Income Tax Planning for Clients Living With Chronic Illness and Disability

Income Tax Planning for Clients Living With Chronic Illness and Disability

By: Martin M. Shenkman, CPA, MBA, JD

Introduction to Income Tax Planning for Chronic Illness and Disability The Numbers

  • Disability is quite common, and affects a significant number of clients. The impact of income tax planning on clients living with health issues is significant. Too often, planning is reactive (e.g., can the expense be deducted as a medical expense) rather than proactive (what can be done to minimize income or enhance the tax benefits of deductions). The objective of this article is to demonstrate the considerable number of clients that might benefit from this type of planning, and then to provide an eclectic overview of income tax planning issues to help practitioners understand the scope of planning opportunities and how they can proactively use those opportunities to help what is likely a much greater portion of their client base than realized.
  • Consider some of the statistics concerning health issues for Americans age 65 and older:1. The following “statistics” are not presented with citations or references. They are merely data identified on the internet extracted from articles on long term care insurance. While these might have a bias or be inaccurate, and whether or not they should be relied upon to help a client with projections or evaluating the pros and cons of long term care coverage, they suffice to demonstrate that a substantial number of clients are impacted, and income tax planning for these issues should be an important focus of any tax practice. Comments are also provided to help encourage anyone reading the “statistics” to be cautious of the context and touchstones used. 2. The average stay in a nursing home is more than 2.5 years. Exercise some caution in extrapolating from the term “average”, in that the small percentage of people with disabling chronic illnesses that don’t impact mortality may have a skewing impact on the “average” figure quoted. 3. 43% of Americans 65+ need nursing home care. While this percentage seems staggering, it is only for the 65+ age bracket, and there is no indication of the number of days such that even a week in a facility would trigger inclusion. Nevertheless, a significant number of senior clients are impacted. It should also be understood that a substantial number of clients under 65, whether or not requiring nursing care, face a myriad of health related issues that have tax impact. That is discussed below. 4. 25% of those 65+ in age will spend more than a year in a nursing home. This quoted statistic isn’t quite clear either. Is it referring to 25% of the 43% or 25% of the population age 65+. 5. 9% will spend more than five years in a nursing home. This quoted statistic isn’t quite clear either. Is it referring to 25% of the 43% or 25% of the population age 65+.
  • Apart from the data on older Americans, which most people would presume to have included a meaningful impact on health issues and nursing home care, the real surprise for many is the pervasive impact of health issues and disabilities across the entire population base, including many younger people. Consider the following: 1. 51.2 million Americans reported having a disability. While, again, this figure is staggering, and might appear to many to overstate the impact, consider the context of this article. Even if the disabilities for many of these millions are not severe enough to impact the daily living of the person affected in a visible or significant manner, they are still likely to create planning issues, expenditures that warrant tax planning, etc. With the focus of this article on income tax planning, this statistic confirms that there are a substantial portion of taxpayers who should consider the income tax planning issues involved.2. 13-16% of American families have a child with special needs. 3. 15 out of every 1,000 children born in the U.S. have Autism.
  • Overall, estimates show that 120 million Americans are living with chronic illness. Don’t underestimate or ignore the tremendous impact on a large portion of your client base. Every income tax return for these taxpayers will have to consider medical expense deductions and a range of other income tax planning issues.
Myriad of Tax Consequences. i. Income tax planning for chronic illness and health issues certainly includes the determination of whether a particular expenditure qualifies as a medical expense deduction. But even this commonly expected issue is tremendously broad and complex, as will be demonstrated by the analysis presented below. ii. But the issues are far more extensive. Taxation of settlements, life insurance viatical settlements, home improvements, and more are all impacted. Being Retained.
  • Most engagements will be fairly straightforward tax return engagements and may be no more than merely determining whether a particular expenditure is deductible and how it should be reported.
  • However, planning for clients with significant health issues requires far greater involvement and planning. Effective income tax planning for a client with a chronic illness or disability requires much more.
  • Depending on the chronic illness or other health issue involved, cognitive impairment may currently affect the client, or may in the future as the disease advances. Practitioners need to address this and other potential developments from a number of perspectives.
  • What should an adviser do when he/she becomes aware of cognitive impairment before the family does? What if the family is not involved with the client? What is the proper way to approach the family on behalf of the client who is becoming impaired? Practitioners should proceed with caution and deference because the client himself or herself may not perceive the cognitive decline, or even if he or she does, discussing the matter even with them may evoke a response of anger.
  • Do you have the authority to speak to other family members? It is advisable to address these issues as early on in the relationship as possible. If there is a current, or a potential cognitive impact, or a sufficiently significant physical impact that the tax adviser will have to assist the client/taxpayer through, other arrangements should be made in advance to address this. Practitioners will have to start with the client to receive authorization. Even if you have authority, starting with the client is vital. Approach the topic very delicately and with as much poise as you can muster. If you’re uncomfortable, bear in mind that if you don’t take the lead, no one else may have. And if no one steps up to the plate, the consequences to the client and his or her family or loved ones could be catastrophic. So even if you don’t handle it perfectly, handling it is the most important. If the client is receptive, you can obtain input from the client, or get a HIPAA release to speak with the client’s medical advisers (neurologist, psychiatrist, etc.) to obtain a better understanding of the current status and likely course of the cognitive impairment. Then you can begin planning. Bear in mind that cognitive decline can proceed in a myriad of ways. It may affect certain spheres and not others, it can vary by time of day or medication status. Cognitive impact may maintain the status quo for a long period, or sharp decline may ensue. There are no rules of thumb and each case is different.
  • The real answer, and the best answer for all clients, is to have this type of discussion long before the event occurs. When planning is properly handled the accountant, estate planning attorney, financial adviser and other professional advisers all communicate (whether by conference call to minimize costs or actual meeting if the client will tolerate the billing). These types of issues should be addressed proactively. In this manner not only will you have the authority to speak but the issue will have been addressed so that the family has planned for it. This is analogous to a family taking the prudent step of a fire drill in their home so all the family members know the way out and where to meet if an emergency does occur.
  • Documents to address cognitive and other current or future impairments. 1. Engagement letter.a. Consider including in your engagement letter an express authorization by the client for you to communicate any matters concerning their financial and tax information to persons the client authorizes. b. Address how future engagement letters can be approved if the client is unable to do so. c. Consider listing steps that you are authorized to take if the client requires assistance. d. Be certain to comply with any ethical or other issues in this provision. 2. Durable power of attorney. a. The client should have a durable power of attorney. Durable assures it will remain legally valid in the event that the client is disabled. b. A sample clause can be found at c. The persons named in the durable power of attorney should ideally have some communication with the accountant before they are required to act. d. Be wary of standard forms. Be sure to review the power of attorney with the client’s attorney to be certain that it contains the authorizations and provisions that you need to assist the client in the manner the client wishes if greater disability occurs. This might include express authorization for the agent to execute IRS powers of attorney, make tax elections, approve engagement letters, etc. e. Any authority to make gifts should be carefully crafted to facilitate achieving the client’s unique goals. If the client is of more modest wealth the gift provision might permit the transfer of the entire estate if it facilitates planning to protect assets from medical and nursing home costs. If the client is of substantial means the power might include broad authority to make gifts, even of the lifetime exemption amount. For extremely wealthy clients the provision might extend to other provisions that broadly authorize the agent to engage in a wide array of estate tax minimization steps. 3. Revocable living trust. a. This can be the most comprehensive and significant document to protect a client with a worsening chronic illness or disability. b. Consider the provisions above concerning powers.
  • Apart from the general issues of who can sign an engagement letter and how broad it should be, clients with significant health issues incurring a large cash outflow for medical expenses, may be reluctant to pay for hourly accounting, financial planning, and legal services. How can and should professionals charge? Do many professionals charge a flat fee for their services?
  • As with most clients with or without health issues, the entire spectrum for fee tolerance is likely spanned. There are clients living with chronic illness that, obviously from loss of jobs due to their health issues, perhaps loss of health coverage, or maybe a spouse leaving as a result of the illness, etc., face substantial financial hardship. For these people, free services provided through the many disease organizations are perhaps the only option.
  • Another category of clients living with chronic illness are those with not only adequate means to pay regular hourly fees, but if they knew practitioners could help them deal with their specific issues, they would want to incur the fees to obtain the useful expertise. This is a much larger category of clients than most practitioners realize exists. Some of the more complex planning discussed in the materials provided for the webinar, and posted on website are designed to help practitioners deal with these clients. Hopefully by alerting practitioners to the tremendous scope of chronic illness planning issues, more of these clients will be identified and better served.
  • The middle category is the most difficult to address. Many people struggling with chronic illness have resources, but those resources are very limited, and they, by necessity, have to be very fee conscious. For these clients a fixed fee they can budget for may be the only manner in which they can or will proceed with planning.
Dependents; Exemptions; Filing Status. Dependency Exemption.
  • Disabled child. 1. A dependency exemption may be claimed for a qualifying child. There are six tests that must be met for a child to be a qualifying child:a. Relationship. b. Age. i. Under age 19 at the end of the year and younger than you (or your spouse if filing jointly). ii. A full-time student under age 24 at the end of the year and younger than you (or your spouse if filing jointly). iii. Permanently and totally disabled at any time during the year, regardless of age. c. Residency. d. Support. e. Joint return. f. Special test for qualifying child of more than one person. 2. Your child is permanently and totally disabled if both of the following apply. a. He or she cannot engage in any substantial gainful activity because of a physical or mental condition. b. A doctor determines the condition has lasted or can be expected to last continuously for at least a year or can lead to death.
  • Parent or other Relative. 1. A taxpayer can claim a dependency exemption for a “Qualifying Relative.” There are four tests all of which must be met for a person to be a qualifying relative:a. Not a qualifying child test. b. Member of household or relationship test. The following people/relationships do not have to live with you to qualify: i. Your child, stepchild, foster child, or a descendant of any of them (for example, your grandchild). (A legally adopted child is considered your child.) ii. Your brother, sister, half brother, half sister, stepbrother, or stepsister. iii. Your father, mother, grandparent, or other direct ancestor, but not foster parent. iv. Your stepfather or stepmother. v. A son or daughter of your brother or sister. vi. A brother or sister of your father or mother. vii. Your son-in-law, daughter-in-law, father-in-law, mother-in-law, brother-in-law, or sister-in-law. c. Gross income test. The qualifying relative's gross income for the year must be less than $3,650. For purposes of this test (the gross income test), the gross income of an individual who is permanently and totally disabled at any time during the year does not include income for services the individual performs at a sheltered workshop. The availability of medical care at the workshop must be the main reason for the individual's presence there. Also, the income must come solely from activities at the workshop that are incident to this medical care. d. Support test. i. To meet this test, you generally must provide more than half of a person's total support during the calendar year. ii. If you make a lump-sum advance payment to a home for the aged to take care of your relative for life and the payment is based on that person's life expectancy, the amount of support you provide each year is the lump-sum payment divided by the relative's life expectancy. iii. The amount of support you provide also includes any other amounts you provided during the year. If you provide a person with lodging, you are considered to provide support equal to the fair rental value of the room, apartment, house, or other shelter in which the person lives. Fair rental value includes a reasonable allowance for the use of furniture and appliances, and for heat and other utilities that are provided. 2. A common application of the above rules is for a taxpayer to claim an elderly or infirm parent as an exemption. Often the parent or other loved one is confined to a nursing home. Since your parent is related to you in the manners noted above, your parent can qualify as your dependent even though your parent doesn't live with you, provided the support and other tests are adhered to. Amounts you pay for qualified long-term care services required by your parent and eligible long-term care insurance premiums, as well as amounts you pay to the nursing home for your parent's medical care, are included in the total support you provide. If you alone don’t provide a sufficient percentage of your parent (or the other qualified relative’s support) the support test may be met by a group (e.g., you and your siblings combining to support your parent). A multiple support form can be filed to grant one of you the exemption, subject to certain conditions.
Dependent Medical Expenses.
  • You can generally include in medical expenses you endeavor to deduct for income tax purposes the costs you pay for yourself, as well as those you pay for someone who was your spouse or your dependent. These costs may be deductible either when the services were provided or when you paid for them.
  • You may be able to deduct medical expenses you paid for your dependent. This requires that the person must have been your dependent either at the time the medical services were provided, or at the time you paid the expenses. A person generally qualifies as your dependent for purposes of the medical expense deduction if both of the following requirements are met: (1) The person was a qualifying child or a qualifying relative; and (2) The person was a U.S. citizen or national or a resident of the United States, Canada, or Mexico. The term “qualifying relative” is defined above.
  • If you are considered to have provided more than half of a qualifying relative's support under a multiple support agreement, you can include medical expenses you pay for that person. A multiple support agreement is used when two or more people provide more than half of a person's support, but no one alone provides more than half.
  • Again, a common application of this rule is to permit a taxpayer to endeavor to deduct medical expenses paid for a parent as part of their deductible medical expenses.
  • If your parent does not qualify as your dependent solely because they have more gross income than permitted to be a dependent, or because they file a joint return, you can still include these medical costs with your own.
Filing status.
  • Head-of-household filing status.    1. If you are not married, but you are entitled to claim a dependency exemption for a qualifying relative, such as your parent, you may qualify for the more favorable head-of-household filing status.2. To be eligible, you must have paid more than half the cost of maintaining a home for yourself and the qualifying relative for more than one-half of the tax year. 3. You may be eligible to file as head of household even if the parent for whom you claim an exemption doesn't live with you. Thus, if your parent is confined to a nursing home, you may qualify if you meet the other requirements.
IRA and Retirement Plan Considerations. Hardship Waivers Generally.
  • General rule: Any amount distributed out of an IRA shall be included in gross income by the distributee in the manner provided under section 72 of the Code, unless an exception is provided. IRC Sec. 408(d).
  • Rollover exception: If the entire amount received (including money and any other property) is paid into an IRA or qualified retirement plan for the benefit of such individual not later than the 60th day after the day on which the individual receives the payment or distribution, income is not recognized. IRC Sec. 408(d)(3). A similar rule is provided for partial rollovers. IRC Sec. 408(d)(3)(D).
  • Hardship Exceptions for Rollover: What if the taxpayer that took a distribution was unable to complete the distribution for reason beyond the taxpayer’s control? The IRS may waive the 60 day requirement under Code Sections 408(d)(3)(A) and 408(d)(3)(D) if the failure to waive the 60 day requirement would be against equity or good conscience, including casualty, disaster, or other events beyond the reasonable control of the individual subject to such requirement. IRC Sec. 408(d)(3)(I). In determining whether to waive the 60 day rollover requirement the IRS will consider all of the relevant facts and circumstances, including: (1) errors committed by a financial institution; (2) inability to complete a rollover due to death, disability, hospitalization, incarceration, restrictions imposed by a foreign country or postal error; (3) the use of the amount distributed (for example, in the case of payment by check, whether the check was cashed); and (4) the time elapsed since the distribution occurred.
  • In many instances, health issues faced by clients with chronic illness or disabilities may support the waiver of the 60 day period.
PLR 201025084.
  • The taxpayer failed to meet the 60 day rollover requirement for an IRA and endeavored to have the requirement waived because of a medical issue. The IRS held that the information and documentation submitted by the taxpayer supported her assertion that her failure to accomplish a timely rollover was caused by her medical condition, which impaired her ability to handle her financial affairs.
  • The taxpayer suffered from a worsening medical condition that causes her to experience problems with her memory and impaired her ability to handle her financial affairs. The Form 1099-R issued to the taxpayer reflected that the amount was distributed due to disability. Five days prior to the taxpayer withdrawal from her IRA the taxpayer mother-in-law was diagnosed with a life-threatening disease. Five days after the taxpayer deposited the funds withdrawn from her IRA into a non-IRA certificate of deposit, the taxpayer mother-in-law unexpectedly died. As a result of her own medical condition and the disruption to her family caused by the illness, hospitalization and sudden death of her mother-in-law during the 60-day rollover period, the taxpayer did not inform her husband of the withdrawal and he remained unaware until he was notified by a tax preparer months after the 60-day rollover period had expired.
PLR 201022025.
  • The taxpayer withdrew funds from an IRA intending to roll them over, but did not meet the 60 day requirement. A hardship exception to the 60 day requirement was sought.
  • The son of the taxpayer petitioned the Court to declare the taxpayer incapacitated and in need of a guardian. The Court found the taxpayer to be an incapacitated person, and a Commission of Guardians was issued naming a guardian of the property of the taxpayer. The Court also appointed a geriatric care manager that was also a registered nurse. The taxpayer's medical records indicated that the taxpayer had been suffering from diminished cognitive ability dating back for a significant period. The taxpayer had been diagnosed as having dementia and other progressive illnesses which contributed to her cognitive decline over the past years. The records established that the taxpayer was unable to understand the implications of a withdrawal from a qualified account and the tax ramifications of such a transaction.
  • The IRS held that the taxpayer failure to complete a timely rollover of the amount distributed from her IRA was due to her mental incapacity. Evidence submitted documented that the taxpayer lacked the capacity to understand the ramifications of her actions. Furthermore, shortly after the taxpayer withdrew the amount from her IRA she was placed under the supervision of a court appointed guardian. The guardianship supports the proposition that the taxpayer did not comprehend the nature of her action when she accomplished the withdrawal from her IRA. The IRS granted the taxpayer’s guardian a period, not to exceed 60 days as measured from the date of this ruling letter, to contribute, by means of a rollover contribution the amounts involved into one or more traditional IRAs set up and maintained in the name of the taxpayer.
Employment and Business. Introduction.
  • There are a number of disparate income tax provisions that affect businesses, employers, employees and the self-employed that are affected by disability and chronic illness. The following discussion provides a review of some of them.
Impairment Related Work Expenses.
  • Impairment related work expenses of an employee who has a physical or mental disability limiting their employment, may be deductible business expenses in connection with their work income. The expenses that qualify must be “necessary” for the taxpayer to work.
  • These costs are deducted as business expenses instead of as medical expenses which avoids the 7.5% (increasing to 10%) limitation that might otherwise prevent the taxpayer from obtaining an income tax deduction. The increase of the 7.5% reduction to 10% makes planning to characterize costs as impairment related work expenses even more important to enable you to obtain a benefit from the expenditures.
  • They are claimed on Form 2106 for an employee, “Unreimbursed Employee Business Expenses”. Enter on Schedule A (Form 1040), line 28, that part of the amount on Form 2106, line 10, or Form 2106-EZ, line 6, that is related to your impairment. Enter the amount that is unrelated to your impairment on Schedule A (Form 1040), line 21. These are deducted on Form 1040 if you are self-employed, on the appropriate form (Schedule C, C-EZ, E, or F) used to report your business income and expenses. IRC Sec. 67(b)(6).
  • If your chronic illness, disability or other health issue, has progressed to the point that you need to incur extra business expenses (“impairment related expenses”) to perform your work satisfactorily, those costs may be deducted as business expenses instead of as medical expenses.
  • While most employee business expenses are reduced by 2% of your adjusted gross income (“AGI”), similar to the reduction for 7.5%/10% of AGI for medical expenses, impairment related business expenses are not.
  • Example: In order to continue working, you purchase a scooter and hire a part time assistant to move equipment for you because of the progression of your fatigue resulting from Multiple Sclerosis. These costs should be fully deductible under this special rule. Your deduction will not be subject to the 7.5%/10% medical limitation because it would be treated as business expenses. It is not subject to the 2% general limitation on business expenses because it is an “impairment related expense”.
  • To qualify for an impairment-related work expense, you must be disabled as a result of a physical or mental disability (for example, blindness or deafness) that functionally limits your being employed, or a physical or mental impairment (for example, a sight or hearing impairment) that substantially limits one or more of your major life activities, such as performing manual tasks, walking, speaking, breathing, learning, or working.
  • Impairment-related expenses are defined as ordinary and necessary business expenses that are necessary for you to do your work satisfactorily. Qualified expenses do not include the payment for goods and services that are required or used, other than incidentally, in your personal activities.
  • Example. You are living with a significant vision impairment and are legally blind. You must use a reader to perform your work. You use the reader both during your regular working hours at your place of work and outside your regular working hours away from your place of work. The reader's services are only for your work. You can deduct your expenses for the reader as business expenses.
Home Based Business.
  • Planning for a home based business can be more important for you if you are living with a chronic illness or disability. The modifications you may have already made to your home may enable you to work in some controlled, comfortable and safe manner longer or more easily than at employment outside of your home. The creation and operation of a home based business raises a host of tax issues, most of which are common to any home based business.
  • Tax considerations or steps might include: 1. Tax Identification Number.2. Estimated tax payments. If you are not an employee subject to payroll withholding taxes, you may be obligated to pay quarterly estimates. Failing to do so can trigger interest and penalties on the underpayment. 3. Sales tax. If you’re selling a product, and in some cases a service, your local tax authorities may require that you collect and remit sales taxes. 4. If you hire employees you may have payroll related taxes to pay to federal, state and local authorities.
  • Home businesses can provide valuable tax benefits in term of enabling you to deduct some of the cost of maintaining the portion of your home in which the business is located. To qualify the same requirements for any home office must be adhered to: 1. The space in your house must be used exclusively for business. If your business is a daycare business, this rule is relaxed. Also, if you use the area for storage of inventory and your home is the only business location, some leniency is provided.2. The space in your house must be used regularly for business. Regular use means you use that area on a continuing basis, occasional use won’t suffice. 3. It must be your principal place of business. If you have more than one location the relative importance of activities performed at each location is considered. Also the time spent at each location should be considered. Alternatively, it must be used as a place to meet or deal with clients and customers in the normal course of your business. 4. If the space is separate from your residence (e.g., a garage you converted to an office or business warehouse) it must be used in connection with your business.
Classification of Workers in Sheltered Workshops.
  • Special rules are provided for the proper classification of workers in sheltered workshops that are more lenient than the general rules, and may permit charitable and other sheltered workshop employers to treat qualifying workers as independent contractors instead of employees.
  • Revenue Ruling 65-165 discusses the treatment of such workers in each of the following categories: 1. Individuals in training in a rehabilitation program are designed to prepare them for placement in private industry. The intent of the training, which averages 16 weeks in length, is to accustom the individual to industrial working conditions. These individuals are not employees of the workshop for federal employment tax purposes while they are being trained.2. Regular workshop employees who have completed training and are capable of performing one or more jobs in the sheltered workshop temporarily if awaiting placement in private industry or permanently if unable to compete in regular industry. These individuals are paid by the workshop that provides working conditions and pay scales comparable to those in private industry, fixes working hours and production schedules so an employment relationship is intended. The trained workers in the workshop are employees for federal employment tax purposes. 3. Individuals working at home that are incapable of working in the workshop that are able to produce salable articles and may sell them wherever they please. These individuals are not considered employees, as no employer-employee relationship exists under the usual common law rules.
  • Programs that are indefinite in duration and in lieu of full time employment are more likely to result in the worker being characterized as an employee for federal tax purposes than a program that is of finite duration, especially if the objective is training.
  • Rev. Rul. 65-165, 1965-1 CB 446. See also: IRS Letter Ruling 9801003 ; IRS Letter Ruling 9804023 ; IRS Letter Ruling 9804024.
Work Opportunity Credit.
  • The Work Opportunity Credit (Work Opportunity Tax Credit, or “WOTC”) provides eligible employers with a tax credit up to 40 percent of the first $6,000 of first-year wages of a new employee if the employee is part of a “targeted group.”
  • An employee with a disability is one of the targeted groups for the Work Opportunity Credit, provided the appropriate government agencies have certified the employee as disabled. These are qualified SSI recipients. IRC Sec. 51(d).
  • Generally, you must request and be issued a certification for each employee from the state employment security agency (SESA). The certification proves that the employee is a member of a targeted group. You must receive the certification by the day the individual begins work or completes Form 8850, Pre-Screening Notice and Certification Request for the Work Opportunity Credit, on or before the day you offer the individual a job.
  • The credit is available to the employer once the employee has worked for at least 120 hours or 90 days. Employers claim the credit on Form 5884, Work Opportunity Credit.
  • Special Work Opportunity Credit rules apply for veterans with a service-related disability. The first-year wages taken into account for qualified veterans with disabilities who were hired after May 25, 2007 is increased to $12,000.
  • See Form 5584.
Barrier Removal.
  • Taxpayers may elect to treat qualified architectural and transportation barrier removal expenditures as a deduction. These are expenditures incurred to make a facility or public transportation vehicle owned or leased by the taxpayer used in connection with his trade or business more accessible to, and usable by, handicapped and elderly individuals. IRC Sec. 190.
  • The Architectural Barrier Removal Tax Deduction encourages businesses of any size to remove architectural and transportation barriers to the mobility of persons with disabilities and the elderly. Businesses may claim a deduction of up to $15,000 a year for qualified expenses for items that normally must be capitalized. Businesses claim the deduction by listing it as a separate expense on their income tax return.
  • A business may claim the Disabled Tax Credit (“DAC” under Code Sec. 44, discussed below) and the architectural/transportation tax deduction together in the same tax year, if the expenses meet the requirements of both sections. To use both, the deduction is equal to the difference between the total expenditures and the amount of the credit claimed.
ADA Compliance Expenses Credit (“DAC”).
  • An eligible small business may elect to take a tax credit on expenditures to comply with the Americans with Disabilities Act of 1990 (“ADA”). This includes: removing architectural, communication, physical, or transportation barriers which prevent a business from being accessible to, or usable by, individuals with disabilities, to acquire or modify equipment or devices for individuals with disabilities, etc. The amount of the disabled access credit is equal to 50 percent of the eligible access expenditures that exceed $250 but do not exceed $10,250. IRC Sec. 44.
  • The Disabled Access Credit (“DAC”) provides a non-refundable credit for small businesses that incur expenditures for the purpose of providing access to persons with disabilities. An eligible small business is one that earned $1 million or less or had no more than 30 full time employees in the previous year; they may take the credit each year they incur access expenditures. See: Form 8826, Disabled Access Credit.
  • The DAC is different from the deduction for expenditures to remove architectural barriers provided in IRC Sec. 190.iv. IRC Sec. 44 Expenditures to provide access to disabled individuals:(a) General rule. For purposes of section 38 , in the case of an eligible small business, the amount of the disabled access credit determined under this section for any taxable year shall be an amount equal to 50 percent of so much of the eligible access expenditures for the taxable year as exceed $250 but do not exceed $10,250. (b) Eligible small business. For purposes of this section , the term “eligible small business” means any person if— (1) either— (A) the gross receipts of such person for the preceding taxable year did not exceed $1,000,000, or (B) in the case of a person to which subparagraph (A) does not apply, such person employed not more than 30 full-time employees during the preceding taxable year, and (2) such person elects the application of this section for the taxable year. For purposes of paragraph (1)(B) , an employee shall be considered full-time if such employee is employed at least 30 hours per week for 20 or more calendar weeks in the taxable year. (c) Eligible access expenditures. For purposes of this section — (1) In general. The term “eligible access expenditures” means amounts paid or incurred by an eligible small business for the purpose of enabling such eligible small business to comply with applicable requirements under the Americans With Disabilities Act of 1990 (as in effect on the date of the enactment of this section ). (2) Certain expenditures included. The term “eligible access expenditures” includes amounts paid or incurred— (A) for the purpose of removing architectural, communication, physical, or transportation barriers which prevent a business from being accessible to, or usable by, individuals with disabilities, (B) to provide qualified interpreters or other effective methods of making aurally delivered materials available to individuals with hearing impairments, (C) to provide qualified readers, taped texts, and other effective methods of making visually delivered materials available to individuals with visual impairments, (D) to acquire or modify equipment or devices for individuals with disabilities, or (E) to provide other similar services, modifications, materials, or equipment. (3) Expenditures must be reasonable. Amounts paid or incurred for the purposes described in paragraph (2) shall include only expenditures which are reasonable and shall not include expenditures which are unnecessary to accomplish such purposes. (4) Expenses in connection with new construction are not eligible. The term “eligible access expenditures” shall not include amounts described in paragraph (2)(A), which are paid or incurred in connection with any facility first placed in service after the date of the enactment of this section . (5) Expenditures must meet standards. The term “eligible access expenditures” shall not include any amount unless the taxpayer establishes, to the satisfaction of the Secretary, that the resulting removal of any barrier (or the provision of any services, modifications, materials, or equipment) meets the standards promulgated by the Secretary with the concurrence of the Architectural and Transportation Barriers Compliance Board and set forth in regulations prescribed by the Secretary. (d) Definition of disability; special rules. For purposes of this section — (1) Disability. The term “disability” has the same meaning as when used in the Americans With Disabilities Act of 1990 (as in effect on the date of the enactment of this section). (2) Controlled groups. (A) In general. All members of the same controlled group of corporations (within the meaning of section 52(a) ) and all persons under common control (within the meaning of section 52(b) ) shall be treated as one person for purposes of this section . (B) Dollar limitation. The Secretary shall apportion the dollar limitation under subsection (a) among the members of any group described in subparagraph (A) in such manner as the Secretary shall by regulations prescribe. (3) Partnerships and S corporations. In the case of a partnership, the limitation under subsection (a) shall apply with respect to the partnership and each partner. A similar rule shall apply in the case of an S corporation and its shareholders. (4) Short years. The Secretary shall prescribe such adjustments as may be appropriate for purposes of paragraph (1) of subsection (b) if the preceding taxable year is a taxable year of less than 12 months. (5) Gross receipts. Gross receipts for any taxable year shall be reduced by returns and allowances made during such year. (6) Treatment of predecessors. The reference to any person in paragraph (1) of subsection (b) shall be treated as including a reference to any predecessor. (7) Denial of double benefit. In the case of the amount of the credit determined under this section — (A) no deduction or credit shall be allowed for such amount under any other provision of this chapter, and (B) no increase in the adjusted basis of any property shall result from such amount. (e) Regulations. The Secretary shall prescribe regulations necessary to carry out the purposes of this section.
Group Long Term Care Coverage.
  • An employer may opt to provide employees with a group long term care insurance program. This can provide coverage for such costs as physical and occupational therapy, home health care, nursing care, etc. Group coverage may enable employees who would otherwise not be entitled to coverage to obtain benefits. It may also provide better coverage and/or lower costs than individual polices.
  • To qualify for income tax benefits, a group plan must be funded with long term care insurance and meet the requirements contained in Code Section 7702B(b). These include not providing a cash surrender value and generally requiring that refunds be applied to reduce premiums.
  • Long term care coverage is not a permissible benefit under a cafeteria plan, but the costs may be reimbursed from a Health Savings Account (“HSA”). IRC Sec. 125(f).
  • Plans may be structured in many different ways but often either reimburse qualified costs or pay a daily stipend if the insured’s ability to perform a specified number of the activities of daily living (“ADL”).
  • The Code establishes requirements for qualified long-term care insurance contracts and issuers of those contracts. Code Sections 7702B and 4980C. Section 7702B(b)(1)(A) requires a qualified long-term care insurance contract to provide insurance protection only for “qualified long-term care services”. These are defined as necessary diagnostic, preventive, 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 health care practitioner. IRC Sec. 7702B(c)(1).
  • The definition of “chronically ill” is important because under the long-term care provisions added to the Internal Revenue Code in 1996, certain payments received on account of a chronically ill individual from a qualified long-term care insurance contract are excluded from income. IRS Notice 97-31, 1997-1 CB 417, 5/06/1997. (The same criteria are used to determine whether expenditures qualify as deductible medical expenses).
  • The Code defines “chronically ill” for purpose of long term care coverage. IRC Section 7702B(c)(2)(A). A “chronically ill individual” as any individual who has been certified by a licensed health care practitioner as meeting any one of the following three requirements: 1. Being unable to perform without substantial assistance from another individual at least two out of six activities of daily living listed in section 7702B(c)(2)(B) (ADLs) for a period of at least 90 days due to a loss of functional capacity (the ADL Trigger). The individual must be unable to perform (without substantial assistance from another individual) at least two ADLs for a period of at least 90 days due to a loss of functional capacity.2. Having a level of disability similar to the level of disability described in the ADL Trigger as determined under regulations prescribed by the Secretary of the Treasury in consultation with the Secretary of Health and Human Services (the Similar Level Trigger). 3. Requiring substantial supervision to protect the individual from threats to health and safety due to severe cognitive impairment (the Cognitive Impairment Trigger).
  • The six activities of daily living (ADLs) listed in section 7702B(c)(2)(B) are eating, toileting, transferring, bathing, dressing, and continence. An insurance contract is not a qualified long-term care insurance contract unless it takes into account at least five of these six activities in determining whether an individual is a chronically ill individual. IRC Section 7702B(c)(2)(B).
  • The level of incapacity required by these provisions is quite severe and a taxpayer can struggle with substantial disability and difficulty without meeting this stringent test.
  • If instead of meeting the above test, a taxpayer meets a cognitive impairment trigger test, they will be treated as "chronically ill” for purposes of determining whether long term care benefits can be excluded from income, etc. For purposes of the Cognitive Impairment Trigger, taxpayers may rely on either or both of the following safe-harbor definitions to qualify (i.e., without meeting the two of six ADL requirement above for physical conditions): 1. “Severe cognitive impairment” means a loss or deterioration in intellectual capacity that is (a) comparable to (and includes) Alzheimer's disease and similar forms of irreversible dementia, and (b) measured by clinical evidence and standardized tests that reliably measure impairment in the individual's (i) short-term or long-term memory, (ii) orientation as to people, places, or time, and (iii) deductive or abstract reasoning.2. “Substantial supervision” means continual supervision (which may include cuing by verbal prompting, gestures, or other demonstrations) by another person that is necessary to protect the severely cognitively impaired individual from threats to his or her health or safety (such as may result from wandering). 3. Under the Cognitive Impairment Trigger, unlike the ADL Trigger, a qualified long-term care insurance contract is not required to take any ADL into account for purposes of determining whether an individual is a chronically ill individual. 4. The magnitude of disability required to comply with this “trigger” is quite severe and a taxpayer may struggle with rather substantial limitations without meeting this threshold.
  • Code Sections 7702B and 4980C were added by sections 321 and 326 of the Health Insurance Portability and Accountability Act of 1996 (Pub. L. 104-191, 110 Stat. 1936, 2054 and 110 Stat. at 2065)(HIPAA).
Overhead and Business Interruption Insurance Affected by Tax Concepts.
  • If you have a business overhead policy it should protect you if you cannot work full time. These policies are sold to help cover your fixed costs, like rent, utilities, property insurance and other general or business overhead costs. You may have to prove partial or total disability to collect on them. You also have to corroborate the expenses you are incurring. Often these are geared to expenses that are deductible for federal income tax purposes.
  • The definitions and calculations may differ from those under your disability insurance income replacement policy. Again, the concepts are likely to be technical and the paperwork substantial. If you are totally disabled and close down your practice or business the coverage may prove ephemeral.
  • Try to be consistent, within the parameters of the varying definitions, with what you report to your business overhead insurer, disability company, the IRS, credit and mortgage applications, etc. Consistency, unfortunately, is probably impossible given the different definitions and purposes of the financial and tax reporting you might be involved in. The confusion can be substantial and differences may have to be reconciled.
Home Ownership Considerations. Home Sale Exclusion.
  • The general home sale exclusion rules are modified to provide flexibility in the event of illness.
  • If you become physically or mentally incapable of self-care, and you own and use a particular property as your principal residence during the 5-year period, for periods aggregating at least one year, then you will be treated as if you had used the property as your principal residence during any time during the 5-year period in which you owned the property and resided in any licensed facility (including a nursing home) to care for someone in your condition. IRC Sec. 121 (d) (7).
  • The time period is extended up to ten years for qualifying military services, Foreign Services members, or employees of an intelligence community. Code Sec. 121 (d) (9) (A).
Reverse mortgage. i. It is often desirable for an elderly person to remain in his or her own home with proper in-home care rather than entering a nursing home. A reverse mortgage loan may make this a feasible alternative to a nursing home. Many states permit a reverse mortgage loan, which is designed to permit elderly persons with limited income to remain in their homes by borrowing against the value of their homes. Typically, a bank commits itself to a principal amount based on the appraised value of the property, which is loaned to the borrower in installments over a period of months or years. The monthly installments can be used to help pay for the upkeep of the home and for in-home care. Repayment of the loan is due when the principal amount has been fully paid to the borrower, or the residence that secures the loan is sold, or the borrower dies or ceases to use the home as his principal residence. The loan agreement may provide that interest will be added to the outstanding loan balance monthly as it accrues. However, interest isn't deductible by the borrower at that time. Interest isn't deductible until it is actually paid.
  • The tax consequences of a reverse mortgage will depend on the exact legal nature of the transaction. The transaction could be structured as a loan, so that there would be no tax consequences to your client on the receipt of monthly or other payments. Alternatively, the transaction could appear to be an installment sale. If this were the case, a portion of each payment received by your client would be taxable as capital gains on the sale of the house. Interest expense is deductible by the borrower when it is actually paid by the borrower. Actual or constructive payment does not occur when the interest is added to your client’s outstanding loan balance. See Rev. Rul. 80-248, 1980-2 CB 164.
Disability Payments as Income. Taxation of Disability Payments Generally.
  • IRC. Sec. 104 Compensation for injuries or sickness. (a) In general. Except in the case of amounts attributable to (and not in excess of) deductions allowed under section 213 (relating to medical, etc., expenses) for any prior taxable year, gross income does not include—(1) amounts received under workmen's compensation acts as compensation for personal injuries or sickness; (2) the amount of any damages (other than punitive damages) received (whether by suit or agreement and whether as lump sums or as periodic payments) on account of personal physical injuries or physical sickness; (3) amounts received through accident or health insurance (or through an arrangement having the effect of accident or health insurance) for personal injuries or sickness (other than amounts received by an employee, to the extent such amounts (A) are attributable to contributions by the employer which were not includable in the gross income of the employee, or (B) are paid by the employer); (4) amounts received as a pension, annuity, or similar allowance for personal injuries or sickness resulting from active service in the armed forces of any country or in the Coast and Geodetic Survey or the Public Health Service, or as a disability annuity payable under the provisions of section 808 of the Foreign Service Act of 1980; and (5) amounts received by an individual as disability income attributable to injuries incurred as a direct result of a terroristic or military action (as defined in section 692(c)(2) ).
  • Payments you receive as qualifying workers' compensation should be excluded from gross income. There are a number of special rules and exceptions: 1. If the compensation offsets previously deducted medical expenses it will be taxable (i.e., to wash against the prior deduction).2. The injury or illness for which you receive the compensation must be job or occupation related. 3. The state statute under which payment to you is made must restrict the benefits paid under that law to injuries or sickness related to the recipient’s job. 4. IRC Sec. 104(a)(1); Treas. Reg. Sec. 1.104-1(b).
  • Rev. Rul. 81-47 provides a good overview of the law affecting taxation of disability payments. 1. The issue was whether the payments made to a disabled police officer were excludable from gross income pursuant to IRC Section 104(a)(1)?2. IRC Section 61(a) and the Regulations thereunder provide that, except as otherwise provided by law, gross income means all income from whatever source derived, including compensation for services. 3. IRC Section 104(a)(1) provides, with certain exceptions gross income does not include amounts received under workmen's compensation acts as compensation for personal injuries or sickness. 4. Treas. Reg. Section 1.104-1(b) provides that section 104(a)(1) of the Code excludes from gross income amounts received by an employee under a workmen's compensation act, or under a statute in the nature of a workmen's compensation act, that provides compensation to the employee for personal injuries or sickness incurred in the course of employment. 5. The disability benefits in this Ruling were authorized by a collective bargaining agreement that provided benefits to a class restricted to employees with service-incurred disabilities. These benefits are thus payments for those disabilities. Therefore, the collective bargaining agreement that was incorporated by reference into the county code of and qualifies as a statute “in the nature of a workmen's compensation act”. Compare Rev. Rul. 72-291, 1972-1 C.B. 36; Rev. Rul. 72-44, 1972-1 C.B. 31.
  • In contrast to the above Ruling, in Rev Rul 83-77, 1983-1 CB 37, the IRS held that disability payments to a police officer were not excluded because the underlying collective bargaining agreement required payments whether or not the injuries or disability occurred in the line of duty.
Disability payments to firefighter under union's contract with city weren't excludable
  • In John T. Bayse, TC Summary Opinion 2010-118, the Tax Court held that payments made by a city to a firefighter injured in the line of duty had to be included in his gross income. The payments involved were made under a collective bargaining agreement. They were not made under a workmen's compensation act as compensation for personal injuries or sickness which would have been excludable from income under Code Sec. 104(a)(1).
  • There is a two part test under the Regulations. Specifically, Treas. Reg. Section 1.104-1(b) provides that IRC Section 104(a)(1) excludes from gross income: 1. Amounts received by an employee under a workmen's compensation act, or under a statute in the nature of a workmen's compensation act [the latter part of this test is analyzed in the Bayse case].2. That provides compensation to the employee for personal injuries or sickness incurred in the course of employment.
  • The taxpayer worked as a firefighter for the city of Cleveland, Ohio. He was injured in the line of duty and was considered to have suffered a “hazardous duty injury.” The taxpayer was placed on hazardous duty injury status and was paid pursuant to the terms of a collective bargaining agreement between Cleveland and the union, Cleveland Fire Fighters, Local 93. Under the terms of the collective bargaining agreement, he eventually applied for and was granted a disability retirement pension.
  • The IRS determined that the disability payments received from the City of Cleveland were includable in gross income. This determination was based on the fact that the payments were not received under a workmen's compensation act as compensation for personal injuries or sickness as required under Code Sec. 104(a)(1).
  • The Tax Court concurred with this conclusion. The Court’s reasoning was that the collective bargaining agreement entered into between the City of Cleveland and the union was a labor contract which did not rise to the force and effect of law. See the language in the Regulations under IRC Sec. 104 that require “…or under a statute in the nature of a workmen's compensation act.” If the collective bargaining agreement had been incorporated by reference into the municipal code by legislative act it would have met the requirements of Code Sec. 104(a)(1). Mere approval of the agreement by the mayor or the city council does not suffice to meet the requirements of IRC Sec. 104.
  • Although the collective bargaining agreement was ratified by the Cleveland City council this did not suffice to characterize the collective bargaining agreement as legislation because it remained modifiable under its own terms, and the State of Ohio was not shown to have had a statute that required the collective bargaining agreement be incorporated into the Cleveland City Code.
Veteran’s Disability Income.
  • Gross Income may exclude certain disability-related payments such as Veterans Administration disability benefits, and Supplemental Security income. Gross income does not include amounts received, on account of personal physical injuries or physical sickness. IRC Sec. 104(a)(1); PLR 200318051. This includes: 1. Payments Under workmen's compensation acts as compensation.2. Damages received, other than punitive damages which are taxable, whether obtained as a result of a lawsuit or settlement agreement, and whether as lump sums or as periodic payments. 3. Amounts received through accident or health insurance.
Disability Insurance Tax Considerations. Taxation of Disability Insurance Company Payments.
  • Identify and address all aspects of disability planning. This is often more diverse and complex than clients realize.
  • Advise the client as to the tax status of insurance paid for personally, versus insurance paid for from a business. If the premiums for disability insurance are paid personally, or if paid by the employer they are included in the taxpayer/insured’s income, then the proceeds are not taxable. If the premiums were paid by the employer and not taxed to the employee then the benefits paid are taxable.
Tax Concepts Embodied in Disability Insurance Claims.
  • Determining whether disability payments of any nature are taxable or not is only one component of income tax planning considerations of disability payments a taxpayer may receive. The actual determination of the amount of those payments is often intertwined with many tax definitions and concepts. Parsing through private disability income replacement, buy out or even other insurance policies is often based on application of tax law concepts. Policies often have a mixture of tax and policy definitions making this a complex and difficult process. The discussion below introduces the application of income tax concepts to disability insurance policy interpretation and analysis.
  • Your policy is the key document. You must read and understand the policy. Even when tax terms are used, sometimes they may be defined in the body of the policy so that tax definitions of common tax terms are irrelevant. In other instances, tax law is expressly cited. Sometimes, the policy is silent as to the definition of a key term or income/expense concept and tax law may only be used informally in an effort to try to explain an unclear term. In these situations, the tax law definitions are not binding, only presented as a possible interpretation. In some instances, the disability insurance company may apply tax concepts (even erroneously) if they believe it minimizes potential payments to the insured/claimant and then these applications have to be reviewed in light of the policy terms and tax law.
  • "Residual" disability is a partial disability payment based on your reduced work hours. When there is a partial disability the likelihood of tax analysis is greater because the earnings or income of the taxpayer will have to be analyzed to determine what amount should be paid under the policy if anything. This contrasts to a situation of total disability for which the terms of the policy would likely provide for payment of the full benefit with perhaps no concern over income or expense calculations.
  • Residual or partial disability may be defined very differently from one policy to the next, so be certain that you understand what your policy says.
  • If you have your own business the determination of your earnings is not as simple as comparing pay checks, presenting a K-1, etc. You don't want to misinterpret the provisions of the policy. Even if you're an employee and receive different types of compensation (e.g., deferred compensation, stock options, etc.) it might be unclear how each of these items are treated under the policy. You should evaluate and interpret each of these items.
  • What expenses may be used to offset business income or wages if you are an employee? How does the policy define expenses? If you have significant employee business expenses are they deducted from your wages in full or only to the extent you obtained an income tax benefit (e.g., after reduction for 2% floor, etc.)? What if you don’t itemize. Will this affect the offset under the terms of the policy? What if you itemize in some years and not others? Can you proactively plan how you pay expenses, and how you report on your income tax return to have a positive impact on the payments under your disability policy while staying within the legal parameters of the policy? This may affect your base earnings under the policy (which could lower the amount on which payments are based, or lessen the decline in earnings under a residual income calculation). These may affect your post disability earnings as well. The impact may be difficult to estimate without actual calculations.
  • If the policy mandates that tax calculations or definitions be used (which is common), but then applies those concepts and definitions to a time period based on your disability (e.g. earnings the 60 months prior to disability), how can you allocate tax deductions and earnings that span two partial tax years (i.e., when the policy tax definitions have to be applied to calendar periods that are not congruent with calendar year income tax reporting)?
  • If pre-disability period earnings have to be evaluated, how should an NOL from a closely held business or professional practice be treated? What will the impact be of a larger payout of a dividend from a closely held corporation?
  • You should maintain a log from the first disability incident. Keep track of every possibly relevant event concerning your health/disability status, your employment/work situation, and your claim. These may have considerable importance to the time frames set forth in the policy and the calculations that would have to be made
  • Review the policy and identify any key dates by when you have to file a claim, dates for calculations (do they follow calendar year, policy year or from the time of becoming disabled). With a chronic illness the dates at which certain events or situations occur can be much less clear than for example, for a work site injury that occurred on a specific date.
  • The definitions of “disability” and “income”, etc. will often be different under disability income replacement policies, business overhead interruption insurance, disability buyout insurance and employment or shareholder agreements. Review all contractual arrangements that apply to the client and endeavor to develop a consistent, yet accurate set of calculations for each. Consistency may be impossible because of the differing definitions. If that is the case, document and explain the differences between each calculation to avoid creating an impression of taking inconsistent positions to simply advantage yourself.
Disability Buyout Insurance.
  • In contrast to disability income insurance which is used to replace earnings if you are disabled, many closely held business owners use disability buy out insurance to repurchase shares of a disabled partner.
  • The disability buyout insurance premiums paid for this coverage are not deductible regardless of whether they are paid by the entity (e.g., pursuant to an equity redemption agreement) or directly by the owners (e.g., a cross-purchase agreement).
  • Payments made under a disability buy out policy do not appear to be subject to income tax under the general IRC Sec. 104(a) provisions. Rev. Rul. 66-262.
  • A C corporation that owns the policy and receives the proceeds of a disability buyout redemption policy will have to increase the corporation’s ACE adjustment, and this may adversely affect its AMT liability.
Taxation of ADA and Other Suit Settlements or Awards. Taxable versus Non-taxable Proceeds.
  • The determination of the tax consequences of a settlement or award generally depends on the nature of the underlying claim. For example, the language used in a release given as part of a settlement can affect the tax result.
  • The following items are generally included in taxable ordinary income: 1.Interest on any award.2.Compensation for lost wages or lost profits in most cases. 3.Punitive damages, in most cases. It does not matter if they relate to a physical injury or physical sickness. 4.Amounts received in settlement of pension rights. 5.Damages for: a. Patent or copyright infringement. b.Breach of contract. c. Interference with business operations. 6.Back pay and damages for emotional distress received to satisfy a claim under Title VII of the Civil Rights Act of 1964. 7.Attorney fees and costs (including contingent fees) where the underlying recovery is included in gross income.
  • Where a lump sum settlement is negotiated out-of-court, the division of the settlement as to the various types of payments being received can be crucial. The tax laws generally treat all income from whatever source derived as taxable. Thus, unless there is a specific statutory exclusion, or court created doctrine under which the settlement to be received by the Plaintiff receives can be excluded, the proceeds will be taxable. i. A settlement received on account of a personal injury is generally not included in gross income, other than punitive damages. IRC Sec. 104(a)(2). This result will be available whether or not the amounts are received by suit or settlement agreement, and whether or not received in a lump sum or as periodic payments by individuals on account of personal physical injuries (including death) or physical sickness. A fundamental concept of this exclusion provision had been that the excluded damages must derive from some type of tort claim against the person paying the claim. This requirement, however, was expressly relaxed in REG-127270-06 (14 September 2009) IRS Prop. Regs. on Damages Received on Account of Personal Physical Injuries or Physical Sickness published 9/15/09. The proposed regulations expressly delete the requirement that to qualify for exclusion from gross income, damages received from a legal suit, action, or settlement agreement must be based upon "tort or tort type rights." The proposed regulations affect taxpayers receiving damages on account of personal physical injuries or physical sickness and taxpayers paying these damages.ii. In the Schleier case, the court found that the awards were taxable. The taxpayer received a settlement award for back pay and liquidated damages under the Age Discrimination in Employment Act. These amounts were not excludable from income because neither back pay nor liquidated damages were awarded “on account of” personal injury. No personal injury or sickness affected the award's amount. Also, Congress intended ADEA's liquidated damages to be punitive, not compensatory. Finally, the taxpayer's ADEA claim wasn't “based on tort or tort-type rights and the taxpayer did not satisfy independent requirement that damages be on account of personal injury or sickness. Comm. v. Schleier, 75 AFTR 2d 95-2675 (115 S CT 2159, 515 US 323), 6/14/1995. The September 2009 proposed regulations ), state that the Schleier Court interpreted the statutory "on account of" test as excluding only damages directly linked to "personal" injuries or sickness. The proposed regulations also note that the 1996 Act restricted the exclusion to damages for "personal physical" injuries or "physical sickness." iii. Amounts received through accident or health insurance for personal injuries are excluded from income. However, amounts which were deducted as a medical expense in a prior year are taxable when received in a later year. Amounts received by an employee attributable to insurance purchased by the employer are taxable when received by the employee. iv. Generally, amounts received as a result of a tort or tort-type right are not taxable. The IRS has allowed the exclusion of a recovery where the amount of injury is measured by lost wages. Rev. Rul. 85-97, 1985-2 C.B. 50. v. The proposed regulations state that IRC section 104(a)(2) exclusion does not depend on the scope of remedies available under state or common law. In effect, the proposed regulations reverse the result in the Burke Case by allowing the exclusion for damages awarded under no-fault statutes. iv. Emotional distress itself is not a physical injury or physical sickness, but damages received for emotional distress due to a physical injury or sickness are treated as received for the physical injury or sickness and are not included in income. See IRS Publication 525. If the emotional distress is due to a personal injury that is not due to a physical injury or sickness (for example, unlawful discrimination or injury to reputation), amounts received as damages are included in taxable income, except for any damages received for medical care due to that emotional distress. Emotional distress includes physical symptoms that result from emotional distress, such as headaches, insomnia, and stomach disorders. v. Amounts recovered for the infliction of emotional distress were not taxable under prior law. Fono v. Comr., 79 T.C. 680 (1982). Taxation of recoveries for injuries to reputation may depend on whether the reputation injured was business or personal. Libel and slander can generate awards, which should be non-taxable. vi. Payments made in settlement of an employee's contract claims are generally taxable. Payments made to settle a claim for sick leave, severance pay or vacation pay, will probably have to be included in income. Glynn v. Commr., 76 T.C. 116 (1981), aff'd without publ'd op., 676 F.2d 682 (1st Cir. 1982). The IRS has, however, allowed the exclusion of a recovery where the amount of injury is measured by lost wages. Rev. Rul. 85-97, 1985-2 C.B. 50. See A.M. Metzger, 88 T.C. 834 Dec. 43,832 (1987), aff'd by unpublished opinion (1988). This case held that if lost wages are merely evidence of the amount of damages, the award should not be taxable. vii. Amounts awarded on the basis of a discrimination claim have been held to be amounts awarded with respect to a tort-type action so that the damages awarded are considered to be on the account of personal injuries. Thompson v. Commr., 866 F.2d 709 (4th Cir. 1989). In United States v. Burke, 504 U.S. 229 (1992), the Supreme Court interpreted the tort type rights test as limiting the section 104(a)(2) exclusion to damages for personal injuries for which the full range of tort-type remedies is available. The Court held that section 104(a)(2) did not apply to an award of back pay under the pre-1991 version of Title VII of the 1964 Civil Rights Act because the damages awarded under the statute provided only a narrow remedy and thus did not compensate for a tort type injury. The Burke interpretation precluded section 104(a)(2) treatment for similar personal injuries redressed by "no-fault" statutes that do not provide traditional tort-type remedies. Many critics thought the Burke remedies test was too restrictive. The Burke case has been overruled by the September 2009 proposed regulations. viii. Under the September 2009 proposed regulations, damages for physical injuries may qualify for the section 104(a)(2) exclusion even though the injury giving rise to the damages is not defined as a tort under state or common law. Thus, the IRC Section 104(a)(2) exclusion does not depend on the scope of remedies available under state or common law. In effect, the proposed regulations reverse the result in the Burke case by allowing the exclusion for damages awarded under no-fault statutes. ix. Payments made for discrimination against a federal employee under Section 717 of the Civil Rights Act of 1964, however, were held to be taxable. Sparrow v. Commr., 50 F.E.P. Cases 197 (T.C. 1989); Hodge v. Commr., 64 T.C. 616 (1975). Compensatory damages awarded for an action under Section 1983 may be excluded. One court's opinion indicates that the entire award may be held not included in income on the basis that the lost wage amounts were merely an evidentiary factor in determining the amount by which the Petitioner was damaged. Bent v. Commr., 87 T.C. 236 (1986), aff'd, 835 F.2d 67 (3rd Cir. 1988); Treas. Reg. Sec. 1.104-1(c). In another case, the court held that the amount awarded for purposeful racial discrimination was for a tort-type claim, and not for back wages. Therefore, the amount was not taxable. Rowlett v. Anheuser-Busch, Inc. Civ. No. 83-229-D (D.N.H. 1988). The conclusion may depend on whether there is a statute which provides a basis for concluding that the violation of Plaintiff's civil rights may be compensated for by an award for personal injuries. x. An important issue in determining whether payments are taxable arises because payments for lost profits or wages are taxable but payments for personal injury are not. In many cases, the payments for damages are based on calculations of lost wages. If lost wages are merely evidence of the amount of the damage the taxpayer suffered the award shouldn't be taxable. In Roemer, the court stated that: "Although there are different types of defamation actions...depending on the form of the defamatory statements, all defamatory statements attack an individual's good name. This injury to the person should not be confused with the derivative consequences of the defamatory attack, i.e., the loss of reputation in the community and any resulting loss of income. The non-personal consequences of a personal injury, such as a loss of future income, are often the most persuasive means of proving the extent of the injury that was suffered. The personal nature of an injury should not be defined by its effect." Roemer, Jr. v. Commr., 83-2 USTC Para. 9600 (1983). xi. Punitive damages after the effective date of the Revenue Reconciliation Act of 1989 are not excluded from income except where physical injury or sickness is involved. This legislative change applies to amounts received after July 10, 1989 in tax years ending after that date. A transition rule excludes amounts received under a written binding agreement, court decree or mediation award in effect on or issued before July 10, 1989, or amounts received pursuant to suits filed on or before July 10, 1989.
Allocation of Proceeds.
  • Income taxation of settlements is important to address pro-actively, preferably prior to settlement. Suits against an employer or partners for discrimination, damages, back wages, are common, and the amounts must be allocated to each tax category as the tax impact can be significant.
  • Generally, the determination as to whether a settlement amount received by compromise (e.g., settlement agreement) or judgment must be included in income, consider the item that each settlement amount replaces. Similarly, the character of the income as ordinary income or capital gain depends on the nature of the underlying The proper characterization (i.e., wage-based or tort-based) of damage awards depends in part on the types of remedies that are available for the asserted claim against the employer. For example, a broad range of remedies, including back pay, compensatory damages, and punitive damages are available for employment discrimination claims brought under Title VII. Conversely, under the Employee Retirement Security Act (ERISA), the available remedies are narrow and compensatory damages are not available. The nature of the remedies available for state law claims determines whether the claim is wage or nonwage based.vii. It is preferable that any settlement agreement contain specific allocations to the amounts claimed as taxable and non-taxable, but the reality is that the adversarial nature of most cases precludes focus on tax niceties. 1. If a settlement agreement clearly allocates proceeds between tort-like personal injury damages (i.e., damages that are excluded from gross income) and other damages, the allocation is generally binding for tax purposes to the extent that the agreement is entered into by the parties in an adversarial context at arm's length and in good faith. Edward E. Robinson, (1994) 102 TC 116, affd on this issue (1995, CA5), 70 F3d 34, 95-2 USTC ¶50644. 2. An express allocation in a settlement agreement generally will be respected if the agreement was negotiated by parties with an adversarial interest, at arm's length, and in good faith. An agreement that settled a terminated employee's claims against his former employer stated that the lump-sum payments under the settlement agreement were intended solely as compensation for the employee's alleged personal injuries. This statement was held to reflect the payor's intent to compensate the former employee for personal injuries where there was evidence that the payor recognized that the employee had bona fide claims for defamation and age discrimination. However, severance payments under that agreement were not excludable because the settlement agreement lacked express language stating that the severance pay was made on account of personal injury and there was evidence that the payor did not intend these payments as compensation for personal injuries. Ronald M. Gross (2000) TC Memo 2000-342. 3. Evidence established that a settlement agreement between a partnership and a former partner was negotiated in good faith by the parties with adversarial interests. In making the payment on account of personal injury or personal sickness, the payor's intent was determined by the Tax Court to be reflected in the agreement's allocation of a portion of the payments for personal injuries. Wright, Charles Whittaker Est., (2007) TC Memo 2007-278.
  • The Tax Court disregarded the allocations set forth in two settlement agreements where (1) the parties to each settlement were not adversarial since the defendants didn't care how the allocations were made, and (2) the allocation language was entirely tax-motivated. Also, the allocation language did not reflect the realities of the settlement since the pleadings and the record of the underlying litigation were devoid of a claim for damages as a result of tortuous actions. Burditt, Allen II, (1999) TC Memo 1999-117.
  • Where a settlement agreement does not expressly provide for an allocation of the proceeds of the settlement among various types of damages, the most important factor is what motivated the payor to pay the settlement amount. This determination requires an examination of the pleadings, jury awards or other court orders or judgments. Here, the pleadings alleged wrongful termination and claimed damages for mental distress and punitive damages. The Tax Court determined that the only relevant items of damages were damages for mental distress and punitive damages. The court found that one-half of the settlement amount was attributable to mental distress and that the other half of the settlement amount was attributable to punitive damages. The court went on to conclude that the damages attributable to mental distress were excludable from gross income under Code Sec. 104(a)(2), finding that the wrongful termination directly caused her mental distress, which was a recognized tort under state law. However, the portion of the settlement amount attributable to punitive damages was taxable to the recipient since the punitive damages were not attributable to personal injuries. Pauline Barnes, (1997) TC Memo 1997-25.
  • Where a settlement agreement between an employer and a terminated employee was intended to resolve “any and all claims,” and made no allocation between personal injury damages and other claims, the entire amount paid under the agreement was taxable, even though its signing had been preceded by threats of a sex discrimination suit. The agreement was typical of, and consistent in size with, those the employer made with other officers who were asked to resign. The officer who signed the agreement on behalf of the employer didn't think that he was settling a sex discrimination claim. Jenne Britell, (1995) TC Memo 1995-264, RIA TC Memo ¶95264.
  • Where (1) a settlement agreement provided for the settlement of claims alleging the violation of the taxpayer's civil rights, (2) the agreement specifically provided that the payor took no position on the tax effect of the payment, (3) the payor issued an IRS Form 1099 to the taxpayer for the payment, and (4) the taxpayer provided no evidence that the payments were on account of personal physical injury or sickness, the full settlement payment was held to be includable in the taxpayer's gross income. Robert L. Allum, (2005) TC Memo 2005-177.
  • Language in the settlement agreement for taxpayer's wrongful dismissal and emotional distress claims stating payments were entirely for “personal damages” was discounted as not made in an adversarial context. Although the parties were initially at odds, once the settlement amount was agreed to, the payor had no interest in how the payments were characterized. However, the court held that the claim for emotional distress was treated seriously in the settlement negotiations. Thus, the court allocated half of the payments to excludable personal injury claims and half to taxable “economic” injuries. Gerard, Damian, (2003) TC Memo 2003-320, RIA TC Memo ¶2003-320, 86 CCH TCM 604.
  • Other factors to consider in allocating the gross amount of an award among taxable and non-taxable categories may include: 1. Details surrounding the litigation in the underlying proceeding.2. Allegations contained in the payee's complaint and amended complaint in the underlying proceeding/ 3. Arguments made by each party.
  • A jury award can be determinative of the appropriate allocation. 1. When a jury verdict precedes a settlement, and the verdict clearly allocates damages to an identifiable claim, the nature of the claim—as identified under state law personal injury concepts—determines the allocation of the award between taxable and nontaxable damages. Thus, where taxpayers sued for tortuous interference with business relations, breach of fiduciary duty, defamation, injury to business reputation, and emotional damages, and the jury awarded $2.5 million for tortuous interference with business relations and $1 for slander, only $1 was excludable from income under pre- August 21, 1996 law as damages for personal injury. Robert Henderson, (2003) TC Memo 2003-168 , RIA TC Memo ¶2003-168 , 85 CCH TCM 1469 , affd (2004, CA9) 94 AFTR 2d 2004-5246 , 104 Fed Appx 47. See also Bonnie A. Miller, (1993) TC Memo 1993-49 , RIA TC Memo ¶93049 , 65 CCH TCM 1884 , affd (1995, CA4) 76 AFTR 2d 95-5718 , 95-2 USTC ¶50384 (unpublished).2. If judgment proceeds have been clearly allocated to an identifiable claim in an adversarial proceeding by a judge or jury, the IRS will usually not challenge their character because of the impartial and objective nature of the determinations. However, many lawsuits are settled prior to a jury verdict; it is more difficult to make an allocation for cases settled out of court. The settlement agreement often does not distinguish between the various claims of the settlement, is silent as to the types of damages awarded, or states that all the damages awarded are compensatory. The allocation of proceeds among the various claims of the settlement can be challenged where the facts and circumstances indicate the allocation does not reflect the economic substance of the settlement. Furthermore, the characterization of the payments by the employer and the employee is not necessarily controlling PLR 200303003; TAM 200244004; FSA 200146008. 3. The IRS will look beyond the mere labels used by the parties to determine the true facts and true intent of the parties. The intent of the payor, not the mere assertions of the recipient, are important to determining the proper allocation of the damage payments made. Dudley G. Seay, 58 T.C. 32 (1972), acq. 1972-2 Cum. Bull. 3. The IRS was influenced by the fact that the negotiations between the parties included the petitioner/taxpayer's claims for personal injury damages for which amounts were later allocated as non-taxable. Correspondence between the parties supported this characterization since amounts were discussed as compensation for the petitioner's embarrassment, mental strain, and other matters. The complaint filed on behalf of the Plaintiff will be an important factor in determining the proper allocation. Rev. Rul. 58-418, 1958-2 C.B. 18. The relative percentages of the amounts alleged in the complaint were used to allocate between the various damages. For example, if the complaints and other documents consistently sought damages for lost wages, it may be difficult to support an allocation in the settlement agreement with no amount allocated to back wages. Where the defendant refuses to recognize tort liability, the courts have not been willing to permit allocations to non-taxable tort-type claims. Agar v. Commr., 290 F.2d 283 (2nd Cir. 1961); Knuckles v. Commr., 349 F.2d 610 (10th Cir. 1965).
Deducting Expenses of Litigation.
  • Legal fees that are properly allocable to non-taxable settlement proceeds not deductible. IRC Sec. 265(a)(1).
  • The expenses incurred to recover the damages, primarily attorneys' fees, are generally deductible as expenses for the production of income. IRC Sec. 212. Instead, these expenses are subject to the two-percent floor on itemized deductions. IRC Sec. 67. Thus, such expenses are deductible only to the extent the taxpayer's total miscellaneous itemized deductions exceed two percent of adjusted gross income. Any amount allowable as a deduction is subject to reduction under the overall limitation of itemized deductions if the taxpayer's adjusted gross income exceeds a threshold amount. IRC Sec. 68. For purposes of the alternative minimum tax, no deduction is allowed for any miscellaneous itemized deduction.
  • Legal fees may be deductibility and the AMT trap that would otherwise eliminate a deduction avoided. IRC Sec. 62(a)(20) may permit deduction against adjusted gross income (AGI).
Charitable Contributions – Income and Deductions. Charitable Gift Annuities (“CGAs”).
  • CGAs are not uniquely used for clients living with a chronic illness or disability, but their perception of the use of these investment vehicles often is different thereby making CGAs a more common and significant issue. CGAs provide more than just a cash flow and charitable contribution deduction to the purchaser, they provide the personal satisfaction of helping an organization that may have provided substantial personal assistance to you.
  • If you purchase CGAs to help a particular charity that serves those living with your illness or disability, you may qualify for an income tax charitable contribution deduction if you itemize deductions. The contribution deduction is based on the amount of the contribution reduced by the present value of the annuity payments that will be made to you (and other beneficiaries, if any) during your lifetime (and possibly that of other beneficiaries). These calculations are made based on IRS tables regarding life expectancy, estimated earnings, and the rate paid to you on your gift annuity. IRC Sec. 7520. Table B of the IRS valuation tables is used for an annuity with a term certain. Table R(2) of the IRS valuation tables is used for valuing a joint and survivor annuity Table S of the IRS valuation tables is used for a single life annuity.
  • Often gift annuities are purchased with appreciated property. If the property you donate/exchange in the purchase of the gift annuity has a tax basis that is less than the fair value of the gift annuity then you may have to recognize gain to the extent of this excess. IRC Sec. 1011(b). This capital gain is reported over your life expectancy.
  • Your investment in the CGA will be fully recovered, and all taxable gain you were required to recognize will have been reported when you attain your actuarial life expectancy. Any payments you receive after that point in time will be taxed as ordinary income.
  • If you die before your investment in the contract that has been recovered, any remaining investment is deductible as a miscellaneous itemized deduction on your final Form 1040. This amount is not subject to the 2% AGI floor. If you purchase a joint and survivor annuity for you and your spouse, and your spouse survives you, the remaining gain will continue to be recognized as payments and are received by your survivor spouse. See IRC Sec. 67(b).
Charitable Remainder Trusts (“CRTs”).
  • Not addressed in this article.
Life Insurance Tax Considerations. Introduction.
  • Evaluate existing life insurance policies. Identify and evaluate all planning opportunities which may include: accelerated death benefit options; borrowing against cash value to fund needed expenditures; viatical settlements; possible sale into the secondary market versus cash surrender value (CSV).
Accelerated Death Benefit.
  • Life insurance may include an accelerated death benefit options that may permit a chronically or terminally ill policy holder to obtain current needed funds.
  • Income taxation is governed by IRC Sec. 101(g). If the requirements are met, amounts received can be excluded from income.IRC Sec. 101(g) Treatment of certain accelerated death benefits.(1) PPCWG&L Treatises In general. For purposes of this section, the following amounts shall be treated as an amount paid by reason of the death of an insured: (A) Any amount received under a life insurance contract on the life of an insured who is a terminally ill individual. (B) Any amount received under a life insurance contract on the life of an insured who is a chronically ill individual. (2) Treatment of viatical settlements. (A) In general. If any portion of the death benefit under a life insurance contract on the life of an insured described in paragraph (1) is sold or assigned to a viatical settlement provider, the amount paid for the sale or assignment of such portion shall be treated as an amount paid under the life insurance contract by reason of the death of such insured. (B) Viatical settlement provider. (i) In general. The term “viatical settlement provider” means any person regularly engaged in the trade or business of purchasing, or taking assignments of, life insurance contracts on the lives of insureds described in paragraph (1) if— (I) such person is licensed for such purposes (with respect to insureds described in the same subparagraph of paragraph (1) as the insured) in the State in which the insured resides, or (II) in the case of an insured who resides in a State not requiring the licensing of such persons for such purposes with respect to such insured, such person meets the requirements of clause (ii) or (iii) , whichever applies to such insured. (ii) Terminally ill insureds. A person meets the requirements of this clause with respect to an insured who is a terminally ill individual if such person— (I) meets the requirements of sections 8 and 9 of the Viatical Settlements Model Act of the National Association of Insurance Commissioners, and (II) meets the requirements of the Model Regulations of the National Association of Insurance Commissioners (relating to standards for evaluation of reasonable payments) in determining amounts paid by such person in connection with such purchases or assignments. (iii) Chronically ill insureds. A person meets the requirements of this clause with respect to an insured who is a chronically ill individual if such person— (I) meets requirements similar to the requirements referred to in clause (ii)(I) , and (II) meets the standards (if any) of the National Association of Insurance Commissioners for evaluating the reasonableness of amounts paid by such person in connection with such purchases or assignments with respect to chronically ill individuals. (3) Special rules for chronically ill insureds. In the case of an insured who is a chronically ill individual— (A) In general. Paragraphs (1) and (2) shall not apply to any payment received for any period unless— (i) such payment is for costs incurred by the payee (not compensated for by insurance or otherwise) for qualified long-term care services provided for the insured for such period, and (ii) the terms of the contract giving rise to such payment satisfy— (I) the requirements of section 7702B(b)(1)(B) , and (II) the requirements (if any) applicable under subparagraph (B) . For purposes of the preceding sentence, the rule of section 7702B(b)(2)(B) shall apply. (B) Other requirements. The requirements applicable under this subparagraph are— (i) those requirements of section 7702B(g) and section 4980C which the Secretary specifies as applying to such a purchase, assignment, or other arrangement, (ii) standards adopted by the National Association of Insurance Commissioners which specifically apply to chronically ill individuals (and, if such standards are adopted, the analogous requirements specified under clause (i) shall cease to apply), and (iii) standards adopted by the State in which the policyholder resides (and if such standards are adopted, the analogous requirements specified under clause (i) and (subject to section 4980C(f) ) standards under clause (ii) , shall cease to apply). (C) Per diem payments. A payment shall not fail to be described in subparagraph (A) by reason of being made on a per diem or other periodic basis without regard to the expenses incurred during the period to which the payment relates. (D) Limitation on exclusion for periodic payments. For limitation on amount of periodic payments which are treated as described in paragraph (1), see section 7702B(d). (4) Definitions. For purposes of this subsection — (A) Terminally ill individual. The term “terminally ill individual” means an individual who has been certified by a physician as having an illness or physical condition, which can reasonably be expected to result in death in 24 months or less after the date of the certification. (B) Chronically ill individual. The term “chronically ill individual” has the meaning given such term by section 7702B(c)(2) ; except that such term shall not include a terminally ill individual. (C) Qualified long-term care services. The term “qualified long-term care services” has the meaning given such term by section 7702B(c) . (D) Physician. The term “physician” has the meaning given to such term by section 1861(r)(1) of the Social Security Act ( 42 U.S.C. 1395x(r)(1) ). (5) Exception for business-related policies. This subsection shall not apply in the case of any amount paid to any taxpayer other than the insured if such taxpayer has an insurable interest with respect to the life of the insured by reason of the insured being a director, officer, or employee of the taxpayer or by reason of the insured being financially interested in any trade or business carried on by the taxpayer.
Borrowing on Life Insurance.
  • For a client that does not qualify for a viatical settlement it may be feasible, or preferable to borrow on an insurance policy to fund certain expenses.
  • Properly handled the borrowing should not trigger any current income taxation.
Sale of Life Insurance.
  • Evaluate the possible sale into the secondary market versus cash surrender value (CSV) of your life insurance policies.
  • Section 72(e) defines “investment in the contract”. Amount realized less investment in contract is gain. Investment in the contract is all of your premiums minus non-taxable distributions such as dividends. It is essentially premiums paid unless it is a participating policy.
  • Concerning the income tax consequences of a sale See Revenue Ruling 2009-13.
  • Insurance can be a capital asset and if you have a “sale or exchange” part of the gain may be capital, but any part of the gain which would represent ordinary income must be treated as such.
  • See Revenue Ruling 2009-14 concerning your receipt of proceeds from the sale of your insurance to a life settlement company.
Standard and Itemized Deductions Other than Medical Expenses. Blind Taxpayer Entitled to Additional Standard Deduction. i. Standard deduction for taxpayers who are legally blind may be higher. In addition to the regular standard deduction, a blind taxpayer is permitted an additional standard deduction. IRC Sec. 63(f)(2). Conference Expenses. i. The cost to attend a medical conference that addresses the concerns of a chronic illness you, a spouse or dependent (e.g., child) has can be deducted. You can deduct the costs of admission and travel, but not meals and lodging. Medical Expenses as an Itemized Deduction. Insurance Reimbursements and Deductions. i. Being able to deduct unreimbursed medical expenses is not a simple task. There are a host of reporting requirements and hurdles. ii. If your insurance company pays for an expense, or reimburses you, you cannot deduct the amount paid. You can only deduct the amount you actually paid over the reimbursement. General Requirements for Medical Deductions. i. To qualify for a medical expense deduction, your payments for medical or dental bills have to be according to the IRS, “primarily to alleviate physical or mental defects or illnesses”. Payments for your general health, such as vitamins or a vacation are not deductible. Therefore, if you take a vitamin or over the counter remedy others use generally, e.g. Lecithin or other supplements specifically to address your illness, be certain to have your physician formally prescribe them. Then save the prescription in your tax file so you can demonstrate to the IRS that they are not just for general health. This will help support your deduction. ii. You must actually pay the bill in the particular tax year in order to deduct it in that year. If you pay by check it’s the date you mail or deliver the check that determines the year of deduction. For credit cards it’s the date your charge appears on the bill, even if paid in a later year. Save your cancelled checks and credit card receipts to prove your deductions. Service Animals. i. A medical deduction may be obtained for the costs of a service animal. These might include the cost of buying, training, and maintaining a service animal, such as a dog, to assist an individual with cognitive disabilities. These expenditures may qualify as medical care expenditures under IRC Sec. 213 if the taxpayer uses the service animal primarily for medical care to alleviate a cognitive defect or illness, and would not have paid the expenses but for the disease or illness. INFO 2010-0129. Home Improvements as Medical Expense Deduction. i. Home improvements may qualify as a medical expense deduction. You can deduct the cost of special equipment and home improvements if the main purpose is your medical care. These can include: adding an accessible entrance ramp, installing a lift, widening doorways, building handrails, modifying cabinets, etc. ii. Your deduction is limited if the improvements increase the value of your home, or were for personal motives such as aesthetic reasons. Specifically, you cannot deduct your expenditures to the extent of any increase in the value of your home. iii. Example: You spend $10,000 to add a wheel chair ramp to your front porch, and an elevator to your home. Your home was worth $350,000 before and $353,000 after. Your $10,000 expenditure is reduced by $3,000 the increase in your home’s value, providing a $7,000 tax deduction. iv. If you are incurring substantial costs, have your house appraised before and after the improvements. Since improvements to your home to accommodate a disability generally don’t increase the value of your home the least costly and safest approach may be to have a qualified appraiser (some choose to rely on merely a local realtor) provide you a before and after valuation. The cost will be modest compared to a formal appraisal, but far more persuasive than ignoring the issue until you are audited. Gym Fees. i. A medical expense deduction may be obtainable for gym fees under certain conditions. A taxpayer inquired whether/when gym fees could be a deductible medical expenses. The IRS responded in an information letter that a taxpayer cannot deduct costs associated with using a gym to improve general health and well-being and not to cure a specific disease or ailment. However, gym fees may be deductible if the taxpayer can prove that he or she would not have paid the expense but for living with a particular disease or illness. ii. To corroborate meeting the above requirements obtain a written diagnosis from your attending physician of: 1. The specific disease and its impact. 2. That you were prescribed/recommended to use the gym to treat the specific disease. iii. You must also demonstrate that you would not have incurred the gym fees but for the specific disease. INFO 2010-0175. In Home Health Care Expenses. i. In-home health care expenses may raise more thorny issues than other health care costs. In particular, you may have to demonstrate that the expenditures are not personal expenses which are not deductible. You will also have to demonstrate the factors surrounding the expense to corroborate that it is for medical care and hence deductible. ii. What are your motives and purposes for buying the service or product? iii. Has a physician recommended the service or product to treat a diagnosed medical condition? Obviously the best evidence is a written prescription. iv. You will have to establish that the service or product would not have been bought but for the disease or illness. This “but for” test can call into question deductions for common over the counter remedies for a range of issues such as: incontinence, arthritis, constipation, sinus problems, dehydration, indigestion, support braces, etc. For these to qualify as medical deductions a prescription from the physician and something documenting that the client purchased the product or service, such as in home care you mention, because of the disease, is essential. See IRC Sec. 213(d) and INFO 2009-0209. Long Term Care Costs. i. Are the costs the client is incurring for qualified long-term care, including nursing home care that is deductible as medical expenses? What planning can be done to maximize the deductions? ii. You may qualify to deduct the unreimbursed cost of certain long-term care services if you qualify as a “chronically ill individual.” IRC Sec. 213(d)(1)(C); Reg. § 1.213-1(e)(1)(i) and (ii). See discussion above concerning group long term care insurance. Some medical expense deductions incorporate some of the same definitions and standards discussed previously. iii. For example, the cost of services provided in a nursing home for a chronically ill individual normally would be deductible as long-term care services. Deductible long-term care services include “necessary diagnostic, preventive, therapeutic, curing, treating, mitigation, and rehabilitative services.” IRC Sec. 7702B(c)(1). iv. There are, however, some significant differences between the IRC Sec. 213 and 7702B provisions. 1. Long-term care deduction is limited to “services.” Other deductible medical expenses are not limited only to services. 2. Long-term care services include “maintenance or personal care services.” IRC Sec. 7702B(c)(1). These services are not deductible as general medical expenses by someone who is not chronically ill under Code Section 213(d). v. These costs are not restricted only to assistance with the “activities of daily living” that may have qualified the individual as chronically ill. Rather, services are deductible if their primary purpose is to provide needed assistance with any of the disabilities causing the chronic illness. Code Sec. 7702B(c)(3). It does not matter that workers who are not healthcare professionals perform these services. Meal preparation, household cleaning, and other similar services for you if you meet the requirements of being “chronically ill” may qualify. vi. Limiting the deduction for long-term care to the cost of services is somewhat restrictive. But the term “services” has been defined to include the use or transfer of medical supplies as an integral part of the performance of medical services. Hospital Corporation of America, 107 TC 116 (1996), aff'd 92 AFTR 2d 2003-6705 , 348 F3d 136 (CA-6, 2003) , cert den; Osteopathic Medical Oncology & Hematology, P.C., 113 TC 376 (1999), acq in result. vii. You cannot deduct the cost of long-term care services provided to you by your spouse or relatives unless they are licensed to provide the particular service involved (e.g., registered nurse). IRC Sec. 213(d)(11)(A). “Relative” is defined in Code Sec. 152(d)((2)(A) viii. You may deduct medical expense incurred for care in an assisted living or dementia. This fee may include medical expenses, meals and lodging, etc. For meals and lodging to be deductible, however, additional requirements must be met: 1. The institution regularly engages in providing medical care or services. 2. A principal reason for your living in the institution is the availability of medical care. This is defined to include supervisory care for an individual who is unsafe when left alone due to severe cognitive impairments. 3. The institution furnishes meals and lodging as a necessary incident to the medical care. 4. See Reg. Sec. 1.213-1(e)(1); 7702B(c)(2)(A)(iii). Medical Expenditures Generally. i. What affirmative steps can a client take to enhance the likelihood that certain expenditures will qualify as deductible medical expenses for tax purposes? How can the client corroborate that an otherwise personal expense is for medical care? What is the taxpayer’s motive or purpose for incurring the expense? Has a physician recommended the item or expense to treat a diagnosed medical condition? Has this been confirmed in writing? Can the taxpayer establish that the item would not have been bought but for the disease or illness? IRC Sec. 213(d); INFO 2009-0209. Car Purchase. i. If a disabled taxpayer buys a car specifically designed to compensate for his or her disabilities, the portion of the price attributable to the special design of the vehicle in excess of a standard vehicle is a medical expense. Rev Rul 76-80, 1976-1 CB 71. Tuition May be Deductible. i. The cost of a special school for a handicapped dependent may be deductible as a medical expense if the principal reason for attendance is the institution's special resources for alleviating the disability or handicap. Room and board supplied by a special school is included. Reg. § 1.213-1(e)(1)(v)(a). Home Health Aides and Related Issues. i. Payroll taxes for in home aides can be a nuisance. Proposed regulations may permit home care service recipients to designate an agent to report, file, and pay all employment taxes, including FUTA. Prop. Reg. 31.3504-1; REG-137036-08. ii. A medical expense deduction may be permitted for a portion, allocable to the medical care provided, of the costs of meals and lodging provided to an in-home medical caregiver. Limitations on Deducting Medical Expenses as Itemized Deduction. i. You can only deduct expenses to the extent that they exceed 7.5% of your adjusted gross income (AGI). This is all your taxable income (wages, dividends, interest) less certain adjustments (e.g., alimony). However, you may deduct these expenditures for alternative minimum tax (AMT) purposes only to the extent they exceed 10% of AGI. IRC Sec. 213(a); 56(b)(1)(B). ii. Estimate what 7.5% of your income is likely to be. If you’re likely to be close this year, try to defer medical expenses until a designated year to bunch them in that year, or accelerate medical expenses you’d otherwise pay to that same designated year. The goal is to bunch medical expenses in years when you can exceed the 7.5% threshold to get the most tax benefit. iii. Example: You earn $45,000 and $5,000 of investment income, for a total of $50,000. You spend $16,000 on medical costs, of which $9,000 is reimbursed by insurance. You deductible medical expenses are $7,000 [$16,000 - $9,000], but this must be reduced by $3,750 [7.5% x $50,000] to $3,250. If you’re in a 30% state and federal tax bracket your tax benefit would be worth about $1,000. Individual Tax Credits. Disability Credit. i. A credit for the elderly or disabled may be available. This credit is generally available to certain disabled taxpayers who are younger than 65 and are retired on permanent and total disability. ii. IRC Sec. 22. Earned Income Credit. i. Earned income tax credit EITC is available to disabled taxpayers as well as to the parents of a child with a disability. Dependent Care Credit. i. Dependent care credit taxpayers who pay someone to come to their home and care for their dependent or spouse may be entitled to claim this credit. There is no age limit if the taxpayer’s spouse or dependent is unable to care for themselves. ii. Dependent care credit taxpayers who pay someone to come to their home and care for their dependent or spouse, who is physically or mentally incapable of caring for herself and has the same principal place of abode as the taxpayer for more than one-half the year, may be entitled to claim this credit. There is no age limit if the taxpayer’s spouse or dependent is unable to care for themselves. The expenses must be incurred to enable the taxpayer to be gainfully employed. IRC Sec. 21. iii. IRC Sec. 21 Expenses for household and dependent care services necessary for gainful employment. (a) Allowance of credit. (1) In general. In the case of an individual for which there are 1 or more qualifying individuals (as defined in subsection (b)(1) ) with respect to such individual, there shall be allowed as a credit against the tax imposed by this chapter for the taxable year an amount equal to the applicable percentage of the employment-related expenses (as defined in subsection (b)(2) ) paid by such individual during the taxable year. (2) Applicable percentage defined. For purposes of paragraph (1) , the term “applicable percentage” means 35 percent reduced (but not below 20 percent) by 1 percentage point for each $2,000 (or fraction thereof) by which the taxpayer's adjusted gross income for the taxable year exceeds $15,000. (b) Definitions of qualifying individual and employment-related expenses. For purposes of this section — (1) Qualifying individual. The term “qualifying individual” means— (A) a dependent of the taxpayer (as defined in section 152(a)(1) ) who has not attained age 13, (B) a dependent of the taxpayer (as defined in section 152 , determined without regard to subsections (b)(1) , (b)(2) , and (d)(1)(B) ) who is physically or mentally incapable of caring for himself or herself and who has the same principal place of abode as the taxpayer for more than one-half of such taxable year, or (C) the spouse of the taxpayer, if the spouse is physically or mentally incapable of caring for himself or herself, and who has the same principal place of abode as the taxpayer for more than one-half of such taxable year. (2) Employment-related expenses. (A) In general. The term “employment-related expenses” means amounts paid for the following expenses, but only if such expenses are incurred to enable the taxpayer to be gainfully employed for any period for which there are 1 or more qualifying individuals with respect to the taxpayer: (i) expenses for household services, and (ii) expenses for the care of a qualifying individual. Such term shall not include any amount paid for services outside the taxpayer's household at a camp where the qualifying individual stays overnight. (B) Exception. Employment-related expenses described in subparagraph (A) which are incurred for services outside the taxpayer's household shall be taken into account only if incurred for the care of— (i) a qualifying individual described in paragraph (1)(A) , or (ii) a qualifying individual (not described in paragraph (1)(A) ) who regularly spends at least eight hours each day in the taxpayer's household. (C) Dependent care centers. Employment-related expenses described in subparagraph (A) which are incurred for services provided outside the taxpayer's household by a dependent care center (as defined in subparagraph (D) ) shall be taken into account only if— (i) such center complies with all applicable laws and regulations of a State or unit of local government, and (ii) the requirements of subparagraph (B) are met. (D) Dependent care center defined. For purposes of this paragraph , the term “dependent care center” means any facility which— (i) provides care for more than six individuals (other than individuals who reside at the facility), and (ii) receives a fee, payment, or grant for providing services for any of the individuals (regardless of whether such facility is operated for profit). Sec. (c) Dollar limit on amount creditable. The amount of the employment-related expenses incurred during any taxable year which may be taken into account under subsection (a) shall not exceed— (1) $3,000 if there is one qualifying individual with respect to the taxpayer for such taxable year, or (2) $6,000 if there are two or more qualifying individuals with respect to the taxpayer for such taxable year. The amount determined under paragraph (1) or (2) (whichever is applicable) shall be reduced by the aggregate amount excludable from gross income under section 129 for the taxable year. (d) Earned income limitation. (1) In general. Except as otherwise provided in this subsection, the amount of the employment-related expenses incurred during any taxable year which may be taken into account under subsection (a) shall not exceed— (A) in the case of an individual who is not married at the close of such year, such individual's earned income for such year, or (B) in the case of an individual who is married at the close of such year, the lesser of such individual's earned income or the earned income of his spouse for such year. (2) Special rule for spouse who is a student or incapable of caring for himself. In the case of a spouse who is a student or a qualifying individual described in subsection (b)(1)(C) , for purposes of paragraph (1) , such spouse shall be deemed for each month during which such spouse is a full-time student at an educational institution, or is such a qualifying individual, to be gainfully employed and to have earned income of not less than— (A) $250 if subsection (c)(1) applies for the taxable year, or (B) $500 if subsection (c)(2) applies for the taxable year. In the case of any husband and wife, this paragraph shall apply with respect to only one spouse for any one month. (e) Special rules. For purposes of this section — (1) Place of abode. An individual shall not be treated as having the same principal place of abode of the taxpayer if at any time during the taxable year of the taxpayer the relationship between the individual and the taxpayer is in violation of local law. (2) Married couples must file joint return. If the taxpayer is married at the close of the taxable year, the credit shall be allowed under subsection (a) only if the taxpayer and his spouse file a joint return for the taxable year. (3) Marital status. An individual legally separated from his spouse under a decree of divorce or of separate maintenance shall not be considered as married. (4) Certain married individuals living apart. If— (A) an individual who is married and who files a separate return— (i) maintains as his home a household which constitutes for more than one-half of the taxable year the principal place of abode of a qualifying individual, and (ii) furnishes over half of the cost of maintaining such household during the taxable year, and (B) during the last 6 months of such taxable year such individual's spouse is not a member of such household, such individual shall not be considered as married. (5) Special dependency test in case of divorced parents, etc. If— (A) section 152(e) applies to any child with respect to any calendar year, and (B) such child is under the age of 13 or is physically or mentally incapable of caring for himself, in the case of any taxable year beginning in such calendar year, such child shall be treated as a qualifying individual described in subparagraph (A) or (B) of subsection (b)(1) (whichever is appropriate) with respect to the custodial parent (as defined in section 152(e)(4)(A) ), and shall not be treated as a qualifying individual with respect to the noncustodial parent. (6) Payments to related individuals. No credit shall be allowed under subsection (a) for any amount paid by the taxpayer to an individual— (A) with respect to whom, for the taxable year, a deduction under section 151(c) (relating to deduction for personal exemptions for dependents) is allowable either to the taxpayer or his spouse, or (B) who is a child of the taxpayer (within the meaning of section 152(f)(1) ) who has not attained the age of 19 at the close of the taxable year. For purposes of this paragraph , the term “taxable year” means the taxable year of the taxpayer in which the service is performed. (7) Student. The term “student” means an individual who during each of five calendar months during the taxable year is a full-time student at an educational organization. (8) Educational organization. The term “educational organization” means an educational organization described in section 170(b)(1)(A)(ii) . (9) Identifying information required with respect to service provider. No credit shall be allowed under subsection (a) for any amount paid to any person unless— (A) the name, address, and taxpayer identification number of such person are included on the return claiming the credit, or (B) if such person is an organization described in section 501(c)(3) and exempt from tax under section 501(a) , the name and address of such person are included on the return claiming the credit. In the case of a failure to provide the information required under the preceding sentence, the preceding sentence shall not apply if it is shown that the taxpayer exercised due diligence in attempting to provide the information so required. (10) Identifying information required with respect to qualifying individuals. No credit shall be allowed under this section with respect to any qualifying individual unless the TIN of such individual is included on the return claiming the credit. (f) Regulations. The Secretary shall prescribe such regulations as may be necessary to carry out the purposes of this section. Record Keeping; Returns. Record Keeping. i. The key to maximizing your tax deductions, making an audit easy, minimizing your time and effort, is proper record keeping. The best approach is to use a computerized checkbook and bookkeeping program, like Quicken. You can easily memorize all your payments, set automatic reminders to pay regular bills, and more. Once the set up is done (and you can have someone help you if you’re not familiar with it) a few key strokes will make everything you do routine and easy. Be sure to modify the standard Quicken (or other program) categories to reflect the various medical deduction categories you need (most are discussed in this article). Not only will this eliminate most of the paperwork, it will make it really easy to print out schedules of deductions for your tax return. If you still use a manual check register, use two lines per check entry so you can write a detailed description for each check. You could use a special symbol or color of ink for each tax category to make the year end work easier. Then at year end you’ll have to manually write up a summary for each tax deduction category, or have your tax preparer do it. The final step in the process is to coordinate the back up for these schedules. The easiest way to do that is to set up a filing system that matches your computerized (or manual) checkbook. Two approaches: 1) Check number order: Set up a file folder or loose leaf binder and put all your receipts in check number order. ii. Example: You pay a credit card bill that includes a medical deduction. Number the credit card and medical receipts with the check number and put them in the file or binder in check number order. 2) Categories: Set up file folders or a loose leaf binder with tabs for each tax deduction category, and put all your receipts in date order (as they come in) in the appropriate folder or behind the appropriate tab. Signing Your Return. i. If your spouse cannot sign because of injury or disease and tells you to sign, you can sign your spouse's name in the proper space on the return followed by the words “By (your name), Husband (or Wife).” Be sure to also sign in the space provided for your signature. Attach a dated statement, signed by you, to the return. The statement should include the form number of the return you are filing, the tax year, the reason your spouse cannot sign, and that your spouse has agreed to your signing for him or her. ii. If you are the guardian of your spouse who is mentally incompetent, you can sign the return for your spouse as guardian. iii. See IRS Publication 501: Filing Status. Filing Your Return. i. Tax Assistance for Individuals with Disabilities and the Hearing Impaired 1. Special assistance is available for persons with disabilities. If you are unable to complete your return because of a disability, you may obtain assistance from an IRS office, or the Volunteer Income Tax Assistance Program (VITA) sponsored by IRS. For further information on available IRS services, refer to Topic 101 or refer to Publication 910 (PDF), IRS Guide to Free Tax Services. 2. Telephone assistance for the hearing impaired is available for individuals with TTY equipment. The toll-free number for this service is 800-829-4059. Hearing impaired individuals that do not have this equipment may be able to obtain access through the federal or state relay services. 3. Braille materials for the visually impaired are available at any of the 142 regional libraries in conjunction with the national library service for the blind and physically handicapped. To locate your nearest library write to the National Library Service for the Blind and Physically Handicapped, Library of Congress at 1291 Taylor Street, NW, Washington, D.C. 20542. Available materials are limited to Publication 17, Your Federal Income Tax, Publication 334, Tax Guide for Small Business, and Forms 1040, 1040A and 1040EZ (materials include instructions and tax tables). 4. For additional information on these subjects and other areas that may affect persons with disabilities, refer to Publication 907, Tax Highlights for Persons with Disabilities. Health Issues as Reasonable Cause to Avoid Penalties. i. Taxpayers have often claimed overwork, stress or health problems as reasonable cause to avoid penalties. These excuses have rarely withstood court scrutiny. ii. However, IRS has recognized death or serious illness, or unavoidable absence of the taxpayer or a death or serious illness in his immediate family (i.e., spouse, sibling, parents, grandparents, and children) as reasonable cause for failure to file a return on time. The information considered by IRS when evaluating a request for penalty relief based on reasonable cause due to death, serious illness, or unavoidable absence may include some of the following facts and circumstances: 1. The relationship of the taxpayer to the other parties involved. 2. The date of death. 3. The dates, duration, and severity of the illness. 4. How the circumstances involved prevented compliance 5. Whether other financial or business obligations were similarly affected adversely. iii. See: 1. Gasman, Jacob, (1967) TC Memo 1967-42 , PH TCM ¶67042 , 26 CCH TCM 213 . 2. Maher, William, (2003) TC Memo 2003-85 , RIA TC Memo ¶2003-085 , 85 CCH TCM 1053 . 3. Avery, Alice R., (1976) TC Memo 1976-129 , PH TCM ¶76129 , 35 CCH TCM 577 , affd on other issue (1978, CA9) 42 AFTR 2d 78-5048 , 574 F2d 467 , 78-1 USTC ¶9454 . 4. Karmazin, Michael L., (1976) TC Memo 1976-262 , PH TCM ¶76262 , 35 CCH TCM 1148 . 5. Dustin, Herbert W. v. Com., (1972, CA9) 30 AFTR 2d 72-5313 , 467 F2d 47 , 72-2 USTC ¶9610 , affg (1969) 53 TC 491 . 6. Hobson, Tommy L., (1996) TC Memo 1996-272 , RIA TC Memo ¶96272 , 71 CCH TCM 3172 . Additional References. IRS Publication 3966, Living and Working with Disabilities. IRS Publication 907, Tax Highlights for Persons with Disabilities. IRS Publication 502, Medical and Dental Expenses.

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