Tax Planning for Elderly Clients

EXECUTIVE SUMMARY

• Although it is available to all taxpayers, the itemized deduction for medical expenses is especially beneficial for the elderly, who in general have higher medical expenses than younger taxpayers.
• Long-term medical care expenses and premiums for long-term care insurance may be deductible as medical expenses.
• Single taxpayers who are caring for an elderly parent may be able to lower their tax liability by filing as head of household.
• The dependent care credit may be available to taxpayers who are entitled to claim a parent as a dependent and who pay for someone else to care for the parent so they can work or look for work.

The demographic profile of America is rapidly changing. There are currently more Americans over age 65 than under age 25. One person in eight is over 65 years old. The figures for Americans even older are equally astonishing. In 1900, only 0.16% of the population was age 85 or older.¹ Today that figure is 1.7%.² By 2020, the figure is expected to reach 2%; by 2050, 4.9% of the population will be 85 years or older.³

With the rapid increase in the number of elderly clients, tax practitioners will need to become familiar with the special issues that affect tax compliance and planning for the elderly. In many respects the income tax return of an elderly person is not very different from that of other tax filers. The differences may be slight: less earned income, more dividends and interest, and fewer itemized deductions. But there are a few issues that the tax practitioner must know when dealing with an elderly client. This article looks at two areas of special concern: the deduction of medical expenses and tax benefits available to children who care for their parents.

Medical Deductions

All taxpayers may, of course, deduct as itemized deductions medical expenses actually paid (and not reimbursed by insurance or other sources) on their own behalf or on behalf of their spouses or dependents, to the extent that the expenses exceed 7.5% of the taxpayer’s adjusted gross income (AGI).⁴ Although the calculation of the medical deduction for an elderly taxpayer is no different from that of other taxpayers, the benefit is usually greater, given higher medical expenses and lower annual income.

If a married couple files separate tax returns, each may deduct only the medical expenses he or she actually paid. The IRS considers payments made from a joint account as being made one-half by each spouse, with the burden of proof on the taxpayer to prove otherwise.⁵ A married couple should consider filing separate returns if one spouse has more income, and the other spouse more medical expenses, than the other.

Example 1: H’s income was $90,000 last year while his wife, W, earned only $10,000. However, W had $7,000 of medical bills. Considering that the couple may only deduct medical expenses over $7,500 (7.5% of AGI), W should consider filing a separate return. Because 7.5% of her income is $750, she would be able to deduct $6,250 of medical bills when otherwise the couple could not deduct any of the expenses.

Planning tip: In determining whether a married couple should file separate returns, remember that only one-half of the amount of bills paid from a joint account may be deducted on each return. If possible, recommend that the medical bills of a very ill spouse be paid from his or her own separate account.

Under some circumstances, a married couple may want to create a separate account for the ill spouse. As for the source of the money, remember that one spouse may make an unlimited tax-free gift of money or property to the other.⁶ There is no rule on how this gifted money may be spent or that it may not be spent on medical bills.

Note that rules in a community property state are slightly different. Medical expenses paid out of community property are divided equally in such a case. Medical bills paid from separate funds may be deducted by the spouse paying them.

A taxpayer may also deduct medical bills incurred by dependents.⁷ A three-part test determines whether a person is a dependent for purposes of the medical expense deduction:

1. The person must meet the relationship test in Sec. 152(d)(2);

2. The person must have been a U.S. citizen or resident or a resident of Mexico or Canada for part of the year; and

3. The taxpayer must have provided over half of that person’s total support for the calendar year.

A taxpayer may deduct the medical bills of a dependent even if that person cannot be claimed as an exemption on the taxpayer’s return.⁸

Medical Expenses of Decedents

Special deductibility rules apply when a taxpayer dies during the tax year. The surviving spouse or personal representative of the decedent may elect to treat the payment of certain medical expenses by the estate as having been paid by the decedent at the time services were provided. These expenses must have been paid within one year of the date of the decedent’s death. (Note that the Service says they must be paid within that one-year period beginning with the day after the date of death.)⁹

This election may not be advantageous in many cases because a deduction taken on an estate tax return (where the top marginal tax bracket is about 45%) may be worth more than that taken on an income tax return (with a top marginal rate about 38% and reduced further by itemization limitations and thresholds).

Example 2: M’s estate was worth $2,500,000 at his death in 2007. His AGI for the year was $50,000, and his effective income tax bracket was 28%. M incurred $20,000 of medical expenses before his death.Because the estate tax exemption equivalent in 2007 was $2 million, his estate will have to pay a federal estate tax on the excess $500,000 at about 40%.

By deducting his medical expense from his gross estate, his heirs might save about $8,000 in estate taxes ($20,000 × 40% tax savings). Had M’s personal representative chosen instead to deduct this amount on his final income tax return, all other things being equal, this deduction would have been worth only about $3,733. This amount is calculated as follows: 7.5% of $50,000 AGI = $6,667. Only the amount in excess of this—$13,333—would be deductible. In the 28% bracket, the tax saving is $3,733.

There is a different result if no estate tax is due.

Example 3: Assume the same facts as in Example 2, except that M’s estate is worth $1 million and there is no federal estate tax due.In such a case even a $3,733 benefit is preferable to the alternative, which is zero.

A taxpayer can file an amended return if the representative later discovers it would have been more advantageous to deduct the medical bills on the decedent’s return, provided the representative paid the bills during the one-year period after the decedent’s death.

What Medical Expenses May Be Deducted

The list of items that a taxpayer may deduct is available from various sources, including the IRS.¹⁰ Generally, a taxpayer may deduct the costs of medical care, the costs of transportation to receive medical care, the premiums for health insurance policies, the cost of medication, and other medical-related expenses. However, a few items that often arise in the case of an ill elderly client bear closer examination.

Household help: Many elderly persons require assistance at home. The cost of pure household chores is not deductible, however. This is so even if the patient’s doctor recommends such assistance.¹¹

Example 4: C’s doctor believes that she should not be doing housework because, at age 98 and suffering from advanced osteoporosis, she might fall and break a bone. Despite the doctor’s recommendation that her family hire a housekeeper, the cost of the housekeeper is not a deductible medical expense.

Example 5: C needs a special diet rich in calcium, but she cannot prepare her own food because it requires her to stand in the kitchen for 30 minutes or more—something that she cannot do. The cost of the aide to prepare this food is not deductible.

Deduction of capital home improvements: Tax preparation lore is full of stories of people deducting the cost of an indoor swimming pool because their doctor prescribes “hydro-therapy” for their aching backs. The Service frowns on such overreaching.¹² In the case of the elderly, it is likely that questions about deductibility will arise with the installation of equipment that no one would want in their home but for their frailties.

The general rule with regard to the deductibility of capital expenditures is that an individual may deduct as a medical expense any capital expenditures for equipment installed in the home if its main purpose is medical care.

The costs of the following items have been permitted as deductions:

• Elevating lifts (but not the installation of elevators);¹³
• Railings or support bars in the bathroom or elsewhere;¹⁴
• Modification of hallways and doorways to accommodate a wheelchair;¹⁵
• Any other modification, such as lowering counters or moving electrical outlets.¹⁶

In calculating the deductible portion of the capital expenditure, the cost of improvements is reduced by the increase in the value of the property.¹⁷

Example 6: Because N is wheelchair bound, he must have an asphalt path laid across his gravel and dirt front yard. Without it, he cannot gain access to his house. The cost of this work is $5,000. After it is done, an appraisal of N’s house shows that its fair market value has been increased by $3,000. Only $2,000 of the total cost is deductible as a medical expense. The other $3,000 will presumably be recouped on the sale of the home.

Deduction for Nursing Homes and Home Nursing Services

One area about which there had at one point been much disagreement among practitioners was the deductibility of medical expenses for long-term care, whether provided in the home or in a nursing facility. Certain services, such as those provided by registered nurses or licensed practical nurses, were clearly deductible whether provided in a nursing home or at home. Less certain were those services, particularly nursing home services, that were custodial in nature. Custodial services are those that assist the patient with what are known as the activities of daily living, such as feeding, dressing, toilet rituals, moving about, or bathing. Custodial services are normally provided by a personal care attendant (PCA) either in a private home or in a custodial care nursing facility.

The Health Insurance Portability and Accountability Act of 1996, P.L. 104-191 (HIPAA), established rules governing the deductibility of the costs of long-term care. Most of these rules were effective beginning in 1997. HIPAA established that long-term care (LTC) insurance premiums are deductible as medical expenses and that the receipt of insurance proceeds from an LTC policy is excludible from gross income.¹⁸

HIPAA also amended the Code to make clear that the costs of long-term care for a “chronically ill individual” are deductible as medical expenses if they are provided pursuant to a plan of care prescribed by a licensed health care practitioner.¹⁹ Deductible expenses include those necessary for diagnostic, preventive, therapeutic, treating, mitigating, rehabilitative, and maintenance or personal care services.

Chronically ill: A chronically ill individual is one with either a severe functional or a severe cognitive impairment.²⁰ A person is deemed to have a functional impairment when he or she needs substantial assistance in performing two or more of six specified activities of daily living and this impairment has existed for at least 90 days:

• Eating;
• Using the toilet;
• Mobility;
• Bathing;
• Dressing;
• Continence.

An individual is deemed to have a cognitive impairment when he or she requires substantial supervision to protect his or her health or safety. A common example is a patient with Alzheimer’s disease. Although such a patient might be physically healthy, the inability to perform daily tasks can place the patient or others in physical jeopardy. If such a condition requires substantial supervision by another person, this cost is deductible.²¹

Example 7: R has Alzheimer’s disease and lives in an apartment in which there is a gas-fueled oven. The potential danger to himself and others likely qualifies the cost of his PCA as a deductible medical expense.

Prescribed plan: The last prereq-uisite to deductibility is that the patient’s care be provided under a plan prescribed by a licensed health care practitioner (physician, registered nurse, or licensed social worker).²²

Note: Although a discussion of health care regulations is outside the scope of this article, be aware that the rules of hospital admission, treatment, discharge, and aftercare are quite detailed and that their scope and existence are as well known to health care providers as the tax code and rules are to an accountant. So if a person is admitted to a state-licensed nursing home (particularly one that accepts either Medicare or Medicaid payments from some or all of its patients), it is highly likely that the patient’s admission was made under a qualifying plan of care and would be tax deductible.

There is a caveat for clients receiving care at home, however. Often a family will hire a PCA to help a parent continue to live outside a nursing facility. The problem arises when such home care attendants are hired based on informal medical advice rather than on a formal written health care plan. This may occur when a family asks the elderly patient’s doctor whether home care is a good option. A doctor’s almost passive response that it “would not be a bad idea” is not the strongest evidence of tax deductibility. Remember that to deduct the attendant’s charges as a medical expense, the patient receiving the home care must be formally certified as chronically ill and the services must be provided under a formal plan of care.

Written records of the attendant’s services should be kept, and the deductible personal care services should be distinguished from the nondeductible, maid-type services. Good record-keeping is essential under HIPAA because time estimates might be insufficient. But if all tests are met, the cost of a PCA is a deductible medical expense. The incidental costs of the attendant’s hiring are also deductible: the PCA’s withholding taxes, the costs of meals provided to the aide, and, if the required services include having the aide sleep over, lodging costs.

Note that HIPAA prohibits a deduction for services provided to a patient by a spouse or other relative who is not a licensed professional.²³ The long list of relatives also includes descendants, stepchildren, siblings and stepsiblings, ancestors, stepparents, nieces and nephews, uncles and aunts, and various in-laws. The effect is to overrule prior cases, such as Estate of Dodge,²⁴ in which the Tax Court upheld a deduction for nonprofessional nursing services provided by the taxpayer’s daughter.

Deductibility of Long-Term Care Insurance

Before HIPAA, there was great uncertainty about the tax deductibility of LTC (i.e., nursing home) insurance premiums. It was unclear whether insurance for nursing homes could be deducted if the benefits ultimately paid out were nondeductible medical expenses (as, for instance, the payment of a fixed daily amount when the patient was in a nursing home, without distinguishing whether these amounts were for the medical or the room and board components of the stay).

HIPAA contains detailed provisions on the tax treatment of both LTC insurance and benefits received. The tax practitioner should be familiar with the following provisions:²⁵

• Premiums for LTC insurance are deductible as a medical expense and are treated as premium payments for the purchase of insurance;
• Benefits are excluded from gross income;
• Both the premium deductibility limitation and the benefit exclusion limitation are adjusted for inflation; and
• There are limits to the deductibility of premiums and exclusion of benefits as income.

Deductibility is based on the insured’s age. See Exhibit 1 for the applicable rules.²⁶

Although the deductibility of premiums benefits older taxpayers, this can be misleading if viewed out of context. For example, a 71-year-old person may deduct up to $3,850, but the policy will likely cost at least that much. For a younger person, e.g., a 51-year-old, the policy may cost only $800. Thus, the percentage of deductibility is fairly consistent. In addition, most people do not even begin to consider LTC insurance until they are in their mid to late 60s. It is rare for younger people to purchase their own policies.

Tax Benefits Available to Children Caring for Their Parents

Often an adult child will ask whether he or she may claim a dependent exemption for a parent or deduct a parent’s medical bills if the child is paying them. Indeed, several tax benefits may be available to children caring for parents.

Head of Household Status

A single person caring for an elderly parent in his or her household may be entitled to file as head of household rather than as single. The tax brackets are lower for a taxpayer filing as head of household. A married person, however, cannot apply as head of household, but the tax benefits of filing joint returns are even better than those for head of household.

The simplest way to determine whether a client qualifies as head of household is to determine whether he or she may claim an exemption for the parent.²⁷

In order for a child to receive an exemption for a parent, he or she must meet the following five tests:²⁸

1. Member of household test: The parent must have resided with the child for the entire year.

2. Citizenship test: The parent must be a U.S. citizen or resident or a resident of Canada or Mexico.

3. Joint return test: The parents may not file their own joint tax return for the tax year in which the exemption is sought.

4. Gross income test: The parent must not have earned more than a certain amount during the tax year ($3,500 in 2008).

5. Support test: The child must pay for at least half of the parent’s household expenses during the tax year.

Household expenses include the costs of operating a home, such as mortgage payments, rent, property taxes, utilities, insurance, and repair costs, as well as such items as groceries, clothing, and medical care.²⁹ Also counted as support would be the fair rental value of space occupied by a parent living in the child’s home.³⁰

Many tax preparers believe that to meet the over-50%-support test, the child must furnish for the parent’s support an amount equal to the parent’s earnings plus at least $1 more. Interestingly, however, in determining whether a child has provided more than half of the parent’s support, only monies actually expended by the parent count.³¹ As a result, if your clients plan wisely, they might qualify for the exemption even though the amounts expended on the parents are not more than 50% of the amounts received by the parents during the tax year.

Example 8: F is a widower. His income consists of $6,000 per year from Social Security and $7,000 per year from his pension, a total of $13,000. F’s annual expenditures are $10,000. This includes shelter, food, and other needs. F’s daughter, D, believes that she must provide $13,001 to claim her father as a dependent and, because his own income covers his expenses, she feels that she cannot qualify.

In fact, if D pays $5,001 per year for the support of her father, while F pays the other $4,999, D will qualify for the exemption. It does not matter that her father has the means to pay his own bills; what matters is that he did not.

What about the case in which more than one child contributes toward the support of a parent, but no one child contributes more than 50%? Who, if anyone, is entitled to the exemption?

One might suppose either that no one is or that the child who contributes the most may claim the exemption. In fact, however, the procedure is very similar to when two parents divorce and agree who will be entitled to the exemption for their child. As long as the aggregate contributed by all children exceeds 50%, the children may agree among themselves who is entitled to claim the parent as a deduction.³²

Caution: The child claiming the exemption must have contributed at least 10% of the support.³³

Deductibility of a Parent’s Medical Expenses

If a child may claim a parent as a dependent, the child may also deduct that parent’s medical costs if the child itemizes deductions. Such deductions are still subject to the 7.5% floor on medical deductions but they are not dependent on the parent’s earnings. Unlike the personal exemption, the child may deduct the expenses of a parental dependent even if the parent has more than $3,500³⁴ of gross income.³⁵

Dependent Care Credit

A child who is entitled to claim the parent as a dependent may also be eligible for the dependent care credit if he or she paid someone else to care for a disabled dependent so that he or she could go to work or look for work.³⁶

Eligibility tests: For the child to be eligible for the dependent care credit, he or she must meet several tests:

• The parent must be incapable (physically or mentally or both) of providing for his or her own care and thus needs the full-time attention of a caregiver.
• The child’s household must be the parent’s principal residence. Normally, the care might be provided by the caregiver in the child’s home (as, for example, by a home care attendant). But if the care is provided outside the home (for example, in an adult daycare facility), the dependent parent must generally spend at least eight hours each day in the child’s home. Normally this is not a problem because the parent spends the night there. This requirement is intended to prevent a child from claiming the dependent care credit for a parent who is institutionalized. In fact, the credit is not available against the costs of full-time institutional care.³⁷

The maximum qualifying expenses for the credit are $3,000 for one parent and $6,000 for two parents.³⁸ The latter figure is also the maximum amount of deductible expenses regardless of how many qualifying dependents the taxpayer has. Therefore, if both the husband’s and wife’s aged parents are residing with them, the maximum credit is still $6,000. In addition, if the taxpayer couple also has minor children for whom dependent care is being provided (daycare, for example), the credit is still $6,000.

The amount of the dependent care credit ranges from 20% to 35% of the creditable expenses, with the 35% maximum applying to taxpayers with AGIs below $15,000.³⁹ It is highly likely that most children paying a parent’s qualifying expenses will only be entitled to the minimum 20% credit, which kicks in for taxpayers with AGIs of $43,000 or more.

For most taxpayers it would be difficult to support their own family as well as a parent or parents on much less. As a result of this limitation, the dependent care credit, although technically available, may not be the wisest choice. Generally, the credit may be calculated on Form 2441, Child and Dependent Care Expenses, or on Schedule 2 of Form 1040A.

Medical Expense Deduction

The tax preparer should explore the possibility of taking the dependent care expenses as a medical expense deduction, assuming they qualify as such, rather than as a credit. This may seem like a bad idea because generally a credit is worth more to a taxpayer than an itemized deduction, and certainly more than a deduction subject to a 7.5% AGI floor. But watch what can happen in the right circumstances:

Example 9: H and W, a married couple, live with H’s father and mother, F and M, and W’s mother, L. They have a two-year-old son, S.All three grandparents require assistance during the day while H and W are at work. During that time, S is in daycare. It costs H and W $8,000 per year to care for their parents and $4,000 per year to care for S.

The entire amount spent on the grandparents would qualify for the medical deduction if H and W itemized their deductions; the 7.5% medical deduction floor has already been met by other medical expenses. H and W are entitled to a dependent care credit of 20% of the creditable expenses. H and W are in the 28% income tax bracket.

H and W’s accountant could prepare their tax returns in one of two fashions (see Exhibit 2).

Using the same facts but first applying those expenses that would not qualify for any other deductions (S’s care) increases the total tax benefit (credit and deduction) from $1,760 to $2,880, effectively saving the taxpayer $1,120.

The dependent care credit is not limited to expenses paid by children caring for their parents. It is also available for expenses paid for the care of a spouse, if the spouse is physically or mentally incapable of caring for himself or herself and has the same principal place of abode as the taxpayer for more than one-half of the tax year.⁴⁰

Conclusion

As the number of elderly Americans continues to grow, the tax benefits described in this article will become available to more and more taxpayers. Although some taxpayers will be aware of the full extent of these benefits, most will not. It is therefore imperative that all CPAs involved in giving tax advice to individuals be well versed in the rules for these benefits and that they actively consider whether the rules will apply to their clients.

EditorsNote:

This article was adapted from Huber, Adviser’s Guide to Counseling Aging Clients and Their Families (AICPA 2007).

To order, or for more information, call 1-888-777-7077 or visit www.cpa2biz.com.

Notes

¹ U.S. Census Office, Twelfth Census of the United States—1900, Census Reports, Vol. II, Population, Part II, Table 1, Ages of the Aggregate Population of the United States.

² U.S. Census Bureau, 2006 American Community Survey, Table S0101, Age and Sex.

³ U.S. Census Bureau, U.S. Interim Projections by Age, Sex, Race, and Hispanic Origin (2004), Table 2a, Projected Population of the United States, by Age and Sex: 2000 to 2050.

⁴ Sec. 213(a).

⁵ IRS Publication 17, Your Federal Income Tax, chapter 21, “Medical and Dental Expenses” (2007).

⁶ Sec. 2523(a).

⁷ Sec. 213(a).

⁸ Sec. 152 defines dependents; see also Sec. 213 and Regs. Sec. 1.213-1.

⁹ Regs. Sec. 1.213-1(d).

¹⁰ See IRS Publication 502, Medical and Dental Expenses, and Sec. 213.

¹¹ IRS Publication 502.

¹² See, e.g., Ferris, 582 F2d 1112 (7th Cir. 1978) (deduction limited to cost of building a pool functionally adequate to relieving medical condition); Evanoff, TC Memo 1982-600 (deduction disallowed where main use of pool was recreational); Huff, TC Memo 1995-200 (cost of hot tub disallowed); but see Cherry, TC Memo 1983-470 (deduction allowed where primary purpose of constructing pool was medical rather than recreational).

¹³ Rev. Rul. 87-106, 1987-2 CB 67. Interestingly, the section “What Medical Expenses Are Includible?” in IRS Publication 502 gives the following example of deductibility: “Installing porch lifts and other forms of lifts (but elevators generally add value to the house).” However, on the same page, the Service gives an elevator as an example of a partially deductible expense.

¹⁴ Rev. Rul. 87-106, 1987-2 CB 67.

¹⁵ Id.

¹⁶ Id.

¹⁷ Regs. Sec. 1.213-1(e)(1)(iii).

¹⁸ Sec. 162(l).

¹⁹ Secs. 213(d)(1)(C), 7702B.

²⁰ Sec. 7702B(c)(2).

²¹ See generally Sec. 7702B(c); Notice 97-31, 1997-1 CB 417.

²² Sec. 7702B(c)(1)(B).

²³ Sec. 213(d)(11).

²⁴ Estate of Dodge, TC Memo 1961-346.

²⁵ Sec. 7702B.

²⁶ Rev. Proc. 2007-66, 2007-45 IRB 970 (updating for inflation amounts from Sec. 213(d)(10)(A)).

²⁷ See generally Sec. 152 and the regulations thereunder as reference for claiming exemptions and therefore head-of-household status.

²⁸ Sec. 152.

²⁹ Regs. Sec. 1.152-1(a)(2)(i).

³⁰ Regs. Sec. 1.152-1(a)(2)(i).

³¹ Regs. Sec. 1.152-1(a)(2).

³² Regs. Sec. 1.152-3.

³³ Regs. Sec. 1.152-3(a)(3).

³⁴ Rev. Proc. 2007-66, 2007-45 IRB 940.

³⁵ Sec. 213 and Regs. Sec. 1.213-1(a)(3)(i).

³⁶ See generally Sec. 21.

³⁷ Sec. 21(b)(2)(B).

³⁸ Sec. 21(c).

³⁹ Sec. 21(a)(2).

⁴⁰ Sec. 21(b)(1)(C).