The Problem With LTC Riders In The Third Person

The Problem With LTC Riders In The Third Person

Climatologists can argue all day about which hurricane was the worst.  The fact of the matter is the “baddest” is the one that destroyed your home, the number of millibars notwithstanding.  And back in the old days they all were the baddest because you didn’t have any warning.

Nowadays, sophisticated stuff starts measuring a storm as soon as some breeze off North Africa throws a few straws into the wind, allowing homeowners in the “cone” to take proper measures, and all the ships at sea.

And so it is with tax laws, the worst is the one that costs you – made worse by the fact that you didn’t see it coming.

And both may be true depending on how you structure third-person ownership of a life insurance policy with a chronic illness or LTC rider.

The most common planning question involves estate taxation

Insureds want to keep the death benefits out of their taxable estate, but still want access to the rider benefits should the need arise.  Policies with indemnity-type riders are commonly put in irrevocable trusts with the understanding that care costs can be paid out-of-pocket by the insured to reduce the taxable estate.  If the cash payments under the rider are needed by the insured, the trust can provide for loans to the insured.

Reimbursement-type riders present a problem

Because expenses are paid directly to the care provider the trustee is bound by the terms of the policy to benefit the creditors of the grantor/insured.  This could constitute either an incident-of-ownership in the policy or a retained interest in the trust, either of which would have the effect of pulling death benefits back into the taxable estate.

But there may be another tax problem lurking in the weeds for trust-owned life policies, even those with indemnity-type riders, and this time it is an income tax issue.  IRC 101 is the section allowing for income tax-free receipt of proceeds from a policy by reason of death.

Regarding treatment of accelerated death benefits subsection (g)(1)(B) says:

For purposes of this section, the following amounts shall be treated as an amount paid by reason of the death of an insured . . . Any amount received under a life insurance contract on the life of an insured who is a chronically ill individual.

But then the Code goes on to say in subsection (g)(3)(A):

In the case of an insured who is a chronically ill individual . . . [tax-free treatment as an accelerated death benefit] shall not apply to any payment received for any period unless— such payment is for costs incurred by the payee [the person getting paid the benefit, i.e. the policy owner] for qualified long-term care services provided for the insured for such period.

This raises the possibility that benefits paid to a third-party policyowner will not get income tax-free treatment under the rider because the third-party owner (the payee) did not incur the medical costs resulting in the claim.  Material on the topic warns, “. . . there is no specific guidance from the Internal Revenue Service as to the tax effects of such third-party ownership . . . there is the risk that such ownership structure could cause adverse income, estate and/or gift tax consequences.”

The responsibility of the insurance advisor is clear

When helping a client implement third-party ownership of a life policy with an LTC or chronic illness rider the client must be pressed to get the advice of a tax advisor.

To sow the wind by not doing so it to risk eventually reaping the whirlwind.  For help in addressing this concern with you client, contact your LTC Sales & Marketing Manager.