Copyright 1996 by A/N Group, Inc. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is distributed with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional should be sought. The information is not necessarily a complete summary of all materials on the subject.--ISSN 1089-1536
Note. This bill was signed into law on August 20, 1996 and, while the focus of the Act was to provide health insurance coverage for employees who switch jobs, the Act contains a number of tax provisions. Keep in mind that we're only discussing the highlights.
This provision held up the bill for some time. It introduces a controversial medical savings account (MSA) that will be available on a test basis during a 4-year period from 1997 to 2000 to only 750,000 taxpayers who have a high-deductible insurance policy. The rules are complex and there are a number of restrictions. The discussion below is general in nature. If you think you may be eligible and you meet the requirements, check with your tax advisor.
Concept. An MSA is similar to an IRA. Contributions to an MSA by an individual are deductible (within limits); contributions by an employer on behalf of an employee are excludable from the employee's income. Contributions are made to a trust or custodial account. Distributions from an MSA for medical expenses are not taxable. Earnings on MSAs are not currently taxable.
Eligible individuals. MSAs are available to employees covered under an employer sponsored high deductible plan of a small employer (generally, no more than 50 employees during the test period) and self-employed individuals. An employee must be covered under an employer-sponsored high deductible plan and under no other plan (an exception is made for certain permitted insurance).
Contributions. Contributions can be made by either an employer or employee, but not both. The maximum annual contribution is 65% of the deductible under a high deductible plan in the case of individual coverage and 75% for family coverage. The annual contribution limit is the sum of the limits determined separately for each month. Contributions can be made until April 15th. Employers are required to report MSA contributions.
For self-employed individuals, contributions are limited to the income earned from the business. For an employee, contributions can't exceed the compensation earned from the employer.
If an employer makes MSA contributions for full-time employees covered under one type of plan, it must make comparable contributions for employees covered under another high deductible plan. However, no contributions are required for part-time employees. Failure to comply with the comparability rule can results in a 35% excise tax.
Definition of high deductible plan. A high deductible plan is a health plan with an annual deductible of at least $1,500 and no more than $2,250 for individual coverage and at least $3,000 and no more than $4,500 in the case of family coverage. In addition, the maximum out-of-pocket expenses (including the deductible) must be no more than $3,000 for individual and no more than $5,500 for family coverage. These amounts are indexed for inflation after 1998.
Example--Fred Flood is self-employed and has family coverage for all of 1997 with a plan that has a $4,500 deductible. Fred can contribute $3,375 (75% of the $4,500 deductible amount) for the year to his MSA.
Comment--Remember, if your plan doesn't meet the strict high deductible requirements, or you have a supplementary plan, you can't set up an MSA. On the other hand, you won't fail to meet the test if your other coverage is an accident, disability, dental care, or similar type of plan, or covers a specific disease or illness or provides fixed per diem coverage for hospital stays.Taxation of distributions. Distributions for medical expenses for an individual, spouse or children are excludable from income. Medical expenses are those that would qualify as an itemized deduction. Thus, a distribution for a routine medical exam would be excludable, but cosmetic surgery generally wouldn't. Distributions that don't qualify would be subject to a 15% additional tax unless made after age 65, death, or disability.
Tax Tip--Like an IRA, there is a 60-day rollover period. Thus, you can take the funds out of one account and, if you deposit them in another within 60 days, it's not considered a distribution and no taxes or penalties are due.
Tax Tip--Even healthy individuals will benefit from an MSA. Contributions to the account are deductible and earnings are not taxed. Thus, if the amounts in the MSA are not used for medical expenses, they function like an IRA. Amounts withdrawn after age 65 escape the 15% penalty. And, chances are, you'll be in a lower bracket when you retire. Thus, some of the tax savings will be permanent.
Comment--An MSA is better than a flexible spending account (FSA), where any benefits not used during the year are lost.
Tax Tip--Married participants in an MSA should always name their spouse as beneficiary. That will enable the surviving spouse to continue the MSA for himself or herself. Otherwise the MSA ceases and is included in the decedent's estate.
Caution--Insurance companies will have to tailor policies to the definition of a high-deductible plan. You should evaluate your situation carefully. A high-deductible plan coupled with an MSA may be attractive for some individuals, but it's not for everyone.
Tax Tip--If you're considering an MSA, how quickly you act could be decisive. The total number of MSAs are limited to 750,000. The IRS will limit the number through a complicated set of rules, but basically it's first come, first served. For the first test, if the number of MSAs exceeds 375,000 by the April 30, 1997 reporting date, the IRS will announce a halt to the program. The IRS can reopen the program later if the actual limit of 750,000 hasn't been reached.
While subject to several restrictions, self-employed individuals are currently entitled to deduct 30% of amounts paid for health insurance for themselves and their dependents. The new law raises that amount to 40% in 1997; 45% for years 1998 through 2002; to 50% in 2003; 60% in 2004; 70% in 2005; and to 80% in 2006 and subsequent years. In addition, the law provides that certain arrangements having the effect of accident or health insurance are excludable from income. This provision is effect for years beginning after 1996.
In general. Prior law did not provide explicit rules relating to the tax treatment of long-term care insurance policies. This is another complex law change.
There are two important provisions. First, a long-term care insurance contract generally is treated as an accident and health insurance contract. Amounts (other than dividends) received under the policy are excludable from income, subject to a cap of $175 per day, or $63,875 annually, on per diem contracts only. If the total amount of periodic payments under all policies exceeds the dollar cap, then the excess is excludable only to the extent of the individual's costs that are not otherwise reimbursed. The dollar amounts are indexed for inflation.
Caution--A plan paid for by an employer receives the same treatment unless it is provided through a cafeteria plan. Similarly, expenses for long-term care services cannot be reimbursed under an FSA (flexible spending account).Second, long-term care insurance premiums that do not exceed a dollar limit are deductible as medical expenses. The limit is based on the age of the taxpayer at the end of the year. For those age 40 or under the premium limitation is $200; for those more than 40 but not more than age 50 it's $375; more than 50 but not more than 60 it's $750; more than 60 but not more than 70 it's $2,000; for those over 70 it's $2,500.
The premiums on long-term care policies qualify as deductible insurance premiums by self-employed individuals.
Example--Fred Flood, age 55, buys a long-term health care policy. It provides for nursing home coverage or round-the-clock care in his home in the event he becomes disabled and requires constant supervision. The contract costs $800 per year. The first $750 of coverage is deductible on his personal return as a medical expense.
Example--Susan Sharp is 62, self-employed and pays $1,000 for a long-term care policy in 1997. She can deduct $400 (40%) toward her adjusted gross income (AGI) on the front of her return. The remaining $600 can be deducted as a medical expense on Schedule A (itemized deductions) subject to the 7.5% floor.Definition of long-term care insurance. A long-term care insurance contract is defined as any insurance contract that provides only coverage of qualified long-term care services and that meets other requirements. The other requirements are that:
Comment--State law usually governs the type of contract that is sold in a state. Some states will probably have to make conforming changes to their laws to meet the requirements here.Definition of long-term care services. Qualified long-term care services include diagnostic, preventive, therapeutic, curing, treating, mitigating and rehabilitative services, and maintenance or personal care services that are required by a chronically ill individual. A chronically ill individual is one who has been certified within the previous 12 months by a licensed health care practitioner as (1) being unable to perform at least 2 activities of daily living for at least 90 days, (2) having a similar level of disability, or (3) requiring substantial supervision to protect such individual from threats to health and safety due to severe cognitive impairment. Activities of daily living are eating, toileting, transferring, bathing, dressing and continence.
Long-term care riders on life insurance. In the case of long-term care insurance coverage provided by a rider on or as part of a life insurance contract, the requirements applicable to long-term care insurance contracts apply as if the portion of the contract providing such coverage were a separate contract.
Tax Tip--A special provision in the Act allows taxpayers to exchange one long-term care contract for another without having to recognize gain or loss in order to qualify under the new rules. The exchange must be done before January 1, 1998. The transaction can be partially taxable if, in addition to a different insurance policy, you receive money or other property.Policy requirements. The contracts must meet certain requirements of the long-term care insurance model act. In addition, if the policy is a level-premium one, the insurer must offer the policy owner a nonforfeiture benefit in the even of a default. The benefit may be extended term insurance, a reduced paid-up policy, or a shortened benefit period.
Some of the requirements that must be satisfied include the right to return the policy and deny the application, monthly reports on accelerated death benefits, the incontestability period, standards for marketing (including inaccurate completion of medical histories and misrepresentations in selling the contract, appropriateness of recommended purchase, standard outline of coverage, and a shopper's guide.
Caution--Even though the cost may be deductible, get good advice when investigating these policies. The new law may spur more insurers to offer them. The increased competition could lower prices and make them more attractive. However, it is also sure to encourage insurers with less than the best financial ratings to issue policies and is also likely to generate contracts of questionable value.This provision is effective for taxable years beginning after December 31, 1996.
The new law provides an exclusion from gross income amounts paid by reason of the death of an insured for (1) amounts received under a life insurance contract and (2) amounts received for the sale or assignment of a contract to a qualified viatical settlement provider, provided that the insured is either terminally or chronically ill. The exclusion for amounts received under a life insurance contract on the life of an insured who is chronically ill applies if the amount is received under a rider or other provision of the contract that is treated as a long-term care insurance contract and the amount is excludable for long-term care services up to a cap of $175 per day or $63,875 annually (to be indexed for inflation).
Comment--Before the Act was signed, the tax treatment of benefits received under a life insurance policy before the insured died was not uncertain. The new law makes it clear that a terminally ill individual can receive certain payments from the insurance company, or sell his policy, and avoid income taxes on the transaction.A terminally ill person is one who has been certified by a physician as suffering from a condition that is reasonably expected to result in death within 24 months.
The rules for a chronically ill person are slightly different. Amounts received are excludable in the same way that payments are excludable under a long-term care contract. Thus, amounts for medical expenses that are not reimbursed by insurance are excludable or payments of up to $175 per day can be excluded from income.
A chronically ill individual is one who has been certified within the previous 12 months by a licensed health care practitioner as (1) being unable to perform at least 2 activities of daily living for at least 90 days, (2) having a similar level of disability, or (3) requiring substantial supervision to protect such individual from threats to health and safety due to severe cognitive impairment. Activities of daily living are eating, toileting, transferring, bathing, dressing and continence.
Example--Fred Flood is chronically ill and receives $18,000 in life insurance proceeds that qualify under the rules above. His long-term health care expenses for the year are $22,000, of which $10,000 is reimbursed by insurance. Of the $18,000 received from his life insurance policy, he can exclude only $12,000 ($22,000 in health care expenses less $10,000 reimbursed by insurance). He must include the remaining $6,000 from his life insurance policy ($18,000 received less $12,000 excludable) in his income.
Comment--The exclusion doesn't apply if the amounts are paid to any party other than the insured if that party's insurable interest arises because the insured is an employee, stockholder, etc. in a business. For example, Madison Inc. owns a life insurance policy on Fred Flood, a 25% stockholder. Accelerated life insurance payments made to Madison are not excludable from Madison's income.
If you withdraw money from an employer-sponsored plan (e.g., a profit-sharing plan) for medical expenses, you're not subject to the usual 10% penalty tax on early withdrawals (before age 59-1/2) from qualified plans. Until now that rule didn't apply to IRAs.
The new law extends that exception to IRAs. The exception generally applies to medical expenses in excess of 7.5% of AGI. The 7.5% of AGI floor rule doesn't apply to medical insurance premiums if the individual has received unemployment compensation for at least 12 weeks. Even a self-employed person can be treated as unemployed if he or she would have received unemployment compensation if they worked for an employer. The second exception doesn't apply if the individual has been reemployed for at least 60 days.
Example--During 1997 you have deductible medical expenses of $10,000. Your AGI is $80,000; 7.5% of that is $6,000. You take $5,000 out of your IRA to pay medical expenses. Of the amount withdrawn, $4,000 ($10,000 less $6,000) is not subject to the 10% early withdrawal penalty; $1,000 is.
Example--During 1997 your business closes and you're out of work for 6 months. Your only medical expenses are $3,000 for insurance premiums. Under the second exception you can withdraw $3,000 penalty-free from your IRA whether or not your medical expenses exceed 7.5% of your AGI.Amounts withdrawn are subject to the regular income tax.
Effective for taxable years beginning after December 31, 1996.
The general rule has been that, with certain limitations, no federal income tax is imposed on a policyholder with respect to earnings under a life insurance contract. The policyholder can borrow on the contract (often at favorable rates) without affecting these exclusions. Some years ago Congress disallowed interest deductions on borrowings on life insurance policies owned by a taxpayer covering the life of any individual who is an officer or employee of, or financially interested in the trade or business of the taxpayer if the total debt exceeds $50,000. Additional interest deduction limitations are imposed on single premium contracts and where the taxpayer is directly or indirectly a beneficiary under the contract.
Some businesses have taken advantage of the benefits by purchasing life insurance on many of their employees, even those not in the ranks of management.
Under the new law, no deduction is allowed for interest on indebtedness associated with life insurance policies or annuity or endowment contracts owned by a taxpayer covering an individual who is an officer or employee financially interested in the business. An exception is provided on debt with respect to life insurance policies covering up to 20 key persons. The number of individuals that can be treated as key persons cannot exceed the greater of 5 individuals or the lesser of 5% of the total number of officers and employees or 20 individuals.
Example--Madison has 90 employees. Applying the 5% would result in 4.5 employees. But the rules allow the greater of 5 individuals or the lesser of 5% or 20 individuals. Thus, Madison can have a maximum of 5 policies.A special provision allows a company to end the arrangements and spread any income received from the terminations over a 4- year period.
The provision applies to interest paid or accrued after October 13, 1995. A special transition rule applies to existing debt. Check with your tax advisor.
Under the new law, group health plans are subject to certain requirements regarding portability, limitations on preexisting condition exclusion, prohibitions on excluding individuals from coverage based on health status, and guaranteed renewability of health insurance coverage. These requirements are incorporated into the tax law by imposing a tax on any failure of a group health plan to comply with the requirements. The tax is imposed on the employer sponsoring the plan.
The requirements do not apply to plans which on the first day of the plan year cover less than 2 current employees. An additional exception is made for a small employer (defined as one who employed an average of 50 or fewer employees during the preceding calendar year) that provides health care benefits through a contract with an insurer or HMO and the violation is solely because of the coverage offered by the insurer or HMO.
The amount of the tax is $100 per day for each day a failure occurs or until the failure is corrected. The tax applies separately to each individual affected by the failure. The maximum penalty for unintentional failures is generally the lesser of 10% of the amount paid for coverage or $500,000. The tax can be waived in all or part if it would be excessive relative to the failure involved. There is a minimum tax of $2,500 for even a de minimis failure if the failure is not corrected until after the taxpayer is notified of an income tax audit.
The rules discussed above apply to the penalty for noncompliance. The health care rules are involved, and important for any business with two or more employees. Some of the more important provisions under the Act include:
On the other hand, plans are not required to provide any specific level of coverage. Thus, they can exclude certain procedures or restrict benefits as long as they are not discriminatory amongst employees.
The rules don't apply to plans covering less than two employees and don't apply to accident, disability or other types of supplemental insurance. They also don't apply to dental or vision plans, long-term care insurance, etc. if the benefits are provided by way of a separate policy.
Comment--Coverage for preexisting conditions is tricky. If you have continuous health-care coverage, only medical conditions treated within 6 months can be excluded. However, if you've had a break in coverage of 63 days or more, preexisting conditions treated within the last 12 months (18 months in some cases) can be excluded. You should be very careful to avoid any break in coverage.The coverage availability rules apply to plan years beginning after June 30, 1997.
The new law expands, and substantially strengthens in several ways, the provisions that subject U.S. citizens who lose their citizenship for tax avoidance purposes to special tax rules for 10 years after the loss of citizenship. The new law extends the expatriation tax provisions to apply not only to U.S. citizens who lose their citizenship, but also to certain long- term residents of the U.S. whose residency is terminated. A long-term resident is any individual who was a lawful permanent resident of the U.S. for at least eight out of the 15 taxable years ending with the termination. U.S. residence is terminated when an individual either loses his green-card status or is treated as a resident of another country.
Second, the law subjects certain individuals to the expatriation tax provisions without inquiry as to their motive for losing their U.S. citizenship or residency, but allows certain categories of citizens to show an absence of tax- avoidance motives if they request a ruling from the Secretary of the Treasury as to whether the loss of citizenship had a principal purpose of tax avoidance.
Third, the law expands the categories of income and gains that are treated as U.S. source (and therefore subject to U.S. income tax under Sec. 877) if earned by an individual who is subject to the expatriation tax provisions and provisions designed to eliminate the ability to engage in certain transactions that under prior law partially or completely circumvent the 10-year reach of Sec. 877.
The law also contains provisions to enhance compliance with the expatriation tax provisions. It imposes information reporting obligations on U.S. citizens who lose their citizenship and long-term residents whose U.S. residency is terminated at the time of expatriation. The IRS is authorized to issue regulations to treat removal of tangible personal property from the U.S. and other circumstances that result in a conversion of U.S. source income to foreign source income without recognition of any unrealized gain, as exchanges for purposes of computing gain subject to Sec. 877. For example, if you try take appreciated artwork out of the U.S., you could be subject to immediate tax on the appreciation.
Finally, a citizen who loses citizenship is required to provide a statement to the State Department (or other designated government entity) which includes certain information. In the case of individuals with a net worth of at least $500,000, a balance sheet is required. A similar statement would be required from a long-term resident whose residence is terminated. Failure to provide the statement results in the imposition of a penalty for each year the failure continues equal to the greater of (1) 5% of the individual's expatriation tax liability for the year, or (2) $1,000.
A complete discussion of this provision is beyond the scope of this article. Check with your tax advisor if the rules apply to you. The provisions generally apply to any individual who loses U.S. citizenship, and any long-term residents whose U.S. residency is terminated, on or after February 6, 1995.