(1)(A)(ii)). However, a contribution can be made until the birthday. For example, if a child becomes 18 years old on May 1, 2017, a contribution of up to $2,000 can be made for 2017 until April 30, 2017. The contribution amount does not have to be prorated for the portion of the year in which the child was under age 18.

Ages 19 and 24

For purposes of treating a child as a qualifying child for the dependency exemption, these two birthdays come into play (Code Sec. 152(c)(1)(C)). A child can be a qualifying child if younger than the taxpayer claiming the exemption and is under age 19. A child can continue to be a qualifying child up to the age of 24 if he/she is a full-time student and younger than the taxpayer.

However, a parent may still claim a dependency exemption for a child who does not meet the definition of a qualifying child if the child can be treated as a qualifying relative (Code Sec. 152(d)). Thus, if a parent is supporting a child who is 32 years old in the parent’s home, a dependency exemption can be claimed as long as the child’s gross income is not more than a set amount ($4,050 in 2017) and other requirements are met.

Ages 19 and 24 are also key birthdays for the kiddie tax (Code Sec. 1(g)). Once this age is obtained, all of a child’s unearned income is taxed only at the child’s rates rather than the parent’s top tax rates.

Age 26

Under the Affordable Care Act, a child can remain on his/her parent’s insurance policy until the age of 26. This is so whether the child is a dependent or even lives with the parent. However, once the child attains age 26, this coverage is no longer permissible.

Age 30

When a beneficiary in a Coverdell ESA attains age 30, the account must be distributed to him or her within 30 days of this birthday (Code Sec. 530(b)(1)(E)). Even if there is no actual distribution, it is deemed to occur on this date. Earnings in the account become taxable at this time.

However, the deemed distribution rule does not apply if the beneficiary has special needs. Also a deemed distribution can be avoided by changing the beneficiary of the account to a “member of the family” (as defined in Code Sec. 529(e)(2), such as the beneficiary’s child, sibling.

Age 50

Individuals with compensation from a job or selfemployment can make a “catch-up” contribution to certain qualified retirement plans and IRAs (including Roth IRAs). These additional contributions are permitted to enable workers to maximize retirement savings. Despite the term “catch up” for those age 50 and older, there is no relationship to prior contributions or the absence of such contributions.

For 2017, the additional catch-up amounts (Notice 2016-62):

• 401(k), 403(b), and 457 plans: $6,000

• SIMPLE IRAs: $3,000

• IRAs and Roth IRAs: $1,000

Age 55

The 10% early distribution penalty on distributions from qualified retirement plans prior to age 59 ½ does not apply if distributions are made because of separation from service after age 55 (Code Sec. 72(t)(2)(A)(v)).

As in the case of retirement plans and IRAs, additional contributions based on age can be made to health savings accounts (HSAs) beginning at age 55. The additional contribution is $1,000. This amount is fixed by law; it is not indexed for inflation.

Age 59½

The 10% early distribution penalty on distributions from qualified retirement plans and IRAs does not apply after attaining age 59 ½ (Code Sec. 72(t)(2)(A)(i)).

Age 65

An individual who uses the standard deduction can claim an additional amount for age (Code Sec. 63(f)). For 2017, the additional standard deduction amount is $1,550 for singles and $1,250 for joint filers (for each spouse age 65 and older).This applies to someone who attains age 65 before the close of the taxable year. It also applies to anyone with a January 1 birthday; he or she is deemed to have reached age 65 in the previous year. For example, a person who attains age 65 on January 1, 2018, can claim the additional standard deduction on a 2017 income tax return.

This age also impacts the threshold for filing an income tax return (Code Sec. 6012(a)(1)(B)). More specifically, the gross income threshold is increased by the additional standard deduction amount.

Age 65 is also the age when distributions from HSAs can be taken penalty free for nonmedical expenses. However, these distributions are still subject to income tax.

Age 70½

Becoming 70½ years old bars any further contributions to an IRA (Code Sec. 219(d)(1)). No contribution is allowed if this age is attained by the end of the year. This contribution limit applies even though the individual continues to work. However, contributions to a SEP and a SIMPLE-IRA, which are IRA-based retirement plans, continue past this age, even though required minimum distributions simultaneously start at this time, explained next.

Attaining age 70½ triggers the required minimum distribution (RMD) rules for qualified retirement plans and IRAs. Owners of these accounts must begin their RMDs by the end of year in which this age is reached. For example, an individual’s 70th birthday is March 1, 2017. She reaches age 70½ in 2017, so her first RMD is due by December 31, 2017. If her birthday had been July 1, she would not attain age 70½ until 2018 and her first RMD would be due by December 31, 2018.

The failure to take an RMD can trigger a 50% penalty (Code Sec. 4974(a)). However, the RMD can be delayed in some circumstances:

• The first RMD is treated as timely if taken by April 1 following the year in which the taxpayer attains age 70½. In the earlier example, she would not have a penalty if her first RMD were taken by April 1, 2018. However, in any event, the second RMD is December 31, 2018.

• An individual who is still working for a company with a qualified plan may postpone RMDs until actual retirement if the plan permits it. However, this delay does not apply to anyone who is a more-than-5% owner of the company. And it does not apply to IRAs and IRA-based plans (e.g., SEPs, SIMPLE IRAs, and SARSEPs).

There are no lifetime RMDs for the owner of a Roth IRA.

Conclusion

Attorneys are used to working with tickler systems and calendars to ensure that key deadlines for certain actions are timely met. The same methods should be used to ensure that age-related tax rules are observed.


Executive Editor Sidney Kess is CPA-attorney, speaker and author of hundreds of tax books. The AICPA established the Sidney Kess Award for Excellence in Continuing Education in his honor, best-known for lecturing to over 700,000 practitioners on tax. Kess is senior consultant for Citrin Cooperman, consulting editor to CCH and Of Counsel to Kostelanetz & Fink.

Tax Issues of Long-Term Care

  • Written by Sidney Kess, CPA, J.D., LL.M.

kess sidneyLong-term care is different from medical treatment designed to cure a condition or illness. Long-term care is meant to address the needs of an individual who, because of a chronic condition, accident or other trauma, or illness, requires assistance with basic self-care tasks (called activities of daily living, or ADLs, such as dressing and bathing) or other necessary assistance (called instrumental activities of daily living, or IADLs, such as cooking and managing finances). Here are the tax issues related to long-term care.

Long-Term Care Insurance

Those who cannot easily afford to pay for long-term care out of their own resources may want to consider buying long-term care insurance. Generally, this type of coverage provides a fixed daily amount when the insured needs long-term care. The coverage may run for a set term (e.g., three years) or for the life of the insured.

For federal income tax purposes, premiums for long-term care insurance are treated as deductible medical expenses up to set dollar limits (Code Sec. 213(d)(10)). For 2017, the limits are (Rev. Proc. 2016-55, IRB 2016-45, 707):

• Age 40 and younger: $410

• Over age 40 but not over age 50: $770

• Over age 50 but not over age 60: $1,530

• Over age 60 but not over age 70: $4,090

• Over age 70: $5,110

These limits are per individual, so if both spouses are 72 years old and each has a policy, the dollar limit on their joint return for 2017 would be $10,220.

The deduction for itemized medical expenses is based on a percentage of adjusted gross income. For 2017, all taxpayers, including those age 65 and older, the threshold is 10% of adjusted gross income (Code Sec. 213(a)). Seniors had a 7.5%-of-AGI threshold that expired in 2016, but proposed legislation failed to extend this special rule.

Retired public safety officers who elect to pay long-term care premiums with tax-free distributions from their qualified retirement plans cannot deduct the premiums. This rule applies where the distributions are paid directly to the insurer but would otherwise be taxable if received by the officers.

Self-employed individuals, who can deduct their health insurance premiums as an adjustment to gross income rather than as an itemized deduction, can treat long-term care premiums in the same way (Code Sec. 162(l)). However, only amounts up to the age-related dollar limits can be deducted (Code Sec. 162(l)(2)(C)).

Combination policies. The Pension Protection Act of 2010 allows life insurance contracts and commercial annuities to be combined with long-term care coverage (hybrid policies), typically with a rider on a whole life insurance policy or an annuity (Code Sec. 7701B(e)). None of the premiums paid for hybrid policies are deductible if they are a charge against the cash surrender value of life insurance contracts or cash value of annuities (Code 7701B(e)(2)).

Employer-provided coverage. Employer payments of long-term care insurance premiums for employees, spouses, dependents, and employees’ children under age 27 by the end of the year are treated as a tax-free fringe benefit (Code Sec. 106). These premium payments, regardless of cost, are not subject to FICA taxes.

HSAs. Funds in health savings accounts (HSAs) can be used to pay for long-term care insurance (IRS Publication 969). These HSA distributions are tax-free to the extent of the age-based limitations discussed earlier.

FSAs. A medical flexible spending account (FSA) cannot be used to pay premiums on long-term care insurance (Code Sec. 125(f)). This is not an eligible expense of an FSA.

State income tax treatment. States may provide different treatment for the payment of long-term care insurance for state income tax purposes. For example, New York residents can claim a tax credit of 20% of the full amount of long-term care premiums. (https://www.tax.ny.gov/pit/credits/longterm_care_insurance_credit.htm).

Continuing Care Facilities

There is a spectrum of care provided in different living arrangements ranging from independent living, to assisted living, to skilled nursing care, to intensive nursing home care. The cost of living in a nursing home, which is used primarily for medical reasons, is a deductible medical expense to the extent the care is not covered by insurance or government program. No allocation is needed for medical services; all of the cost, including amounts for food and lodging, are deductible.

Those residing in continuing care facilities to receive long-term care assistance may also claim a deduction, but only for a portion of their costs. If this living arrangement is primarily for personal reasons and not primarily for medical care, only costs related to medical care are deductible. This can be based on the percentage of costs allocated to medical care (see e.g., Rev. Rul. 67-185, 1967-1 CB 70; Rev. Rul. 75-302, 1975-2 CB 86; Rev. Rul. 76-481, 1976-2 CB 82, and Baker, 122 TC 143 (2004)).

Proceeds From Long-Term Care Policies

When it is medically determined that the insured needs long-term care, the policy begins to pay off. If the policy pays a per diem amount without regard to the insured’s needs, only the portion up to a set dollar limit is tax-free. For 2017, this amount is $360 per day (Rev. Proc. 2016-55, IRB 2016-45, 707).

However, if the policy has a higher per diem amount, it can be tax-free to the extent of qualified long-term care services for a chronically ill individual. Qualified long-term care services are necessary diagnostic, preventive, therapeutic, curing, treating, mitigating, rehabilitative services, and maintenance and personal care services for a chronically ill individual under a plan of care prescribed by a health care practitioner. A chronically ill individual is a person who, within the previous 12 months, has been certified as being either of the following:

• Unable to perform at least two activities of daily living without substantial assistance for at least 90 days because of a loss of functional capacity. Activities of daily living are eating, toileting, transferring, bathing, dressing, and continence.

• Requires substantial supervision to be protected from threats to health and safety due to severe cognitive impairment.

Proceeds from life insurance policies. A policy may pay accelerated death benefits to the insured. Like proceeds payable on the death of the insured, proceeds payable to an insured who is chronically or terminally ill can be tax-free (Code Sec. 101(g)). Tax-free treatment applies to all proceeds payable on account of a terminal illness (i.e., one expected to result in death within 24 months with some exceptions). Tax-free treatment on account of chronic illness is limited to the amount described earlier for long-term care insurance proceeds.

Tax-free treatment also applies to the sale of a life insurance policy in a viatical settlement (Code Sec. 101(g)(2)).

Out-of-Pocket Costs For Long-Term Care

Even though long-term care is not medical treatment, the costs that are not covered by insurance which are for qualified long-term care services of a chronically ill individual (defined earlier) can be treated as a deductible medical expense (IRS Publication 502).

Conclusion

It has been projected that the number of individuals requiring paid long-term care services in 2050 is expected to be double the number in 2000. (https://aspe.hhs.gov/basic-report/future-supply-long-term-care-workers-relation-aging-baby-boom-generation). Understanding how tax rules fit into the financial picture of addressing long-term care can go a long way in paying for this personal need.

 


Executive Editor Sidney Kess is CPA-attorney, speaker and author of hundreds of tax books. The AICPA established the Sidney Kess Award for Excellence in Continuing Education in his honor, best-known for lecturing to over 700,000 practitioners on tax. Kess is Senior Consultant to Citrin Cooperman & Company and Counsel to Kostelanetz & Fink.