If you were thinking about donating your old car to charity, you better do so quick, and in 2004, because on January 1, 2005, Congress (in the American Jobs Creation Act of 2004) and the IRS will begin discriminating against those who would donate vehicles, boats and planes to charities.  Historically, when someone donates property to their favorite charity they may deduct its fair market value.  The common definition of fair market value is what a willing buyer will pay a willing seller.  When we donate a car (or boat) to a charity, they typically will sell it to a whole seller at an auction or for a bargain sale, who in turn sells it to a used car lot, who in turn sells it to the end user.  Although the whole seller is a willing buyer, the charity is not a willing seller.  The willing seller and buyer tests, establishing the fair market value, are not satisfied until the used car company sells it to the end user.  For example, a car worth $5,000 donated to a charity might be sold by the charity to the whole seller for $3,000, who might sell it for $4,000 to the used car company, who then sells it for $5,000 to the end user, which establishes the fair market value of the car.  Since the contributor could not likely ever know the details of the final sale, estimations of this value have historically been estimated by either consulting a used car value guide, such as Kelly Blue Book, or for assets over $5000, hiring an appraiser.  Beginning January 1, 2005, no longer.  In the example above, under the old rules the charitable contribution deduction is $5,000, next year the contribution would be only $3,000.

In order to close a perceived abuse of taxpayers by Congress, claiming higher values than reasonable, we can only deduct the amount charity is able to sell the car for, assuming that they actually sell it.  All other property given to charity such as clothes, toys and furniture can still be valued at fair market value.  Therein is the discrimination.  The IRS in IR-2004-142 has spelled out many of the details of the new law.  I have included it below.

Tom Umstattd, CPA

IRS Officials Urge Care for Those Making a Car Donation; New Law Changes Rules at End of the Year

IR-2004-142, Nov. 30, 2004

WASHINGTON — The Internal Revenue Service issued a consumer alert today to help taxpayers avoid potential pitfalls when they donate their automobiles to charities.

In addition, as taxpayers plan their charitable giving, donors should understand the way that the American Jobs Creation Act of 2004 will alter the rules for the contribution of used motor vehicles, boats and planes after Dec. 31, 2004.

Next year, if the claimed value of the donated motor vehicle, boat or plane exceeds $500 and the item is sold by the charitable organization, the taxpayer is limited to the gross proceeds from the sale.

Under the new rules, the charitable organization must provide an acknowledgement to the donor within 30 days of the sale stating the amount of gross proceeds. Alternatively, if the charity significantly uses or materially improves the vehicles, the charity must certify this intended use and duration and provide an acknowledgement to the donor within 30 days of the contribution. If the charity significantly uses or materially improves the vehicle, generally, the donor may deduct the vehicle’s market value.

For the remainder of 2004, however, the new rules do not apply. Under the rules in effect for 2004, taxpayers will be able to deduct the fair market value of the contributed property.

“Just because the rules will be tightened for vehicles donated next year doesn’t mean anyone should give a car to charity and claim an inflated value this year,” said IRS Commissioner Mark W. Everson.

IRS officials recommend that people who want to donate their vehicle by Dec. 31, 2004, take the following steps:

*  Check That the Organization is Qualified — Taxpayers should make certain that they contribute their car to an eligible organization; otherwise, their donation will not be tax deductible. Taxpayers can use the IRS Web site to check that an organization is qualified by searching Publication 78. Publication 78 is an annual, cumulative list of most organizations that are qualified to receive deductible contributions. Publication 78 is also available in many public libraries. In addition, taxpayers can call IRS Tax Exempt/Government Entities Customer Service at 1-877-829-5500. Be sure to have the organization’s correct name and its headquarters location, if possible. Churches, synagogues, temples, mosques and governments are not required to apply for this exemption in order to be qualified. They frequently are not listed in Publication 78. Donations to these institutions are tax deductible.

*  Itemize in Order to Benefit — Many taxpayers can’t take a deduction for car donations because they don’t itemize deductions on their personal tax return. For taxpayers, the decision to itemize is determined by whether their total itemized deductions are greater than the standard deduction (for 2004, the standard deduction will be $4,850 for single; $9,700 for married filing jointly). Slightly more than one-third of the 130 million individual taxpayers itemized in 2001, the last year for which complete data is available.

*  Calculate the Fair Market Value — The donor must take many factors into consideration to establish the value of the car. Many used-car buying guides contain step-by-step instructions so that readers can make adjustments to the value of a car for accessories, mileage and other indicators of its general condition. Both Publication 526, Charitable Deductions, and Publication 561, “Determining the Value of Donated Property,” provide detailed instructions.

*  Deduct Only the Car’s Fair Market Value — Some car donation program operators have mistakenly claimed that donors can deduct the highest value listed in a used-car buyer’s guide for their make and model of car, regardless of the donated car’s condition. The IRS, however, will only allow a deduction for the fair market value of the car. Fair market value takes into account many factors, including the vehicle’s condition. The fair market value of the taxpayer’s car may be substantially different than the highest value listed in a used-car buyer’s guide for that make and model of car.

*  Document the Charitable Contribution Deduction — For vehicle donations, taxpayers must document the car donation and its fair market value. Recordkeeping requirements are comprehensive and vary depending on the amount of the contribution and the total amount of the charitable deduction. IRS Publication 526 details requirements for the types of receipts taxpayers must obtain and the forms they must file.

*  Contact State Charity and IRS Officials When in Doubt — Donors with questions about whether a contribution is deductible should call the IRS at 1-800-829-1040 or for TTY/TDD help, call 1-800-829-4059. They can also find IRS forms and publications at IRS.gov. Donors concerned that contributions are being solicited for fraudulent purposes should contact the appropriate state charity official, who is often located in the state attorney general’s office. A list of state charity official offices can be found online.

Related Items:

*  IRS Publication 78
*  State Charity Officials
*  State Attorneys General
*  Publication 526, Charitable Deductions (PDF 177K)
*  Publication 561, Determining the Value of Donated Property ( PDF 101K)

We are always looking for ways to increase our cash flow.  My favorite is receiving non-taxable income by cutting my income tax bill, without actually having to “pay” for any extra cash expenses.  It seems our homes are filled to the brim with things that we have paid $1,000s  for or that we were given & have not used for years.  Now, I am not talking about family heirlooms or something that will have a specific future use to us.  But the Clutter, Clutter, Clutter!  How can we rid ourselves of this great American plague?

One man’s junk is another man’s treasure.  There are many folks less blessed than we and would greatly appreciate the stuff in our garages & attics.  Or perhaps we have moved, lost or gained weight or lost a beloved family member and still have some of  their personal effects that no one else in our family wants.  There are countless charities that receive gifts of personal property:  boats, cars, clothing, appliances, shoes, toys, household furnishings, you name it, even real estate.  Ginger and I have given to the Salvation Army, various churches, private schools, public schools, municipalities, neighborhood organizations, worthy Christian ministries, the Boy Scouts of America, Salvation Army, and others.  I personally prefer the Salvation Army due to their Christian ideals, rather than Goodwill.  Consult their Valuation Guide for Items Donated to the Salvation Army schedule which lists the average prices charged in their thrift stores.  A problem is, when we collect our “junk” we tend to just leave it off at the Salvation Army and do not get with a receipt, not itemize what we gave, and forget all about it at tax time.

It is amazing to me, after 24 years of experience, how many under report their charitable contributions.  I usually hear, “I don’t want to get the IRS mad at me,” like the IRS has emotions?!  There are 2 emotions inappropriate for making investment decisions:  fear and greed; same with determining fair market values.  So, what are things worth?  As usual, when taking an income tax position, there are some objective criteria to follow, and lots of subjective.  Objective criteria are:  using published (e.g. Wall Street Journal) trading ranges for common stocks donated, hiring a qualified appraiser for items valued over $5000, or donating the ownership of, for example, real estate, moments before the sale to an unrelated party, then using that sales price as the fair market value.  As president, Bill Clinton, setting an example for the rest of us by making public his tax return showing his deduction of $2 per pair of used underwear.  However, it is usually not reasonable to hire the expensive, and often over-worked qualified appraisers.  When this is the case, we must rely on the ambiguous, subjective and exciting measurement criteria offered to us by common law:  the gray area, my favorite color!

Tom’s Top Ten Tips for this type of giving:

1. Treat out of pocket charitable expenses for volunteer work, car miles, or amounts you paid for by check or credit card as cash expenses.  They are cash charitable contributions.  No guess work here, they are worth what you paid for them.
2. Know the locations of charities, so when you happen to drive by, you can easily drop off your items.  Sometimes charities like Texas Paralyzed Veterans can pick up your items from your front porch.  Always get and keep a receipt.
3. Amass less than $500 worth each time, then you do not need to keep track of the date you acquired the property, how you acquired the property, and the cost of the property.  Very important:  write down and itemize the property and number of the items given on a separate piece of paper, or on the receipt from the charity.
4. When the gift is made, write down in detail, using lots of adjectives, what the items are, and the cost(s) especially if over $500.  Instead of “radio” write down e.g. “AM/FM portable, stereo, Lafayette model 76XL, with dual 3 1/2 inch compatible speakers, condition: good.”  I frequently have one of my helpful children fill this page out; it gives them a sense of philanthropy; the IRS will not count off for misspellings.  Put this page and charitable receipt in your current year’s “Income Tax File Folder.”
5. On the day given, do not write down the value.  Psychologically, these items are worth the absolute least to you on the day you give them away.  (If they were worth a lot to you, you would likely not yet give them away.  Also you may be embarrassed that you still have them, bought them in the first place, or, how many pairs of shoes can a woman own. anyway!)  And do not value what they are worth to you, value them at what they are worth to someone else who is a “willing, knowledgeable buyer” and desires them.  Write values down much later, perhaps when you compile your data for me to prepare your return.  You would be surprised at how much some things cost in a thrift shop!  Stop in and see, sometime.  Exception:  when giving away large dollar items:  laptops, equipment, cars, etc., right before you give them away, look to see what they have sold on eBay recently.  Click the link below, then type in your item under “basic search” and click “search:”  http://search-completed.ebay.com/search/search.dll?GetResult&query=completed+items&ht=1&combine=y&SortProperty=MetaEndSort Then print out the comparable sale or “completed item,” as eBay calls it, and put this with your charitable receipt.
6. First see my article:  Discrimination Against Car Donators, concerning the new law for 2005 donations of vehicles, boats and planes to charities.  Big dollar items such as cars and boats, if valued less than $5000, currently do not need an appraisal, only the date contributed, acquired, how acquired (e.g. by purchase, gift), your cost and fair market value.  Traditionally Kelly Blue Book has been a good source of determining fair market value:  www.kellybluebook.com, but in January 2004, the Bush administration submitted more restrictions on the deductibility of vehicles to Congress.  http://www.usatoday.com/money/perfi/taxes/2004-01-16-mym_x.htm quotes:  “Conrad Teitell, a tax lawyer at the Stamford, Conn., firm of Cummings & Lockwood, says official ambiguity about the legitimacy of blue book values puts the taxpayer “in a very hard position.” Nonetheless, he says, deducting something close to blue book value for a working vehicle under the $5,000 appraisal threshold is probably defensible.”  Otherwise, for vehicles valued over $5,000, getting and attaching an appraisal to your tax return is greatly advisable, especially for 2003 returns.
7. Do not wait for that “great American spring cleaning.”  It is stressful and seldom happens.  Give frequently in small quantities.  Spring cleaning may work well in the Midwest, but the weather here in Texas allows for cleaning year round.  Have a collection box in your trunk ready.  I like those free blue recycle boxes that you can get from any Austin Fire Department station.
8. If you do have a considerable amount of items to give (e.g. spring cleaning, a death of a family member, etc.), consider separating it into groups of about $500 value each, and give them on separate days, contribute them to your partnership, and have the partnership give it.  Give some in the name of a family member in a higher tax bracket than you (you give it to them, and they give it to the charity) .
9. Gifts of appreciated property, held more than 1 year, will give you a charitable contribution at their fair market value, and you will not have to pay any capital gains tax.  Contributing publicly traded marketable securities, such as stock, is extremely easy.  Simply call your stock broker, have him or her open a separate brokerage account with the name and federal ID# of your favored charity, then simply direct your broker to make the stock transfer.  I have had many clients contribute stocks worth $1000s which they bought, inherited, received from their employer, etc. for very little, get the full deduction, and pay no capital gains tax.   If you give property (not including publicly traded securities) worth more than $5,000, you will need to get an appraisal, and have the appraiser sign Form 8283, Section B, which is filed with your tax return.  If you donate art worth $20,000 or more, you will need to attach a complete signed appraisal.  Real estate that you have trouble selling, and whose property taxes are high make good candidates for gifts.  If you are getting ready to sell appreciated real estate, you can have the title company change the deed just before closing, for an undivided interest (e.g. 10%) in the real estate  to your favored charity, then you and the charity together sell the property to the seller.  Make sure you talk to the seller first, and explain what you are doing!  Old buildings (without the land under them), especially in rural areas, like barns or old farmhouses, that may need to be torn down, make great gifts to the local fire department.  They typically will set it on fire, and practice putting it out, for training purposes.  When they are done with it, they usually have destroyed it for you.  Sometimes they will even haul it off for you as well.
10. Your charities need to be incorporated, and Section 501(c) organizations.  Certain Canadian, Mexican, and Israeli organizations also qualify as deductible if you also have taxable income from that country.  If the charity has a written statement saying that they are a IRC Section 501(c)(3) organization, or words to that effect, that should be sufficient.  Do not ask or expect your favored charity to tell you how much your donated items are worth.  Do not embarrass them with this inappropriate request.  They are a  religious, philanthropic educational organization, etc., not in the appraisal business.  Just simply ask for a written acknowledgement and description of your contribution, signed and appropriately dated.  My Southern grandmother called this a “thank you letter.”  If the item, or group of similar items, such as a silver service, collection of books, etc. is worth more than $5,000, then the charity will need to sign Part IV of your Form 8283 which you will need to attach to your Form 1040.  If they then sell this item within 2 years, the charity will be required to report this sale to the IRS on a Form 8282.  This is commonly used when someone wishes to bless a charity by giving them a part or all of a piece of real estate, just before closing as discussed in #9 above.  The title company should have the charity file the required Form 8282 at closing.  I suggest that the taxpayer also file this Form 8282 with their tax return in these circumstances.

And remember, Jesus said, “It is more blessed to give than to receive.”

For more information:   See IRS Instructions to Form 8283

(under an employee benefit program), by Michael Hengst

We would like to bring to your attention a tax saving plan that is relatively unknown.  This plan is for the sole proprietor of a small business or C Corporation.  A partnership or S Corporation cannot successfully use this plan for its owners.  The plan allows for 100% tax deductibility of health insurance premiums and uninsured medical expenses paid by the business.  The deduction can be taken as an employee benefit program deduction, on Form 1040, Schedule C, Line 14 or on Form 1120, Line 25.  Internal Revenue Code 105 & 106, along with Revenue Ruling 71-588 make this plan legal.  This is not a Medical Savings Account (MSA), which tends to be quite cumbersome, hard to manage, and easily penalized by the IRS.  The taxpayer has or sets up a small business and employs his wife or her husband.  (For a C Corporation there is no spousal employment requirement.)

The employee/spouse performs duties needed to help operate the business and receives a reasonable salary for services performed.  The salary paid to the employee/spouse is included on the couple’s federal individual income tax return.  The spouse and dependents (including the employer/spouse) can also receive non-taxable medical reimbursements for qualified medical expenses.  The reimbursement received is not included in gross income for the recipient (Code Section 105) and is fully deductible by the business.  Although legally these plans do not have to be in writing, it is our opinion that they should be.  We have a simple one page form at our office for you.  This will help insure the law is properly followed.  The plan cannot discriminate in favor of a certain employee(s) over others.

The benefits paid by the business along with the reimbursements make this a 100% tax deduction.  Benefits can include:  all uninsured medical expenses (deductibles, co-pays, uncovered expenses), Health Insurance, Disability Income, Long Term Care, Cancer Insurance, Term Life Insurance (up to $50,000 per year), Medicare Supplement, Indemnity Hospital, Indemnity Medical, and Vision/Hearing Insurance.  The uninsured medical expenses that are not covered by insurance should be for the diagnosis, cure, mitigation, treatment, or prevention of disease.

A physician should prescribe the medications.  Also deductible if not covered by the benefits is lodging while away from home while a spouse is in a licensed hospital or in a medical care facility.  The lodging is limited to $50 for each night for each individual.  A medical expense such as cosmetic surgery is not included unless the surgery is necessary to ameliorate a deformity arising from, or directly related to, a congenital abnormality, a personal injury resulting from an accident or trauma, or disfiguring disease.  If you feel that you or your business may qualify for this plan, please contact us.

NEW FOR 2003!! According to the IRS’s new Revenue Ruling 2003-102 (9/5/03):

Over-the-Counter Drugs Can Be Covered by Health Care Flexible Spending Accounts.  The Treasury Department and the IRS announced over-the-counter drugs can be paid for with pre-tax dollars through health care flexible spending accounts.  Treasury and IRS issued guidance clarifying that reimbursements for nonprescription drugs by an employer health plan are excluded from income.  Thus, reimbursements by health flexible spending arrangements (FSAs) and other employer health plans for the cost of over-the-counter drugs available without prescription are not subject to tax if properly substantiated by the employee. See: http://www.irs.gov/pub/irs-drop/rr-03-102.pdf Note, that vitamins for “general good health” are not considered as non-taxable or excludable health benefits for these types of plans.

By Michael Hengst,

Michael Hengst

Some of my colleagues offer electronic filing (E-File); I do not, yet.  This procedure is currently most appropriate with low-budget, seasonal, non-CPA tax return preparers who prepare 1000s of very fast and easy returns with refunds; we prepare almost no easy returns.  We first looked into E-Filing about 8 years ago and every year since.  When a return is E-Filed, the “pertinent information,” according to the IRS, from a tax return is downloaded via the internet directly into the IRS’s computer system.  E-Filers cannot send explanations or attachments.  When a return is filed via the mail, IRS employees keypunch certain entries from the return.

If a return, as the IRS calls it:  gets “kicked out of the pipeline” or, gets selected with “audit potential” by other means, then an IRS employee looks at the paper filed return with all of the attachments and explanations and professionally decides whether to proceed further.  But for E-Filed returns, were no paper is filed, then the IRS is left with little alternative but to contact the taxpayer and begin the arduous experience of examining the taxpayer’s receipts and records which corroborate his or her income, deductions, etc.  And, if the IRS goes through this much trouble, as many of you already know, they tend to examine everything.  Ray Sommerfield, one of my UT tax professors warned us, “When it comes to audits, the IRS has determined that there’s a lot of gold in ‘them thar hills.’”  For example, we have many philanthropic clients who give more than 10% of their income to charities.  This 10% benchmark is one of the IRS’s benchmarks for high audit probability.  If we can attach statements from 1 or more of the charities proving most of the charitable contributions deduction, we have likely assuaged an audit.  This cannot be done with E-Filed returns.

Perhaps the IRS’s chronic lack of security measures is the best reason not to E-File.  Click here for our privacy policy.  Government investigators each year try to hack into the IRS’s computer system, and each year are able to access private information from E-Filed returns in the IRS’s computer system.  Each year we link to an article on this website concerning this reoccurring problem, but these links seem to expire quickly.  So this year, I have copied an Associate Press article in its entirety.  It is now below.  Note:  a hacker can retrieve information and exit without the IRS even knowing that they were ever there.

Study:  IRS Data Open to Hackers, Thursday March 15, 2002, 1:24 PM ET

WASHINGTON (AP) –Government investigators were able to hack into the Internal Revenue Service computer system last year and access Social Security numbers and other sensitive information from electronically filed tax returns, a congressional report said Thursday.

“We demonstrated that unauthorized individuals, both internal and external to IRS, could have gained access to IRS’ electronic filing systems and viewed and modified taxpayer data contained in those systems during the 2000 tax filing season,” the General Accounting Office report stated.

The investigators said they were able to gain access to taxpayer information because the IRS had not securely configured its operating systems, implemented adequate password management practices or used encryption technology.

The IRS said it had no evidence that real intrusions actually occurred, but the GAO concluded the agency did not have “adequate procedures to detect such intrusions.”

The IRS also said in its response that it had taken steps to better protect taxpayer privacy this year.

Sen. Fred Thompson, R-Ten., Chairman of the Governmental Affairs Committee, asked for the investigation.

Written July 2001 by Tom Umstattd, CPA.  Why your business should get and use a website to promote its products and services.

Having a website is a new way of reaching your targeted clients and customers. With today’s computer savvy economical climate, it is becoming more and more imperative that we have at least a minimal website for our businesses. So, what are some of the other reasons to use a website?

• You would like to refer to pictures, plats, charts, graphs, reports, and other information, when promoting your goods or services with your customers on the phone.
• You have answered the same question repeatedly and would like to refer someone to an article (frequently asked questions) that would answer their question.
• You would like to have detailed information about your company, its employees, mission, purpose, locations, directions, maps, hours, readily available to someone who wants to know.
• You would like to have detailed information about your products or services that can be in an electronic brochure that can be bigger, more colorful, continually updated, and perhaps cheaper, than a preprinted brochure.
• You want to reach potential customers who will visit your store or office or contact you directly.
• You want your customers to be able to check your product availability any time, day or night.
• You’d like to sell directly from the web.
• You have products or services with a visual or auditory impact: real estate, sculpture, interior designs, art, music – and you want potential customers to see and hear your work.

It is critical that whatever you are trying to accomplish, your website must be integrated into your sales and marketing strategy. Have your employees: sales people, receptionists, etc. frequently refer to your website to receive and deliver information about your business. They should be very familiar with what information is on the website, so there is more time for salesmanship, and less time spent reporting technical data to potential customers. While communicating with my clients and perspective customers, I find myself referring more and more to my websites, as well as other websites, while we talk on the phone. Listening to my voice while simultaneously looking at my website’s pictures, forms, contracts and the like is tremendously effective, facilitates the communication of difficult subjects, and saves lots of time.

Your marketing strategy must take into account the new and often-ignored characteristics of the World Wide Web, the technology behind it, and the attitudes of the public as they update to connect into this culture-changing phenomenon. Also more and more people are expecting savvy businesses to be on line. Advertisements everywhere include a website address. Perspective customers ask: “What’s your website?” Web presence alone could be the difference of making a sale or not. I think that sooner or later most businesses will have websites.

I frequently refer to my own websites, so that clients, perspective business associates, buyers, sellers, mortgage lenders, governmental bureaucrats, brokers, and yes, even friends, can quickly familiarize themselves with the technical qualifications, capabilities, services, products and experiences of my businesses. That way we can spend more time on the phone, at lunch, etc. negotiating the deal, connecting, winning favor, and best of all having a little fun together.  I used to be obliged to render a pontification my credentials and accomplishments, running the risk of being interpreted as merely having an ego trip.  Now I just refer to my website; and when they get enough, they do not have to be rude, but just click <back.

As a Texas employer, you have a number of responsibilities to fulfill to your employees, the IRS, the Social Security Administration, the Texas Workforce Commission, and even the Immigration and Naturalization Service. You have requirements to meet with all four of these agencies, regardless of how few hours your employee works, or whether your employees are members of your family. This article is intended to outline your basic responsibilities in clear simple steps.

You must use your Federal Employer Identification Number (FEIN) on all items you send to these government agencies. If you do not have a FEIN, you can apply for one on Form SS-4, and have your number assigned over the telephone by calling 512-460-7843. If you take over some one else’s business, do not use their FEIN, be sure to get your own.

If you need any of the forms described in this article, you may call the IRS forms and publications at 1-800-829-3676, or print them out from the IRS website, www.irs.ustreas.gov, or call our office for assistance.

You have some basic record-keeping requirements. Each employee must have three things: a social security number, a current Withholding Allowance Certificate called Form W-4 from the IRS, and Employment Eligibility Verification called Form I-9 from the Immigration and Naturalization Service. Keep these on file.

Whenever you pay your employees, the employer is responsible for withholding a certain amount for federal income tax, social security tax and Medicare tax. The information your employee gives you on the W-4 affects how much you must withhold from their pay for federal income tax. Circular E from the IRS includes tax tables that calculate federal withholding. The tax tables are updated frequently. Using QuickBooks for your paychecks simplifies these calculations tremendously. By subscribing to QuickBooks Basic Payroll Service, your payroll tax tables are continually updated and the proper withholding is automatically calculated on your paychecks.

Social security tax is a straight 6.2% of gross wages. Medicare tax is 1.45% of gross wages. As an employer, you also pay four employer payroll taxes – the matching social security tax of 6.2%, the matching Medicare tax of 1.45%, the federal unemployment tax of 0.3% and the state unemployment tax set for your business by the Texas Workforce Commission, usually 0.3%. QuickBooks, when properly set up, will automatically calculate all these taxes too.

These taxes, with the exception of Medicare tax, are limited to a certain amount of wages. Social security tax only applies to the first $80,400 of earnings for the 2001 tax year. Federal unemployment tax only applies to the first $7,000 in wages. And Texas unemployment only applies to the first $9,000 in wages. These limits are called a “wage base”, and may change each year. Medicare has no wage base limit. If you already use QuickBooks or another computerized payroll program, it would be wise to review your payroll set up at the beginning of each year to determine if you are using the proper tax percentage and wage base for each payroll item.

So, to summarize the above, whenever you write a paycheck, you create seven payroll tax liabilities. Three employee taxes, and four employer taxes. These taxes are due quarterly for many of our clients. The IRS has made a welcome change in the tax due dates starting January 1, 2001. IF YOUR PAYROLL TAX LIABILITIES TOTAL LESS THAN $2,500 FOR THE QUARTER, YOU ARE NOT REQUIRED TO MAKE DEPOSITS WITH THE BANK. You can pay your tax with your quarterly return. QuickBooks will automatically calculate and print your quarterly payroll tax form.

If you have more than $2,500 in payroll tax liability, but less than $50,000, you are a “monthly depositor”. That simply means your federal payroll taxes for the month are due by the 15^th of the following month. Deposit your taxes in any bank using a federal tax deposit coupon called a Form 8109. This coupon is a deposit slip for the federal government, and your account number is your FEIN. These blue deposit slips forms will be sent to you preprinted by the IRS, or may be ordered directly from them.

The quarterly form is Form 941. It is used to pay federal withholding, employee and employer social security tax, and employee and employer Medicare tax. Form 941 is due April 30, July 31, October 31 and January 31. So you have a month after each quarter has ended to determine and pay these five tax liabilities. Your state unemployment tax is due quarterly to the Texas Workforce Commission on the same dates. If you are a monthly depositor, then the Form 941 will account for your deposits, and there will usually be no additional taxes due.

The Texas Workforce Commission’s form is called the C-3 Employer’s Quarterly Report. The Texas Workforce Commission (TWC) form also requires a list of all employees by social security number and wages earned during that quarter. Your state unemployment tax rate is determined by the number of claims for unemployment benefits your past employees have made. The fewer the claims, the lower the rate. The lowest rate is 0.3%. This rate is made up of 0.2% unemployment tax and 0.1% Smart Jobs Assessment or job training tax. You must use the red forms the TWC sends to you. If you have any questions, you can call TWC at 491-4716.

Your federal unemployment tax (also known as FUTA) is only due once a year on January 31, if your federal unemployment tax liability is less than $100 for the year. If you have less than 5 full-time employees, you will probably fall under that limit. Wages paid to your spouse or parent are NOT subject to FUTA if it is paid by you as an individual. Wages paid to spouse or parents are subject to FUTA if they are paid by a corporation or trust. QuickBooks will automatically calculate and print your FUTA Form 940 as well.

At the end of the year, you must file your annual Wage and Tax Statements called Form W-2. These are special three-part forms, which are printed in red and can be ordered free from the IRS or purchased at an office supply store. QuickBooks will automatically calculate and print your W-2’s onto these forms. They are due to your employees by January 31.

Form W-3 is a “cover sheet” for your W-2’s that gives the total of all wages and taxes withheld for your company’s employees. These special red W-2’s and W-3 forms go to the Social Security Administration (SSA). It is another special red form that QuickBooks will print onto automatically. Do not fold, staple, or paper clip these tax forms. And they must be typed or printed from a computer, or they will not be accepted. There are no additional taxes to be paid with these forms. The SSA must receive them by February 28.

If you don’t have QuickBooks, you might want to consider having our office prepare your payroll tax forms. Please feel free to contact us at any time if you have any questions. We are at your service.

By Gail Henkel

Gail Henkel

MEDICAL EXPENSES AND BELOW-MARKET-RATE LOANS IN

CONTINUING CARE RETIREMENT COMMUNITIES

By Robert Atkins Walker, Ph.D., CPA and Chad E. Turner, CPA

Published in 18 Virginia Tax Review 1 (Summer 1998: The University of Virginia School of Law) under the title “Gold at the End of the Rainbow:  Medical Expenses and Below-Market-Rate Loans in Continuing Care Retirement Communities,”

I.  Introduction

A.  Purpose

Residents of continuing care retirement communities (CCRCs) or their children, if the residents are the children’s dependents,¹ face significant tax consequences associated with the fees they pay to a CCRC.  On the positive side, they usually can take a large tax deduction for the medical expense portion of their entrance fee² and may also deduct the medical portion of their monthly fees.  Negative consequences may occur, however, if the CCRC is obliged to refund some or all of the entrance fee when a resident vacates or dies.  The refundable portion of the fee may be treated as a below-market-rate loan in which case residents may have to report imputed interest income, and the CCRC, imputed interest expense, on the refundable portion of the entrance fee.³ Residents also may have taxable income on the refund if they took a medical expense deduction on the entire original fee.  This article addresses these consequences and analyzes the methods CCRCs use in estimating the portions of the entrance and monthly fees allocable to medical care.

In many cases, the tax impact of moving into a CCRC may be very large, resulting in a medical expense deduction of $20,000 or more for the entrance fee and $3,000 or more annually for the monthly fees.⁴ Residents in assisted living units (ALUs) generally should be able to deduct 100% of their monthly fees.  Nursing care residents also may deduct 100% of their monthly fees.

The IRS has provided little guidance regarding the mechanics of computing the deduction, the acceptability of the various rationales used by CCRCs in computing the medical expense percentage of their residents’ fees, or the tax effects on residents or their estates of an entrance fee refund.  Furthermore, there is little consistency among CCRCs in advising their residents as to what is deductible or in their methods of computing the percentage of fees allocable to medical costs.

The need for consistent and proper treatment of the CCRC medical expense deduction is growing in importance.  Since the 1970’s, the number of CCRCs has increased dramatically.  In 1994 there were over 350,000 residents in nearly 1,200 CCRCs.⁵ This number is growing steadily and will accelerate after 2010 as the baby boomers reach retirement age.

To our knowledge, four articles to date have addressed the tax deductibility of CCRC fees.  The first focused on nursing home residents,⁶ the second misinformed the readers,⁷ the third devoted only one paragraph to the issue,⁸ and the fourth discussed the effects of the Health Insurance Portability and Accountability Act of 1996⁹ on deductibility of long-term care expenses and insurance.¹⁰ The second article stated, “[i]n counseling on the tax deductibility . . . of CCRC costs, you must first establish whether the principal reason for entry into the CCRC is the availability of medical and nursing care . . . .”¹¹ This is wrong.  As we discuss in section II.B.2., non-medical reasons for entering a CCRC will not prevent the deductibility of the medical expense portion of the fees.¹²

Our objectives are: (1) to clarify the tax deduction opportunities for CCRC residents, (2) to alert both the residents and CCRC administrators as to the potential tax effects of refundable entrance fees, and (3) to give CCRC administrators direction on allocating the medical expense fee portion properly so as to maximize their residents’ potential tax savings.

Regarding entrance fee refunds, we examine three issues: (1) whether the section 7872¹³ below-market-rate loan rules will trigger imputed interest on the refundable portion of entrance fees, (2) whether an anticipated entrance fee refund must be subtracted from the entrance fee in calculating the medical expense deduction, and (3) whether the residents, their estates, or their heirs will have to recognize income in the year the refund is received to the extent of the previously deducted medical expenses attributed to the refund.

The following example of a CCRC resident related to one of the authors illustrates most of the issues involved as well as the magnitude of the tax savings available in properly taking advantage of the deduction.

B.  An Example

Mrs. W, age 80, paid a $103,500 entrance fee to a CCRC late in the summer of 1992 for a two-bedroom independent living unit; she also began paying a $1,125 monthly fee prorated from September 24, 1992.  According to the basic contract with the CCRC, the refundable portion of the entrance fee, which would be paid to her if she moved out prior to death or otherwise to her estate, decreased two percent for each month of residence until reaching a 50% floor.  The contract also offered a nursing care option under which she agreed to forfeit an additional 12% ($12,420) of her entrance fee in exchange for a guarantee to receive nursing care at no additional charge beyond her regular monthly fee.  In other words, her refundable amount would decrease to 38% instead of 50%.

Fortunately, Mrs. W does not have to contend with the section 7872 below-market-rate loan rules with respect to the guaranteed refundable portion of her entrance fee.  Although the non-interest-bearing refund would qualify as a below-market-rate loan under section 7872, it is well below the section 7872(g) exemption amount¹⁴ for residents of qualified CCRCs, as discussed in section III.B.

In February 1993, she received a letter from the CCRC stating that 20% of her fees paid in 1992 were deductible medical expenses; however, the deductible portion of the non-refundable half of the entrance fee had to be amortized over 480 months.  The letter further advised that, if the nursing care option had been selected, the 12% forfeitable portion of the entrance fee refund would not be deductible until the resident vacated.  Relying on the CCRC’s statement, Mrs. W’s accountant determined that she had $813 in CCRC-related medical expenses for 1992 — $86 for the amortized portion of half of the entrance fee and $727 for the monthly fees she paid to the CCRC in 1992.¹⁵ She did not benefit from the expenses, however, because she did not have enough medical expenses to exceed 7½% of her adjusted gross income.

The CCRC’s letter erred in three ways, the first of which involved the amortization of the entrance fee.  Despite the unlikely possibility that any of the residents would live another 40 years, the CCRC’s administrator maintained that the 480-month amortization period was correct because, according to their Big-5 accounting firm, the residents’ entrance fees were not paid to the CCRC directly but rather to a trust that was liable for the 40-year mortgage on the facilities.  As we elaborate in section II.B.2., a deduction based on the entrance fee must be taken in the year the fee is paid, notwithstanding any serpentine legal structure that exists between a resident’s payment of the entrance fee and the CCRC’s obligation to provide lifecare.  Furthermore, since we determine in section III.B.2. that a refund is a term loan under section 7872 and as such is not deductible, the medical expense deduction should be based on the entrance fee less the discounted present value of the 50% refundable amount.

Second, the letter stated that the portion of the entrance fee refund allocated to the nursing care option, which in Mrs. W’s case amounted to $12,420,¹⁶ would not be deductible until the year that residency is terminated.  In fact, it is deductible in the year paid as we point out in section II.E.

Third, the letter dictated that 20% of both her entrance fee and monthly fees were deductible as medical expenses.  The burden of proof, however, is on the taxpayer to show that the claimed medical deduction is the proper amount.¹⁷ Whether the 20% figure is correct is a question of fact.  Depending on the cost allocation method used, reasonable minds will differ as to the correct percentage.  Section IV. discusses the propriety of different cost allocation methods used by CCRCs.  Because the burden of proof is on Mrs. W, we acquired the CCRC’s 1992 revenue and expense statement from which we determined that 14.72% of the CCRC’s expenses were medically related.  This percentage was applied to the monthly fees paid in 1992.

For the entrance fee, we estimated that 25.48% was for medical expenses over her actuarial life span at the CCRC.  Based on the CCRC’s revenue and expense statements, the medical expense percentage rose steadily from 14.72% in 1992 to 19.99% in 1995.  We projected the CCRC’s medical expense percentage trend across Mrs. W’s actuarial life span, estimating a 25.48% average percentage.   We then multiplied this percentage by the net entrance fee, i.e., the $103,500 fee, less the 38% guaranteed refund discounted over her actuarial life and less the 12% nursing care option.  The rationale for using the net entrance fee rather than the full entrance fee is discussed in section III.C.3.

On our advice, she filed an amendment to claim a $30,988 medical expense deduction in 1992: $18,033 for the entrance fee, $12,420 for the nursing care option, and $535 for the monthly fees.¹⁸ She received a $5,339 federal income tax refund plus interest.¹⁹

C.  CCRC Residential and Medical Arrangements

Most CCRCs offer three levels of residence: (1) independent living units (ILUs) which are similar to apartment living except that nursing assistance is usually available through an emergency pull-cord call system, (2) assisted living units (ALUs), also called personal care units, in which the residents are assisted with tasks such as dressing and eating, and (3) nursing care units providing 24-hour care.  CCRCs generally provide a variety of additional services at all levels of residency: daily meal service, weekly laundry and maid services, electronic monitoring of rooms, local transportation, athletic facilities, and social activities.  To enter a CCRC, residents typically must be ambulatory at the time they sign the residence contract, and only after residing in an ILU may they transfer to an ALU or nursing care facility.

CCRCs offer two occupancy arrangements: proprietary or non-proprietary.  Under a proprietary agreement, residents own their units, often in a condominium or cooperative arrangement.  The cost of purchase is paid in lieu of an entrance fee.  The resident or their estate has the responsibility of selling the unit, and the CCRC may charge an ownership transfer fee.  Until mid-1997 this type of arrangement was attractive because, unlike non-proprietary arrangements, it qualified for tax deferral rollover treatment when a personal residence was sold as part of the process.²⁰ For that reason, proprietary ownership arrangements grew in popularity although only 6% of CCRCs presently offer them.²¹ Now that sellers of personal residences can exclude up to $250,000 ($500,000 if married, filing jointly) of the gains realized, there are few prospective residents who will have a tax incentive to seek proprietary ownership.²²

Non-proprietary agreements requiring payment of an entrance fee are the most common type of arrangement.  The resident pays a monthly fee and may pay an entrance fee, which may be refundable all or in part.  Non-proprietary agreements without an entrance fee are essentially rentals.

CCRCs typically offer one of three nursing-care arrangements:

Contract Type Description

Extensive                      The monthly fees cover all of the residents’ expenses whether they reside in ILUs, ALUs, or nursing care units.

Modified                      Although the monthly fees cover all of the residents’ ILU expenses, they cover only a specified period of ALU and nursing care, usually 10 – 90 days, without additional cost.

Fee-for-service             The monthly fees cover only the residents’ ILU expenses. ALU

and nursing care are provided at market rates.

Normally only CCRCs requiring an entrance fee offer the extensive and modified contractual arrangements.  Depending on the CCRC, fee-for-service nursing care is available under both proprietary and non-proprietary agreements, whether or not an entrance fee is required.  The difference in fees between the three contract types is considerable.  Using a survey conducted in 1988 by the American Association of Homes and Services for the Aging (AAHSA) and Ernst & Young, which we adjusted to 1997 dollars, Frank A. Sloan and his colleagues found that CCRCs with extensive, modified, or fee-for-service contracts charged, on average, $230,000, $167,000, and $138,000 respectively in entrance and monthly fees for the first ten years of residency.²³ After adjusting for non-medical factors affecting the fees in the study, they found that the differential between extensive and fee-for-service CCRCs (adjusted to 1997 dollars) decreased from $92,000 to $53,000, and between modified and fee-for-service CCRCs, from $29,000 to $24,000.²⁴ These differentials indicate the magnitude of ALU and nursing care costs factored into CCRCs’ fee schedules.

According to a survey by the AAHSA, 38% of the responding CCRCs offered extensive agreements, 34% offered modified agreements, 41% offered fee-for-service agreements, 15% offered rental contracts, and 6% offered equity ownership.²⁵ (The total exceeds 100% because some CCRCs offer more than one option.)  Although 77% of more recently built tax-exempt CCRCs offer extensive agreements,²⁶ the direction of the industry with respect to contract type is not as clear when also considering for-profit CCRCs.²⁷ Each of these contractual arrangements has somewhat different tax implications, as discussed below.

D.  Organization

The remainder of the article is arranged as follows:

Section II. tracks the history and discusses the tax deductibility of the medical

expense portion of entrance and monthly fees.

Section III. investigates the application of section 7872 below-market-rate loan

rules to entrance fee refunds and addresses the impact of entrance fee refunds on

deductibility.

Section IV. analyzes and makes recommendations regarding the methods used by CCRC administrators for

determining the medical care portion of their residents’ fees.

Section V. summarizes the findings and recommends strategies for CCRC residents and administrators in treating the medical expense issue.

II.  Deductibility of CCRC Fees as Medical Expenses

A.  Summary

Deductibility of the medical expense portion of CCRC monthly and entrance fees is well-established under both case law and IRS administrative pronouncements.  For ILU residents, monthly fees are deductible only to the extent of the medical expense portion.  For nursing care residents and most ALU residents, the entire monthly fee is deductible even though medical care is simply a, rather than the, principal reason for their being in ALU or nursing care units.  As for entrance fees, the Service allows deductibility of the medical care portion in the year the fee is paid even though the medical services are performed in the future.²⁸

Due to the lack of literature addressing CCRC-related medical expense deductions, we discuss the historical development in the next section.  Included in section B. are discussions of recent IRS action on deductibility (section B.3.) and of the premise that the medical expense portion of CCRC fees is in fact medical insurance (section B.4.).  Section C. covers full deductibility of monthly fees for ALU and nursing unit residents.  Section D. recommends how to deduct fees designated for building CCRC medical facilities, and section E. discusses the full deductibility of nursing care upgrade fees.

B.  Historical Development

1.  Early rulings. Medical expenses and medical insurance costs have long been deductible expenses under section 213 and its predecessor, section 23(x) of the Internal Revenue Code of 1939.  In a General Counsel Memorandum (G.C.M.) issued in 1966,²⁹ the IRS first acknowledged deductibility of the medical portion of an entrance fee as a medical expense.  The IRS next ruled in 1967 on the monthly fee issue, effectively stating that a CCRC’s experience is an acceptable basis for determining the medical allocation.³⁰ Since “[t]he taxpayers proved that on the basis of the [CCRC’s] experience, . . . a specific portion of the fee covers the costs of providing medical care for them,”³¹ they were permitted a medical deduction for 30% of the CCRC’s monthly fee.  The IRS cited this ruling favorably the following year in terms of the monthly fee issue, but denied a deduction for the medical portion of an entrance fee because it was a capital expenditure used solely for building an infirmary.³²

In 1971, the IRS’s General Counsel released a memorandum³³ discussing two proposed revenue rulings that affirmed and amplified the 1966 G.C.M.³⁴ in allowing deduction of the medical expense portion of an entrance fee.  In the portion of the G.C.M. later issued as Revenue Ruling 75-302,³⁵ the Service determined that a resident who paid an entrance fee in exchange for the CCRC’s guarantee of lifecare could deduct 30% of the fee in the year paid even though “the medical services were not to be performed until a future time, if it all.”³⁶ The IRS concluded that the CCRC “demonstrated,” based on its prior experience, that an average of 30% of its lifecare budget was medically related.³⁷

This G.C.M. and subsequent rulings³⁸ raised two new issues, the first of which involved a refundable entrance fee.  If residents received a partial refund of their entrance fee as a result of terminating residence, the previously deducted medical expense attributable to the refunded amount should be included in the residents’ gross income in the year received.³⁹ We examine the refund issue in section III.C.  The second issue was whether the medical care portion of an entrance fee could be characterized as a payment for medical insurance.  Although the IRS initially thought that it could be so characterized, the Service subsequently reversed itself and rejected the insurance rationale when it finally issued the rulings in 1975.⁴⁰ We disagree with the IRS’s reversal and discuss this further in section II.B.4.

In 1976, Revenue Ruling 76-481⁴¹ expanded on Revenue Ruling 75-302⁴² by allowing use of the long-term operating experience of a comparable CCRC for calculating the medical care percentage of both the entrance fee and monthly fees.⁴³ The CCRC addressed in Revenue Ruling 76-481 had not been in operation long enough to determine from its financial experience what portion of the fees was allocable to the medical care of the residents.  Per a letter sent by the CCRC to its residents, 15% of the monthly fee and 10% of the entrance fee would be used to fulfill its medical care obligations.   Since then, private letter rulings have addressed CCRCs reporting medical costs as high as 45%⁴⁴ and 48%⁴⁵ of total expenses, but the Service expressed no opinion on the propriety of those percentages.  Revenue Ruling 76-481 also stated that an additional 5% of the CCRC’s entrance fee would be used to construct health facilities for the residents.  In accordance with Revenue Ruling 68-525,⁴⁶ the ruling denied a deduction for the health facility portion of the entrance fee.

2.  Deducting future medical costs in the year paid – the rationale. Treasury Regulation section 1.213-1(a)(1) requires that a cash basis taxpayer deduct medical expenses in the year paid.   Whether the medical portion of an entrance fee may be deducted in the year paid depends on whether there is a legal obligation to pay in advance for the medical care in exchange for the care giver’s contractual obligation to provide the care.  In Bassett v. Commissioner, the Tax Court held that an advance payment for medical care was not deductible in the year paid because the care giver did not require the advance payment as a condition for providing the future care.⁴⁷ Concurring in Rose v. Commissioner, the court added, “[i]t has long been held that expenses are not incurred in the taxable year unless a legal obligation to pay them has arisen.”⁴⁸ Therefore, if the contract obligates the CCRC to provide the resident with future medical care, the medical expense portion of the entrance fee is deductible in the year paid.

Although the IRS followed the court’s “legal obligation to pay” reasoning through the 1970’s in allowing deduction of medical expenses allocable to CCRC entrance fees,⁴⁹ it apparently decided to contest it in a 1983 case, Estate of Smith v. Commissioner.⁵⁰ Smith had taken a deduction for the medical expense portion of an entrance fee that he had paid for his dependent parents.  Part of the deduction was for future medical care.  In allowing a deduction for the 7% medical portion of the entrance fee, the court stated, “[t]he obligation to pay this fee was incurred at the time the residency agreement was entered into, in return for the corporation’s promise to provide [future medical care, in addition to] lifetime lodging and various services . . . . ”⁵¹ The court rejected the IRS’s assertion “that no legal obligation to pay such amount existed simply because most of the services promised with respect to such payment would not be received until future years.”⁵² The IRS acquiesced⁵³ and has continued to allow deduction of the medical expense portion of entrance fees in every private letter ruling subsequently released on the issue.⁵⁴

a.  Amortizing entrance fee medical expenses.  As mentioned in the example in section I.B., some CCRCs are erroneously advising their residents to amortize the deductible medical expense portion of the entrance fee over the 30- or 40-year life of the facilities mortgage.  In other words, the residents may deduct only one-thirtieth or one-fortieth of the entrance fee medical expense portion each year.  Neither the Service nor the Code permits amortizing medical expenses.  Such expenses must be deducted in the year paid or in the year the legal obligation to provide the services accrues.  The legal obligation of the CCRC accrues when the contract is signed and the entrance fee is paid.  Hence, the entire medical deduction must be taken at that time.  In fact, residents who follow the CCRCs’ advice risk having the IRS deny such deductions in the years following the year of payment.

These CCRCs use a legal structure whereby the entrance fees are paid into a trust that in turn makes monthly payments on the facilities mortgage.  Because of this, they maintain that their residents are not directly paying the medical expenses and may only take a deduction for the medical expense portion of the fee paid monthly by the trust.  Nonetheless, the CCRCs’ serpentine legal structure does not negate the fact that the residents pay the entrance fee in exchange for the future provision of health care.  The IRS⁵⁵ and the courts⁵⁶ have used the step transaction doctrine for many years to defeat taxpayers’ creativity in laundering a transaction through a number of steps to avoid the undesired tax consequence of the basic transaction.

These CCRCs and their tax counsel, we believe, are incorrectly advising their residents and, in doing so, are denying them their right to a sizeable medical expense deduction in the year the entrance fee is paid.  Moreover, it is unlikely that many residents will live the 30 years necessary to realize their full deduction, much less 40 years!  We strongly recommend that these CCRCs correct their advice to their residents.

3.  Recent IRS rulings and Internal Revenue Code amendments.

a.  IRS restricts current-year deductibility. In the 1990’s, however, the winds of deduction have chilled slightly.  Late in 1993, the Service denied deductibility of current payments for future medical care when made to non-lifetime-care providers.⁵⁷ The ruling, which applied to contracts entered into after October 13, 1993, stated that the earlier revenue rulings⁵⁸

should not be interpreted to allow a current deduction of payments for future medical care (including medical insurance) extending substantially beyond the close of the taxable year in situations where the future care is not purchased in connection with obtaining lifetime care of the type described in those rulings.⁵⁹

On the same day, the IRS issued Revenue Procedure 93-43 stating that they would no longer issue advance rulings or determination letters as to “[w]hether amounts paid for medical insurance (or other medical care) extending substantially beyond the close of the taxable year may be deducted under section 213 of the Code in the year of payment, if the conditions of section 213(d)(7) are not satisfied.”⁶⁰

Unlike the ruling, the revenue procedure includes CCRC-type life care contracts in the refusal to issue advance rulings.  In so doing, the IRS seems to imply its increasing discomfort with current-year deductibility of entrance fee related medical expenses.  However, we are not apprehensive for four reasons: (1) Estate of Smith⁶¹ is on point in allowing the deduction, and the IRS would have to reverse its acquiescence,⁶² (2) Congress passed the Health Insurance Portability and Accountability Act of 1996 which overrides the ruling and now permits current deductibility of long-term care insurance premiums,⁶³ (3) an attorney with the IRS’s Office of the General Counsel advised us that they are continuing to allow CCRC residents to take the entire medical portion of the entrance fee in the year paid because the obligation to pay has arisen,⁶⁴ and (4) the CCRC lobby — both providers and residents — is powerful.  For example, the lobby garnered broad Congressional support both in preventing application of the below-market-rate loan rules to the refundable portion of most CCRC entrance fees⁶⁵ and in overriding Revenue Ruling 93-72⁶⁶ to permit current deductibility of long-term care insurance.⁶⁷

Unfortunately our optimism is not shared by some tax professionals.  One big-5 accounting firm refused to give a comfort letter to a CCRC wishing to advise its residents as to the full, current deductibility of the portion of an entrance fee allocable to future medical care.⁶⁸ We believe such conservatism, despite the ruling’s⁶⁹ exemption of CCRC-type contracts, is a disservice to CCRC clients and especially to CCRC residents.⁷⁰

b.  Congress clarifies deductible medical care services for ALU and nursing care residents. On January 1, 1997, the Health Insurance Portability and Accountability Act of 1996 authorized a medical deduction for qualified long-term care insurance contracts⁷¹ and, of significance to CCRC residents, a medical deduction for “qualified long-term care services.”⁷²

“Qualified long-term care services”⁷³ performed by a “licensed health care practitioner”⁷⁴ for a “chronically ill individual”⁷⁵ include “maintenance or personal care services”⁷⁶ in addition to the diagnostic, preventative, therapeutic, curing, treating, mitigating, and rehabilitative services previously allowed under section 213.⁷⁷ The Code defines the chronically ill as those who are certified by a licensed health care practitioner and those who are unable to perform for a minimum of 90 days at least two out of six activities of daily living (ADLs) which include eating, toileting, transferring (e.g., from bed to chair), bathing, dressing, and continence.⁷⁸ “Maintenance or personal care services” mean any care or assistance with any of the ADLs that caused the person to be classified as chronically ill.⁷⁹ All nursing care residents and most ALU residents are “chronically ill” under the new law⁸⁰ because they have at least two or three ADLs.⁸¹ Although the new law does not affect the longstanding deductibility of the medical care portion of fees paid by ILU residents⁸² or the full deductibility of fees paid by nursing care residents,⁸³ it strengthens the full deductibility of ALU monthly fees by defining deductible medical care services for ALU residents.⁸⁴ Consequently, CCRCs should categorize all the costs of caring for most ALU residents as medical expenses, namely the residents’ full monthly fees.⁸⁵

4.  Is the medical portion of a life care contract medical insurance? We believe it is, consistent with the 1971 G.C.M.⁸⁶ discussed in section II.B.1.  In reviewing two proposed revenue rulings, the IRS’s General Counsel argued that the medical expense portion of an entrance fee qualifies as medical insurance, stating that the typical contract between a CCRC and a resident includes “the essential elements of insurance”: “. . . an insurable risk, a shifting of that risk from one to another, [and] a distribution of the risk . . .” across all the resident insureds.⁸⁷ The memorandum followed Helvering v. Le Gierse, which defined insurance as involving “risk-shifting and risk-distributing” and defined health insurance in particular as indemnifying a person for losses caused by illness.⁸⁸ Because a CCRC guarantees the performance of the medical services and is liable for the acts of the service providers, it assumes the risk of medical care and does not merely act as an agent in procuring medical care for the residents.  Hence, the medical expense portion of a CCRC residential contract was deemed to be medical insurance.⁸⁹

When the rulings were finally issued in 1975,⁹⁰ the Service reversed itself and rejected the insurance rationale.  First, the Service maintained that the CCRC entrance fee “. . . was calculated without regard to any similar contracts with other patients at the institution and assured the taxpayer lifetime care at no additional cost and, therefore, was not medical insurance.”⁹¹ In other words, the IRS concluded that there was no distribution of risk.  We disagree.  First, CCRCs typically base their contract fees on the actuarially determined mortality and morbidity (illness) rates of their residents; therefore, ipso facto they take into consideration similar contracts with other residents.  Second, the IRS argued that the taxpayer was assured care at no additional cost.  Although the CCRC offered its residents contracts of the extensive type guaranteeing lifetime care at no increase in cost, it undoubtedly charged a higher fee than CCRCs offering modified or fee-for-service contracts.  Third, per Haynes v. United States, nothing in the Code restricts insurance to that provided by commercial companies.⁹²

Despite the IRS’s reversal,⁹³ we believe the medical portion of an entrance fee is deductible as insurance.⁹⁴ The principal beneficiaries are those CCRC residents with self-employment income.  They may deduct 45% of the medical portion of their monthly fees as a self-employment medical insurance adjustment to income,⁹⁵ not to exceed their self-employment net income.⁹⁶ The remaining 55% of the entrance fee medical portion (more if the deduction was limited by self-employment income) is an itemized deduction.

In the next three sections, we address the impact of nursing facility fees, fees designated for building a medical facility, and nursing care upgrade fees on residents’ medical deductions.

C.  Deductibility of ALU and Nursing Unit Fees.

All of the monthly fees including room and board charges for nursing facility residents and most ALU residents are deductible as medical expenses as long as the need for medical care is a principal reason for residency.⁹⁷ Just as meals and lodging included in a hospital bill have long been deductible medical expenses,⁹⁸ they are also deductible when incurred at an institution other than a hospital if a principal reason for residing there is the availability of medical care and if the meals and lodging are a necessary part of such care.⁹⁹ Medical care does not need to be the principal reason, merely a principal reason.¹⁰⁰

Thus, the entire monthly fee amount is deductible even though the availability of medical care may be just one of several principal reasons for the resident’s presence in the ALU or nursing facility, such as if the resident’s family is unable to provide care at home.  If the availability of medical care is not a principal reason for ALU or nursing facility residence, then only the portion attributable to medical care is deductible.¹⁰¹ Determining the correct portion is a key issue which we examine in section IV.

D.  Deductibility of Fees Designated for Building a Medical Facility

If a CCRC indicates that part of the entrance fee is for building a medical facility, that portion is non-deductible.  In Revenue Ruling 68-525,¹⁰² reiterated in Revenue Ruling 76-481,¹⁰³ the Service denied a medical expense deduction for the entrance fee portion designated for building a medical facility at a CCRC.  Capital expenditures are normally not deductible per section 263.¹⁰⁴

To secure deductibility of medical facility costs for the residents, CCRCs should construct the medical facilities with funds borrowed from another source rather than financing them through entrance fee proceeds.  The entrance fees received from the residents may then be used to amortize the loans and cover the depreciation.  Just as a hospital bill is deductible even though it includes depreciation charges to recover building costs, so is the medical care portion of a CCRC fee which includes the costs of the depreciation and interest on a medical facility.

In their tax information notices to residents, CCRCs should include capital recovery or depreciation costs as part of their medical care costs rather than identifying them as costs of building a medical facility.¹⁰⁵

E.  Deductibility of ALU and Nursing Care Upgrade Fees

Some CCRCs offer new residents entering under modified ALU and nursing care contracts¹⁰⁶ an opportunity to upgrade to an extensive care contract.  The upgrade guarantees that the residents will pay no more than their normal ILU monthly fee if they require assisted living or are admitted to the nursing care facility.¹⁰⁷ CCRCs typically offer one of two payment versions for the upgrade: a higher entrance fee or a lower refundable percentage of the entrance fee upon termination of residence.  Under either version, 100% of the cost is deductible in the year paid because payment is contractually obligated in order to secure the guarantee of future care as discussed in section II.B.2., and because, for the reduced refund version, payment is effectively made at the time the entrance fee is paid.  Based on our analysis in section II.B.4., we believe both upgrades constitute a type of medical insurance, or more specifically, long-term care insurance.  The Health Insurance Portability and Accountability Act of 1996¹⁰⁸ overrides the IRS’s disallowance under Revenue Ruling 93-72¹⁰⁹ of a current deduction of payments for future medical care and now permits the current deductibility of long-term care insurance premiums.

Section 213(d)(7) should not prevent deduction of an ALU or nursing care upgrade fee unless, perhaps, the resident is under 65 years old.  Section 213(d)(7) specifies that medical insurance premiums paid during the year by taxpayers under 65 for coverage after they reach 65 are fully deductible in the year paid only if the premiums are payable in equal installments over a period of ten years or more.  Most new residents are 65 or over, and those that are under 65 are actually buying coverage that starts immediately rather than after they turn 65.  Moreover, the Tax Court has consistently held that full deductibility in the year paid is allowed if the person has a legal obligation to pay in order to obtain the future medical care.¹¹⁰

III.  Tax Treatment of Entrance Fee Refunds

Particularly vexing is the proper tax treatment of an entrance fee refund.  Hence, almost half of our analysis addresses this concern.  Because entrance fee refunds are typically paid without interest, the first issue involves the section 7872 below-market-rate loan rules.   The second issue considers whether the medical expense deduction should be taken on the full entrance fee or the net fee, i.e., the entrance fee less the refundable portion.  As part of examining this second issue, we explain the effect of an entrance fee refund on a decedent resident’s estate and heirs.

A.  Introduction

Most entrance fee contracts provide for a refund following the termination of residency, either to the residents if they move out prior to death or to their estates.  Refunds typically vary from 10% to 100% of the entrance fee depending on the CCRC and the length of residence.  Many contracts contain a refund adjustment or penalty provision under which the refundable percentage declines monthly or annually after the date of initial residency until some percentage floor is reached.  For example, a residence contract might specify that the refundable amount declines by 2% each month until a floor of 50% is reached.  Generally, no interest is paid.  Because non-interest-bearing refunds are considered below-market-rate loans per section 7872, and because the peculiarities of these provisions have a significant impact on the tax treatment of the refunds, we discuss the below-market-loan rules first.

B.  Tax Effects of the Section 7872 Below-Market-Rate Loan Rules on the Refundable Portion of an Entrance Fee

1.  Background. The section 7872 below-market-rate loan rules were enacted in 1984¹¹¹ and require that a lender recognize imputed interest income and a borrower recognize imputed interest expense on loans bearing an interest rate less than the market rate.  Although not specifically mentioned in the initial statute, refundable entrance fee (loan) arrangements between CCRCs and their residents were thought to be included under I.R.C. § 7872(c)(1)(E).    Responding to political pressure from CCRCs and residents,¹¹² Congress enacted section 7872(g) in 1985¹¹³ to exempt below-market-rate loans between residents over 64 years old by the end of the tax year¹¹⁴ and qualified CCRCs up to the first $90,000 of an entrance fee refund, adjusted for inflation.¹¹⁵ For 1998, the exempt amount is $134,800.¹¹⁶

Few residents of qualified CCRCs need be concerned with the below-market-rate loan rules because most refunds are less than the $134,800 current exemption amount.¹¹⁷ In fact, almost all refunds will be exempt if the discounted present value is used, as discussed in section III.B.3.

For a CCRC to qualify for the exemption, it must meet a number of conditions listed in  section 7872(g)(4).  In particular, “substantially all of the residents [must be] covered by continuing care contracts,”¹¹⁸ and “substantially all facilities must be owned or operated by [the CCRC].”¹¹⁹ Although most CCRCs qualify, all residents of non-qualified CCRCs, regardless of the residents’ ages, are currently exempt from the section 7872 rules.

Thanks to bureaucratic delay, section 7872 does not currently cover loans between residents and non-qualified CCRCs, regardless of the amount of the guaranteed refund.  In 1985, the Service issued proposed regulations that classified certain loans including loans to CCRCs as significant effect loans under section 7872.  Declining to give guidelines as to the handling of significant effect loans, the Service stated,  “[n]o transaction will be treated under the regulations as a significant effect loan earlier than the date that future regulations under section 7872(c)(1)(E) are published in proposed form.”¹²⁰ As yet, the proposed regulations have not been issued.¹²¹ Consequently, below-market-rate significant effect loans are presently exempt from the section 7872 requirements.  The remarkable effect of this delay is that refundable entrance fee arrangements of any dollar amount between non-qualified CCRCs and their residents are not subject to the below-market loan rules.¹²²

The IRS issued the proposed regulations on August 20, 1985,¹²³ almost three months prior to the enactment of section 7872(g),¹²⁴ which applied only to qualified CCRCs.  Had section 7872(g) not been enacted, all loans between CCRCs and residents of any age would currently be exempt because there would be no such classification as a “qualified” CCRC!

2.  The refundable portion of an entrance fee should be treated as a term loan rather than a demand loan under section 7872. An important issue for qualified CCRCs and their residents is whether the refundable portion of an entrance fee is considered a demand or term loan.  Term loans are valued at discounted present value under section 7872 whereas demand loans are valued at face value per section 7872(e)(1)(A).  Discounting offers three distinct benefits to CCRCs and their residents.  First, valuing an entrance fee refund at the discounted present value rather than at its full value will exempt more refunds from the below-market-rate loan rules.  Second, discounting produces a higher net entrance fee — the entrance fee less the discounted present value of the refund — on which the deductible medical expense portion may be calculated, as discussed in section III.C.2.  Third, imputed interest (amortization of the original issue discount) will be calculated on the discounted present value rather than on the full refund, resulting in lower reportable interest income by the resident and lower interest expense by the CCRC as well.

We first discuss the rationale for treating an entrance fee refund as a term rather than demand loan.  We then explain why a refund may be valued at its discounted present value rather than at the full value in determining the exempt amount from the section 7872 below-market-rate loan rules.

In the first ruling to touch on the term versus demand loan issue, the IRS treated an entrance fee refund as a below-market-rate demand loan, because the contract with the CCRC allowed the resident to demand payment by terminating residency.¹²⁵ We disagree.  In the analysis section of the ruling, the Service paraphrased section 7872(f)(5), saying that the refund “can be characterized as a demand loan because it is payable at any time on the demand of the lender.¹²⁶ Section 7872(f)(5) defines three types of loans as demand loans:

[Type 1:] The term “demand loan” means any loan which is payable in full at any time on the demand of the lender.  [Type 2:] Such term also includes  . . . any loan if the benefits of the interest arrangements of such loan are not transferable and are conditioned on the future performance of substantial services by an individual.  [Type 3:] To the extent provided in regulations, such term also includes any loan with an indefinite maturity.¹²⁷

If a loan — in this case, an entrance fee refund — is to avoid classification as a demand loan, it must fail all three definitions.

First, the refund cannot be payable in full at any time on the demand of the lender.  Normally an entrance fee refund is not due until death unless a resident terminates residency earlier.  We assert that the option to receive the refund by terminating residency before death is not payment on demand, contrary to the IRS’s conclusion in the letter ruling,¹²⁸ but is a prepayment option:

Acceleration clauses and similar provisions that would make a loan due before the time otherwise specified including provisions permitting prepayment of a loan . . . are disregarded for the purposes of section 7872.  Thus, a loan for a term of 15 years is a term loan for 15 years even if is it subject to [such  provisions].¹²⁹

Second, the benefits of the interest arrangements — those of not charging interest on the refundable portion of CCRC entrance fees — are not transferable.  Also, the benefits are undoubtedly conditioned on the future performance of substantial services by a CCRC, not by an individual.  CCRCs are organized as corporations, partnerships, or trusts, none of which the Code classifies as an individual.¹³⁰

Third, the refundable entrance fee must not have an indefinite maturity.

A loan is treated as a ‘term loan’ if the loan agreement specifies an ascertainable period of time during which the loan is to be outstanding.  For the purposes of this rule, a period of time is treated as being ascertainable if the period may be determined actuarially.  Thus, a loan [for one’s lifetime] will be treated as a term loan because the life expectancy [of the person] may be determined actuarially.¹³¹

This describes a typical lifetime contractual agreement between a CCRC and its residents;  the entrance fee is paid in consideration for the CCRC’s guarantee to provide them with lifetime care.  An entrance fee refund, therefore, is not a demand loan of indefinite maturity but rather a term loan with an actuarially ascertainable maturity.

Because the normal CCRC entrance fee refund contract fails all three demand loan definitions, the refund should be treated as a term loan per section 7872(f)(6) which states: “The term ‘term loan’ means any loan which is not a demand loan.”¹³² It may then be discounted as discussed next.

3.  Term loan discounting will significantly reduce the amount of an entrance fee refund that is subject to the below-market-rate loan rules. Although section 7872(b) allows for the discounting of term loans, section 7872(g) does not specify whether the discounted present value or the face value is applicable for determining whether an entrance fee refund exceeds the exemption amount.  The difference is considerable.  A non-interest-bearing, fully-refundable $250,000 entrance fee paid by new residents as old as their late seventies would have a discounted present value of less than the current $134,800 exemption amount¹³³ based on the residents’ actuarial life and the applicable discount rate¹³⁴ and thus would be exempt from the section 7872 below-market-rate loan rules.¹³⁵ On the other hand, if the face value of the entrance fee refund were used, imputed interest includable in the resident’s taxable income must be calculated on $118,700 of the $250,000.  Based in part on statutory and administrative authority but primarily on case law, we assert that the discounted present value applies as follows.

a.  Statutory and administrative authority. Statutory guidance is almost nonexistent.  In establishing the exemption amount, section 7872(g)(2) provides no clarification as to which loan value applies, referring only to “the aggregate outstanding amount of the loan.”  For term loans, section 7872(b)(1) provides no further clarification, stating that “the borrower shall be treated as having received on such date, cash in an amount equal to the excess of the amount loaned, over the present value of all payments which are required to be made under the terms of the loan.”  The “definitions” subsection (f)(4) of section 7872 merely defines the “amount loaned” as meaning “the amount received by the borrower.”   The Congressional committee report provides no further clarification.¹³⁶

Although the wording of the Code does not help determine the applicable amount, administrative regulations lean toward the discounted present value.  Expanding on section 7872(b)(2), which states that the difference between the face amount of a term loan and its discounted present value is “original issue discount,” Proposed Regulation section 1.7872-7(a)(3),¹³⁷ specifies that the discounted present value is the “issue price” and applies the section 1272 original issue discount (OID) rules to the amortization of the OID.  By saying that the lender’s basis equals the discounted present value of the loan in the case of a term loan, Proposed Regulation section 1.7872-7(a)(6)¹³⁸ comes the closest of any administrative pronouncement to saying that the applicable value of a CCRC resident’s entrance fee refund is the discounted present value.  Case law provides stronger support.¹³⁹

b.  Case law. Although the Tax Court has resisted applying the concept of present value to Code sections that do not mention such calculations, it has assented for sections that do.  In Follender v. Commissioner, the court rejected the IRS’s attempt to discount the taxpayers’ loan to its discounted present value in order to reduce the at-risk amount, stating that section 465 “does not allow for present value calculations, expressly or implicitly.”¹⁴⁰ More recently, the court followed Follender in City of New York v. Commissioner.¹⁴¹ In this case, New York City argued that the $4.8 million present value of a $15 million bond issue was the appropriate valuation for qualifying the bonds as tax exempt under the section 141(c) $5 million private loan financing threshold.¹⁴² The City cited the inclusion of discounted present value in sections 1274 and 7872 as evidence that Congress recognizes the time value of money as an economic reality across the entire Code.¹⁴³ The court disagreed and declined to apply  “this statutory trend to section 141(c),” citing the rationale used in Follender.¹⁴⁴ In both cases, the Tax Court rejected restating of loan amounts to their discounted present values for the purpose of qualifying for a statutory benefit or threshold in cases where the Code sections are silent on the discounting issue.

The Tax Court has ruled, however, in a situation involving a statute that explicitly allows discounting, specifically section 7872.  In Frazee v. Commissioner, a gift tax case involving a below-market-rate loan under section 7872, the court stated: “The value of the promissory note, therefore, must be recomputed [discounted] . . . ” and concluded that, “[t]he face amount of the loan, $380,000 less the discounted value, results in the additional gift of interest under section 7872.”¹⁴⁵ In other words, term loans under section 7872 should be restated at their discounted present value, and the appropriate value for determining the exempt amount should be the discounted present value.

Dictum from the Seventh Circuit adds further support to using the discounted present value: “The new treatment of debt bearing interest less than market rates, 26 U.S.C. § 7872 (1986) [section 7872], added in 1984, would have required the [taxpayers] to restate the debt at its expected value . . . .”¹⁴⁶

c.  Effect on the resident of discounting an entrance fee refund. Residents may significantly lower their exposure to the section 7872 below-market-rate loan rules by using the discounted present value of the entrance fee refund.  In so doing residents will lower the amount of any imputed interest income that they must report in taxable income each year.  We believe that CCRC residents may reasonably argue under section 7872 that the discounted present value is the appropriate measure for determining the amount of an entrance fee refund that is exempt under section 7872(g)(2).  Beneficial as discounting may be to residents, however, it has the opposite effect on CCRCs as explained in section III.B.3.d. below.

What happens if the IRS disapproves of using discounted present value for section 7872(g)(2) exemption purposes?  Although case law implies that the discounted present value is the correct amount for determining whether an entrance fee refund exceeds the section 7872(g)(2) exemption amount, we believe the IRS could take the position that the correct amount is the original, undiscounted loan amount and apply the section 7872 rules to the excess amount.  In the event that the IRS should do so, we believe that the rationale of the courts cited above¹⁴⁷ should be sufficient to satisfy the substantial authority requirements of Regulation section 1.6662-4(d)(iii) regarding taking an aggressive tax return position contrary to the IRS’s views.  The substantial underpayment of income tax penalty will apply if the tax saved by not reporting the interest income from amortizing the discount exceeds the greater of $5,000 or 10% of the tax liability shown on the return.¹⁴⁸

There is a safe harbor, however:  adequate disclosure of the aggressive position.¹⁴⁹ We recommend that residents adequately disclose the nature of the discounting treatment by attaching Form 8275 (Disclosure Statement) to their returns.¹⁵⁰ Of course, the safest approach would be to use the full refund in calculating the amount subject to section 7872.  We illustrate both approaches in Example 1 in section III.B.4.a. below.

d.  Effect on CCRCs of treating a refund as a discountable term loan.

Treating the refundable portion of an entrance fee as a term loan rather than a demand loan benefits residents at the expense of taxable, for-profit CCRCs.  Section 7872(b)(2) requires the discounting of term loans; subsection (b)(1) further states that the borrower — in this case, the CCRC — will be treated as receiving cash equal to the difference between the amount loaned, i.e., the amount of the entrance fee refund, and the discounted present value.  Consequently, CCRCs must report the difference — the amount of the discount — as income in the year the entrance fee is received.

In addition, Regulation section 1.61-8(b) requires that CCRCs recognize the portion of an entrance fee that is not refundable as taxable income in the year received regardless of either the period covered or the method of accounting used by the CCRC.¹⁵¹ In contrast, the American Institute of Certified Public Accountant’s Statement of Position 90-8 maintains that the non-refundable portion should be accounted for as deferred revenue on the liability section of the balance sheet.¹⁵² Moreover, according to Highland Farms, Inc. v. Commissioner, any pro-rata refundable portion of an entrance fee that expires (becomes non-refundable) during the year is also taxable income in that year.¹⁵³

4.  Methods and examples of calculating the tax effects of section 7872 on a refund. Because an entrance fee refund may be considered a term loan for the life of the resident, the discounted present value must be determined using the resident’s actuarial life at the time the entrance fee is paid.   No specific guidance is given as to which actuarial tables to use.  The section 72 annuity tables published in Regulation section 1.72-9 are probably the best.  For a single resident’s expected remaining life span, use  Table V — Ordinary Life Annuities; One Life — Expected Return Multiples.  For married residents, use Table VI — Ordinary Joint Life and Last Survivor Annuities; Two Lives — Expected Return Multiples.  Regulation section 20.2031-7(d)(6) also has annuity valuation tables but only for single persons.¹⁵⁴

Regarding the discount rate for term loans, section 7872(f)(2)(A) requires using “the applicable Federal rate [for the loan term] in effect under section 1274(d) (as of the day on which the loan was made), compounded semiannually.”  The applicable federal rate — short-, mid-, or long-term — depends on the actuarial life of the resident, or for a couple, their joint actuarial life.  In applying section 1274(d)(1), the federal short-term rate should be used for actuarial lives of three years or less, the mid-term rate for lives from four through nine years, and the long-term rate for lives over nine years, calculated beginning with the effective date of the resident’s contract with the CCRC.  The applicable rates are listed in revenue rulings issued monthly by the IRS.¹⁵⁵

If the discounted present value is less than the section 7872(g)(2) exemption amount, currently $134,800,¹⁵⁶ the entrance fee refund is exempt from the below-market-rate loan rules of section 7872.  Nothing must be reported to the IRS.  If it exceeds the exemption, only the excess portion is subject to the section 7872 rules.  Each year, the resident should report as interest income the semi-annual amortization of the original issue discount (OID) according to the section 1272 rules.  To determine the OID applicable to the excess portion on which the amortization is based, the OID apparently must be apportioned between the excess amount and the exemption amount, as shown in Example 1 below.  No specific statutory or administrative guidance is given with respect to apportioning the OID.

The CCRC must report two items regarding the guaranteed refund:  (1) annual interest expense, i.e., the appropriate amount of semi-annual amortization of the OID depending on whether the cash or accrual accounting method is used, and (2) gross receipts income in the year the entrance fee is received, i.e., the OID applicable to the portion in excess of the exemption amount, per section 7872(b)(1), both shown in Example 1 below.

As required under Proposed Regulation section 1.7872-11(g),¹⁵⁷ both the resident and the CCRC should attach a statement to their tax returns which (1) explains that the income (deduction) relates to section 7872, (2) lists the other party, (3) specifies the amount of the imputed interest income (expense), and (4) specifies the mathematical assumptions.

Although examples of determining the discounted present value of a term loan are given in Proposed Regulation section 1.7872-14(b),¹⁵⁸ none applies to a refundable CCRC entrance fee.   Hence, we give two examples.  Example 1 shows the effects of discounted and undiscounted guaranteed entrance fee refunds, and Example 2 illustrates the impact of the imputed interest rules on a discounted refund which exceeds the exemption amount.

a.  Example 1. On June 1, 1997, Mr. and Mrs. T, ages 78 and 76 respectively, pay a $300,000 entrance fee to a CCRC, 90% of which is refundable on the death of the surviving spouse.  Mr. and Mrs. T have made a non-interest-bearing $270,000 loan to the CCRC.  Based on their joint actuarial life of 15.0¹⁵⁹ years and the June 1997 applicable federal long-term rate of 6.99% compounded semi-annually,¹⁶⁰ the discounted present value is $96,335.  This falls below the 1997 exemption amount of $131,300¹⁶¹ and is not subject to the section 7872 below-market-rate loan rules.  If Mr. and Mrs. T are more conservative, however, and treat the undiscounted $270,000 refund amount as applicable with respect to the exemption, the excess would be $138,700.  The discounted present value of this excess amount is $49,487, which is subject to the section 7872 rules.  We present the method for calculating the imputed interest and the discount-related income that must be reported in Example 2.

b.  Example 2. On June 1, 1997, Mrs. Z, an 83-year-old widow, pays a $300,000 entrance fee to a CCRC, 90% of which is refundable on her death.  Her actuarial life is 7.9 years;¹⁶² consequently, the federal mid-term rate of 6.69%, compounded semi-annually,¹⁶³ must be used instead of the long-term rate.  The discounted present value of the $270,000 non-interest-bearing loan is $160,543.  Because this exceeds the $131,300 exemption amount,¹⁶⁴ $29,243, or 18.215% of the total discounted present value, is subject to the section 7872 rules.  The total loan discount is $109,457, but because 18.215% of the discounted present value is subject to section 7872,¹⁶⁵ only $19,938 must be recognized by the borrower, the CCRC, as income in 1997 in addition to the $30,000 forfeitable portion of the entrance fee.

As for the imputed interest on the $29,243 in excess of the exemption, the section 1272 OID rules control.  Since the interest is compounded semi-annually, the discount must be amortized semi-annually and reported as income at the end of each half year.  Therefore, Mrs. Z must report the $978 of amortized discount for the first half year ending December 1, 1997 as income in 1997 ($29,243 x [6.69%/2]).  Likewise, the CCRC must deduct $978 of interest expense if it uses the cash basis of accounting; otherwise it must accrue and deduct seven months of interest expense.  The $978 in amortized discount will increase Mrs. Z’s basis, termed the adjusted issue price, of the loan per section 1272(a)(4), and the CCRC must make the corresponding adjustment on its books.  In 1998, the imputed interest would total $2,056: $1,011 on June 1, 1998 ([$29,243 + $978] x [6.69%/2]) and $1,045 on December 1, 1998  ([$29,243 + $978 + $1,011] x [6.69%/2]).

Having advocated that an entrance fee refund is a discountable term loan and having examined the tax impact of the below-market-rate loan rules, we return to discussing medical expense deductibility.

C.  How Will an Entrance Fee Refund Affect the Deductible Amount of the Medical Expense Portion of the Entrance Fee?

The answer may depend on whether the refund is guaranteed or not.  Since the time this issue was first addressed in 1971 by the IRS’s General Counsel,¹⁶⁶ the Service has consistently ruled that a medical expense deduction based on the full entrance fee is allowed in situations where the entrance fee is partially refundable if residence is terminated “under certain circumstances.”¹⁶⁷ All of the rulings are based on the presumption that once the resident has lived at the CCRC long enough or has not satisfied the “certain circumstances” specified in the contract at the time of termination, there is no refund.  In other words, there is no certainty at the time the entrance fee is paid that any portion will subsequently be refunded.  If a refund is received, the previously deducted medical expense portion attributable to the refund should be included in the resident’s gross income in the year received per Regulation section. 1.213-1(g)(1), mitigated by the tax benefit rule of section 111.¹⁶⁸

In contrast, the IRS and the courts have never specifically addressed the situation when the resident or their estate receives a guaranteed refund at termination.  In recent years, more residency contracts are being written as such, specifying a guaranteed minimum refundable amount of the entrance fee at termination, ranging from 10% to 100%.¹⁶⁹ Many such contracts prorate the refund from the date of initial residency until either the resident dies or vacates, or a guaranteed base refundable percentage is reached, whichever comes first.  One tax commentator has written, “[i]t thus is unclear exactly what effect a refund feature (whether or not that feature includes a penalty) has on the deductibility of prepaid life-care facility entrance fees . . . .”¹⁷⁰ Perhaps because the size of the refund depends on when a resident moves out or dies, the IRS has chosen to allow a medical expense deduction based on the full entrance fee.  Also, unless future payment of the entrance fee refund is insured or bonded, residents do not have complete assurance that the CCRC will be able to pay the refund when it becomes due.  About three tenths of one percent of CCRCs have declared bankruptcy in the recent past.¹⁷¹

Due to the lack of direction from the IRS and the courts as to which entrance fee amount CCRCs and residents should use in calculating a resident’s medical expense deduction where a portion of the entrance fee is guaranteed refundable, we consider three possible amounts in the sections below: (1) the entire entrance fee regardless of the guaranteed refund, (2) the entrance fee less the face (full) amount of the guaranteed refund, and (3) the entrance fee less the discounted present value of the guaranteed refund.

These amounts may be used whether a CCRC allocates its medical costs to its residents as a percentage of their entrance fees or on a per capita basis.  Although the IRS has only ruled on refund situations where CCRCs specified the medical expense portion of an entrance fee as a percentage,¹⁷² the Service,¹⁷³ as do we, recommends calculating the medical portion of an entrance fee on a per capita basis, i.e., the same lump sum amount for each resident irrespective of the cost of their residential units.  We describe the rationale for the per capita approach in more depth in section IV.C.1.b.

Ideally, the amount of a resident’s medical expense deduction should be unaffected by a CCRC’s selection of a fee amount since the numerator — the CCRC’s total medical costs — would be the same.  The size of the denominator — whether the full entrance fee, the entrance fee less the guaranteed refund, or the entrance fee less the discounted guaranteed refund — would differ, and thus the deductible medical expense percentage that the CCRC reports to its residents would also differ.  But when the resident multiplies the CCRC’s percentage by the relevant amount of their entrance fee, the medical expense deduction would end up being the same regardless of the amount used.¹⁷⁴ Ergo, it should be irrelevant which fee amount a CCRC chooses as long as it is consistent in informing the residents as to their deductible medical expense percentage and the relevant entrance fee amount for the computation.  Similarly, the choice of entrance fee amount should not affect residents’ medical expense deductions under the per capita approach.

Realistically, however, CCRCs may not be consistent in advising their residents as to the proper medical expense portion of the entrance fee.  For example, they may have allocated some of the medical costs to the refund portion of the fee while informing residents that they can only deduct the medical expenses associated with the non-refundable portion.  Because CCRCs fund medical costs out of the forfeitable (non-refundable) portion of an entrance fee as well as out of the imputed interest saved on the non-interest-bearing refundable portion, no medical costs should be allocated to the refund.

In any case, it behooves residents, who bear the burden of proof, to use the appropriate entrance fee amount as discussed below for figuring their medical expense deduction.  Although the full fee may serve some CCRC residents best, it is flawed because medical expenses are attributable to the loan portion of the fee.  The second choice is also flawed because it treats the refund as a demand loan rather than as a term loan and therefore is at odds with section 7872.  We recommend the third choice both for CCRCs and their residents.

1.  Calculating the medical deduction on the full entrance fee. This is an attractive choice because it may yield the largest tax savings if the CCRC has been inconsistent in calculating the percentage.  It also the most aggressive choice, but it has a major flaw.  The guaranteed refund is classified as a below-market-rate loan per section 7872 as discussed previously in section III.B.¹⁷⁵ Loans are not expenses and as such are not deductible.  Hence, any medical expenses allocable to the guaranteed refund portion of the entrance fee would not be deductible.  We believe the IRS may take the position that the guaranteed refund is a loan and will deny that portion of the medical expense deduction.¹⁷⁶

Still, we would not discourage a resident from using the full entrance fee for three reasons: (1) the Service’s rulings that mention entrance fee refunds allow taking the medical deduction on the full entrance fee and require that the medical expenses associated with any subsequent refund be taken back into taxable income in the year received,¹⁷⁷ (2) these rulings do not specifically proscribe taking a deduction on the full entrance fee when there is a guaranteed refundable portion, and (3) the rulings say nothing about having to deduct only the medical expenses allocable to the net entrance fee, i.e., the entrance fee net of the guaranteed refund amount.  We recommend that only those residents (or their children if their children are paying the fees and claiming their parents as dependents) whose adjusted gross income is large enough to give them a significant tax benefit from the deduction use the full entrance fee.¹⁷⁸ The time value of money makes it worthwhile for residents to take the medical expense deduction on the full fee in the year paid and then wait to repay the taxes associated with the refund.  In fact, no subsequent taxes may have to be paid, as explained next.

a.  When the resident vacates or dies: Recapture of the previously deducted medical expenses attributed to the refund on the resident’s, estate’s, or heirs’ taxable income. If a resident deducts medical expenses based on the full fee and later moves out of the CCRC, they must include the medical expenses allocable to the refunded portion of the entrance fee in their gross income in the year received,¹⁷⁹ subject to the tax benefit rule under section 111.

But if the resident dies, there is no income tax effect!  None of the previously deducted medical expenses attributable to the refund will have to be included in either the resident’s, their estate’s, or their heirs’ gross income.  Because the refund will be paid to the resident’s estate or other beneficiary rather than the resident at the time of death,¹⁸⁰ the medical expense portion of the refund is not income in respect of the decedent per section 691.  Nonetheless, the refund must be included in the resident’s gross estate and may incur estate tax.¹⁸¹

2.  Calculating the medical deduction on the entrance fee less the face amount of the refund. This choice involves deducting only the medical expenses allocable to the entrance fee less the full or undiscounted value of the guaranteed refundable portion.   It is the most conservative of the three and may yield the lowest medical expense deduction depending on how the CCRC calculates the percentage.  We do not recommend it because it treats the refundable portion as a non-discountable demand loan rather than as a term loan.  There is no basis for this under our interpretation of section 7872 and the proposed regulations.¹⁸² Therefore, the third choice is superior to this one in theory and perhaps in the size of the permitted medical deduction.¹⁸³ If a CCRC reports the entrance fee to its residents in this fashion, we recommend that the residents recompute the amount by discounting the refund as specified in section III.B.   This is what we did for Mrs. W in the section I.B. example.

a.  When the resident vacates or dies:  Recapture of the previously deducted medical expenses attributed to the refund on the resident’s, estate’s, or heirs’ taxable income. Opting to deduct medical expenses based on the entrance fee refund, discounted or not, however, could result in including some of the medical expenses in gross income in the year the refund is received.  When an entrance fee is refundable on a pro-rata basis based on length of residency, premature termination will result in a higher refund than the guaranteed minimum.  If the resident moves out, the medical expense portion allocable to the difference between the guaranteed minimum refund and the actual refund must be included in the resident’s gross income in the year received per Regulation section 1.213-1(g)(1), subject to the tax benefit rule of section 111.  If the resident dies, however, none of the difference will have to be included in either the resident’s, estate’s, or heirs’ taxable income because, as mentioned in section III.C.2.a. above, it is not income in respect of the decedent.

3.  Calculating the medical deduction on the entrance fee less the discounted present value of the refund. We recommend this as the safest choice.  The medical expenses allocable to the entrance fee are figured only on the fee net of the discounted present value of the guaranteed refundable portion.  This makes sense economically as previously mentioned because CCRCs fund medical costs out of the forfeitable (non-refundable) portion of an entrance fee as well as out of the imputed interest saved on the non-interest-bearing refundable portion.¹⁸⁴ By treating the refundable portion as a term loan, the discounted present value of the refund may be less than half of the face value for most residents.¹⁸⁵ This choice will yield a larger deduction than the second choice if the CCRC inappropriately allocated some of the medical costs to the refund because the refund amount is smaller when discounted.

Nevertheless, the size of a resident’s medical expense deduction may be more affected by a CCRC’s medical expense allocation method than by the choice of fee just discussed.  Next we explore and recommend how a CCRC should make the allocation.

IV.  Determining the Fee Percentage Allocable to Medical Expenses

A.  Introduction

CCRCs typically determine the medical expense portion of their operating expenses either of two ways: (1) the expense category approach which entails analyzing each expense account category for the medical expense portion, or (2) the actuarial method which involves estimating the average annual medical expense per resident based on actuarial information about the CCRC’s resident population.¹⁸⁶ However, no industry-wide consistency exists under either method for apportioning the medical expenses between the entrance fee and the monthly fees.

Residents have an important stake in the cost allocation method used by CCRCs to calculate the medical expense deduction.  Even though the computation does not directly benefit  the CCRCs, it may have considerable impact on the tax liabilities of their residents.  By not spending enough time on the calculation or by applying an inappropriate method, the CCRCs could be costing their residents thousands of dollars in tax savings.  Most residents will not realize whether they are being advised correctly since they generally are unaware of the mechanics of the CCRCs’ computations.  While it is the residents’ duty to become better informed, we believe that CCRCs, also, have a fiduciary responsibility to help their residents get the greatest and most accurate deduction possible.

In the next section we examine the views of the IRS and courts regarding CCRCs’ calculation of the medical expense allocation.  In section C we discuss the two calculation methods currently in practice along with the theoretical aspects of the allocation and conclude with what we believe is a consistent and rigorous approach for calculating the allocation.

B.  What Statutory Law, Case Law, and the IRS Say Regarding Allocation

Both statutory law and case law are silent regarding methods for calculating the medical expense fee allocation,¹⁸⁷ and the IRS has given little guidance.  Although the Service has said that the medical expense percentage used by a CCRC is appropriate if based on either the CCRC’s prior experience¹⁸⁸ or the long-term operating experience of a comparable CCRC,¹⁸⁹ it has issued no pronouncement of precedential value with respect to the mechanics of cost allocation.

In private letter rulings, however, the IRS has gone farther with the issue; beginning in 1976, the Service issued a ruling stating that a CCRC’s “prior financial experience is a reasonable method to determine the [allocation].”¹⁹⁰ Rulings in the 1980’s began to give some indication as to the Service’s thoughts on the mechanics of an appropriate allocation method.¹⁹¹ In the early 1980’s, the rulings suggest dividing the CCRCs’ “directly related medical expenses by total expenses” to find the percentage that would then be used to calculate the medical portion of the entrance and monthly fees.¹⁹² While the Service suggested this method, it refused to give an opinion as to what constitutes an appropriate percentage.¹⁹³ Items considered by the rulings as medical expenses in this calculation included, among others: nursing salaries, maintenance utilities, interest on indebtedness, housekeeping, real estate taxes, depreciation, administrative costs, and marketing costs.¹⁹⁴

In the mid-1980’s, the Service began questioning whether residents with different sized units costing different amounts should be able to deduct different medical costs.  The IRS ruled that residents of the same CCRC should be put on an “equal footing”¹⁹⁵ using a “weighted average” to achieve a “proper allocation” of medical expenses.¹⁹⁶ In 1989, the IRS ceased issuing rulings on the issue altogether after stating that “[t]he Service has no published position regarding the method of allocation . . . , there is no basis to favor one method of allocation over another . . . , [and] [b]ecause this issue is currently under study, no opinion is expressed.”¹⁹⁷ Thus, CCRCs continue to have little guidance and consequently have considerable latitude in selecting an allocation method.

C.  Critique of Medical Expense Allocation Methods

1.  Expense category method – issues and recommendations.  Under this method each expense category is analyzed to estimate what portion of each category’s total costs are for medical purposes.  The CCRC adds up the estimates and divides the total by the total expenses of the facility to determine the medical expense allocation percentage as shown in Table 1 in section IV.C.1.c. below.  Residents then use this percentage to compute the deductible amount of their monthly fees paid in that year.  Typically, CCRCs advise new residents to use this same percentage to calculate the deductible portion of their entrance fee paid in their first year of residence.  According to conversations we had in early 1995 with CCRCs using this method, they do not invest much time in analyzing their medical expenses.  Their main concern is to make sure that the percentage seems reasonable to the IRS.

In the following five sections, we make recommendations regarding shortcomings in the way CCRCs typically implement the expense category method.

a.  Estimate the medical expense portion accurately. The medical expense percentage is only as accurate as the estimates of the medical costs per expense category.  CCRCs, at least the ones with whom we spoke, tend to guesstimate each category’s percentage rather than analyzing the additional costs in each category that result from providing for the actual and preventative medical needs of the residents.

The medical proportion of these categories is subjective, and the residents or their CPAs may question or challenge it.  The residents, rather than the CCRCs, bear the burden of proof if questioned by the IRS.  Using the CCRC’s data, residents may make their own reasonable approximations even though they differ from those of the CCRC.  We did this for Mrs.W in amending her return (see section I.B.).  Her CCRC initially estimated the deductible allocation percentage for food service expense and activities expense at 2.5% and 25% respectively.  We raised them to 10% and 50%.  As for food, we believed that 2.5% (about $30,000 out of $1.2 million) was far too small given the salary of a qualified dietician and the costs of providing and preparing foods for the dietary and health prevention needs of the residents.  Regarding the activities expense, we believed well over 50% could have a medical connection based on the therapeutic mental and physical benefits, but settled on 50%.

b.  Assign each resident the same medical deduction amount irrespective of the size of their fees – the per capita approach. CCRCs typically assign all of their residents the same percentage to multiply by their entrance and monthly fees to determine their medical expense deduction.  Residents with larger units get a larger medical expense deduction because they pay higher fees.  This is unreasonable to us because it is unlikely that a relationship exists between a resident’s health and their unit size.  Medical costs depend on the number of residents, not the unit size and cost.¹⁹⁸ The IRS has also recommended that residents with different sized units and fee payments should be put on an “equal footing.”¹⁹⁹

Rather than specifying a percentage, CCRCs should tell each resident their per capita dollar share of the facility’s total expenses applicable to their monthly and entrance fees paid during that year.  To find the per capita medical expense deduction per resident, the medical expense allocation percentage (as determined using the direct cost method explained in the next section) must be multiplied by the total annual fee revenue for the CCRC and then be divided by the number of residents.  (We did not compute Mrs. W’s medical expense deduction in this fashion in the section I.B. example because we could not get a resident count for the year at issue.)  We recommend calculating the per capita amounts for monthly and entrance fees using the direct-cost approach as explained next.

c.  Use direct costs, not total costs, in calculating the medical expense portion. The medically related percentage of a CCRC’s operating expenses ought to be figured using a CCRC’s direct operating costs rather than the total operating costs as is customarily done.  Direct costs directly affect the residents, e.g., food services, housekeeping, utilities, front desk, security, and health services.²⁰⁰ Other costs like depreciation, administration, interest, real estate taxes, and marketing are indirect overhead or support costs because they do not directly affect the residents.²⁰¹

Classifying costs as direct and indirect with respect to the residents makes more sense from a cost accounting standpoint,²⁰² and this method will benefit residents by increasing the percentage deduction.  Similar to computing a manufacturer’s overhead or indirect cost allocation rate based on a direct-cost activity measure such as direct labor hours, the medical cost allocation rate should be calculated using the annual direct operating costs of the CCRC.²⁰³ For monthly fees, this percentage rate may be computed as the weighted average of the medical expenses from each direct cost category for the calendar year (see Table 1 below).  The percentage may then be multiplied by the total monthly fee revenues collected from residents for that year to find the total medical costs allocable to monthly fee revenue for the CCRC.²⁰⁴ This total may in turn be divided by the number of residents to determine the medical expense deduction associated with each resident’s monthly fees for that year.  As discussed in section IV.C.1.e.(1). below, we recommend that only the ILU-related medical costs be figured in calculating the monthly fee medical allocation.  For entrance fees, we recommend using projected, rather than the past year’s, direct costs for the entire facility, not just the ILUs, as discussed in section IV.C.1.e.(2). below.

As may be seen from the sample data in Table 1, use of direct costs rather than total costs nearly doubles the medical expense allocation percentage from 10.89% to 19.13%.  If a CCRC is unwilling or unable to provide residents with a direct cost analysis, we encourage the residents or their CPAs to rework the CCRC’s expense analysis accordingly.  We provided this analysis to Mrs. W, as discussed in section I.B.

TABLE 1

Total-Cost and Direct-Cost Analysis of a Sample CCRC’s Annual Operating Expenses for Determining the Medical Expense Allocation Percentage²⁰⁵

Weighted

Medical                  Average

Actual                   Medical              Allocation                Medical

Expense Category Annual Cost Allocation % Amount Allocation %

Direct Costs:

Front Desk/Security                          $    147,237                    50%                 $   73,619

Resident Transportation                          55,498                    50%                       27,749

Resident Activities                                   53,405                     50%                       26,703

Misc. Resident Services                          75,373                      75%                      56,530

Health Services                                       151,124                    100%                    151,124

Food Service                                         1,175,590                    10%                      117,559

Housekeeping                                          271,415                      10%                      27,142

Laundry                                                      18,533                        5%                            927

Utilities & Resident Units                      769,673                        5%                  38,484 Direct Costs

Sub-Total (Direct Costs)          $ 2,717,848 $519,837 19.13%

Indirect/Overhead Costs:

Marketing                                            $   263,581                       0%                 $          0

Accounting                                              197,956                     15%                       29,693

Employee Services                                    47,118                       5%                         2,356

Administrative                                         426,028                       15%                     63,904

Financial Interest                                     373,938                       5%                       18,697

Building & Grounds                                538,101                       5%                       26,906

Depreciation                                         1,511,145 0%                    0

Sub-Total (Indirect Costs)            $ 3,357,867 $  141,556

Total Costs

Total Operating Expenses             $ 6,075,715 $661,393 10.89%

d.  Give a higher monthly fee deduction to residents of assisted living

units, (ALUs) and nursing care units than independent living units (ILUs). For most residents, we

believe that ALU monthly fees should be 100% deductible as medical care, as discussed in section II.B.3.b.

CCRCs that assign the same percentage to both ALU and ILU residents are overstating the ILU percentage and

understating the ALU percentage.  Other CCRCs merely report a higher medical care percentage for ALU

residents, but far less than 100%, apparently concluding that their ALU residents are not sufficiently chronically ill

to warrant deducting 100% of the costs.  For example, one CCRC that has done so advised its residents that

13% of their ILU monthly fees and 37% of their ALU monthly fees, rather than 100%, were for medical care in

that particular year.²⁰⁶

For those ALU residents who do not have enough ADLs²⁰⁷ to qualify as “chronically ill,” and thus are not eligible for a 100% monthly fee deduction, the additional annual personal care costs may be accounted for separately by the CCRC.  The total of these costs should be divided by the number of non-chronically ill ALU residents, and the resulting amount may be added onto the per capita ILU medical expense amount already calculated for ILU residents using the steps recommended in the section above.

CCRCs need to keep track of their ALU and nursing care expenses separately so as not to inflate the ILU medical deduction.  This is a cost classification issue which is particularly important for those CCRCs that offer extensive-care contracts and also accept private pay ALU or nursing care residents.

e.  Calculate the medical expense portion of monthly fees using a

different method than for entrance fees. Different methods of calculating the tax deductible portion of

monthly and entrance fees ought to be used because of the differing rationales for charging each fee.  Based on

conversations conducted with CCRC administrators in early 1995, entrance fees typically are intended to

provide long-term capital for CCRC facilities, whereas monthly fees cover the ongoing operating expenses.

There is little basis for applying the same medical allocation percentage to both the monthly and entrance fees

other than for convenience or for mature CCRCs whose medical expense percentage remains fairly steady over

the years.²⁰⁸

(1).  Monthly fees. Because monthly fees for chronically ill ALU residents and nursing care residents are fully deductible medical expenses, we recommend including only those expenses for ILU residents’ medical needs in the calculation of the monthly fee medical allocation.  Using the ILU-related medical costs from each particular year’s operating data, the per capita medical allocation for that year’s monthly fees may be calculated by the CCRC as described in section IV.C.1.c. above.  The contract type, whether extensive, modified or fee-for-service, would not affect this calculation because all three treat ILU residents the same with respect to monthly fees.  For monthly fees paid by non-chronically ill ALU residents, see section IV.C.1.d. above.

(2).  Entrance fees. We recommend that CCRCs use their projected future costs rather than the past year’s costs to compute the per capita medical expense portion of entrance fees using the following six steps.  For the cohort of new residents entering the CCRC during a year, (1) calculate the expected number of years of residency (usually the actuarial life) for each resident entering in that year, (2) find the average of step 1 for the cohort, (3) compute the CCRC’s projected medical expense percentage for each of the years up through the year computed in step 2 by dividing each future year’s projected medical cost by the projected operating costs as explained in section IV.C.1.(c) supra,²⁰⁹ (4) find the multi-year average of step 3, (5) multiply the average medical expense percentage in step 4 by the sum of the entrance fees paid by the cohort, and (6) divide step 5 by the number of new residents in the cohort to determine their per capita entrance fee medical deduction.²¹⁰ Steps 1, 3, and 5 bear further explanation as follows.

Step 1:  Calculate the expected number of years of residency for each resident. Because the entrance fee provides benefits over one’s entire residency, it makes better sense using the expected average medical cost over the entire residency in calculating the per capita medical deduction for each new resident rather than using the medical cost for the year in which the entrance fee is paid.  In fact, using the entry year’s medical cost may substantially understate the portion of the entrance fee that is for medical care if the CCRC is in its early years of operation.  Residents of newer CCRCs generally are younger and require less medical care.  Also, for extensive care contracts, using the current year’s medical cost will significantly understate the medical portion if all the medical costs of ALU and nursing care residents are not averaged into the calculation.  Many residents will eventually require assisted living and nursing care, both of which are generally 100% deductible.  For modified contracts, the only items included should be the projected ALU and nursing care costs for the allowable grace period of care, which are received at no additional cost to the residents.  Fee-for-service contracts should have the smallest entrance fee medical cost portion because only the projected ILU medical costs would be included.

Step 3:  Compute the CCRC’s projected medical expense percentage for each of the years by dividing each future year’s projected medical cost by the projected direct operating costs. In contrast to the monthly fee medical cost calculation, the projected medical costs should include ALU and nursing care expenses (100% of them) associated with extensive contracts and modified-contract grace periods.²¹¹ This is because entrance fees include a blend of projected ILU, ALU, and nursing care expenses at such CCRCs.  The projections, however, should exclude projected medical costs and operating expenses for ALU and nursing care services provided to three categories of residents:  fee-for-service residents, modified-contract residents who are past the grace period, and private pay residents.  Also, the projected medical and direct operating costs need not be discounted back to the present because both the numerator and the denominator are similarly affected by the time value of money.

We suggest three options for estimating the expected average medical expense percentage for each year’s new-resident cohort: (1) projected historical trend, (2) comparable CCRC experience, and (3) actuarial projection (which we recommend).

First, if the CCRC has been in existence for three or more years, the previous years’ trend of medical cost percentages including ALU and nursing unit medical costs may be projected into the future arithmetically or using a time-series regression (performable on many hand-held calculators) for the expected average period of residency of the cohort.  We used the historical trend method along with time-series regression to estimate Mrs. W’s entrance fee medical expense deduction in the section I.B. example.

Second, if the CCRC has been in existence for less than three years, data from a comparable CCRC may be used to calculate the expected average medical expense percentage.  The IRS consented to this approach in Revenue Ruling 76-481.²¹² Many of today’s CCRCs are part of chains that likely have comparable data.  A sister CCRC ought to be comparable on several factors — overall size, resident unit cost, and resident demographics (the older the residents, the higher the medical cost percentage, all other things equal).

Third, regardless of the CCRC’s age, data from the CCRC’s actuarial feasibility study and its subsequent updates may be used.  Actuarial studies typically contain data on the projected medical costs of the CCRC over an extended time period and include the additional medical costs of assisted living and nursing care for extensive and modified contracts.  CCRCs’ actuarial consultants should factor the expected medical costs into the size of the entrance fee.  From these data it should be possible to calculate the deductible medical portion of the net entrance fee.  We recommend this approach and discuss it in more depth in section IV.C.2.

Step 5:  Multiply the average medical expense percentage by the sum of the entrance fees paid by the cohort. We recommend multiplying the average medical expense percentage by the sum of the net entrance fees, i.e., the entrance fees less the discounted present value of any guaranteed refunds, as explained in sections III.B.3.c. and III.C., to determine the projected total as medical expense, from which the per capita medical deduction may be computed.  As we explain in section III.C., a CCRC may assert that the per capita entrance fee medical expense is fully deductible because it is paid out of the net entrance fee, not the refundable portion.

If a CCRC prefers advising its residents of the deductible percentage rather than the per capita deductible amount, it should use the percentage estimated in step 4 and should inform the residents of the appropriate entrance fee amount to use in multiplying by the average medical expense percentage.  Again, we recommend using the net entrance fee, i.e., the entrance fee less the discounted present value of any guaranteed refund.  We used the percentage approach in conjunction with the net entrance fee for Mrs. W in the section I.B. example because we did not have the entrance fee and resident count data needed to calculate the per capita amount.

2.  Actuarial method – discussion and recommendations. The second approach used in practice involves applying an actuarially-based financial projection model to estimate future medical costs for existing CCRCs or CCRCs in the planning stage.  Because CCRCs often base entrance and monthly fees on the results of an actuarially-based feasibility study, completed at the time the facility is being planned, it makes sense to derive the medical cost portion of the fees from the data in the study.   Using expected mortality and morbidity (illness) rates based on the gender and age characteristics of the CCRC’s current or anticipated residency population, an actuarial firm computes the total projected medical costs.  This total, less the residents’ expected  medical services payments, is discounted back to the current year and divided by the number of residents to find the expected future health cost per resident.  The discount rate should include only the expected inflation rate and not an interest factor because entrance fees are non-interest-bearing.

At present, the typical CCRC arbitrarily decides how to divide this total between the monthly and entrance fees.  In some cases, CCRC marketing departments have already told prospective residents what portion of the entrance fee is deductible, and, in those cases, the remaining portion is allocated to the monthly fee.²¹³ Arbitrary allocation is not based on cause and effect, it runs the risk of IRS sanction, and it may hurt some residents to the benefit of others.²¹⁴ Nonetheless, in those cases where the marketing department has already advised prospective residents as to the size of the entrance fee medical deduction, the practical solution is to assign the remainder of the total to the monthly fees.

a.  Use the actuarial method to compute the entrance fee medical expense portion and use the expense category method for monthly fees. There should be a sound rationale for allocating medical costs between the monthly and entrance fees.   Because entrance fees provide CCRCs with long-term capital, and monthly fees cover the operating expenses, we recommend determination of the medical costs using two different methods — the expense category analysis for monthly fees and the actuarial method for entrance fees.²¹⁵ The expense category method for monthly fees is consistent with section 213 which permits a medical deduction for those expenses paid in the year.²¹⁶ The actuarial method for entrance fees is consistent with Estate of Smith which held that payments for future medical care are deductible in the year paid only if the CCRC is contractually obligated to provide the future care to the resident.²¹⁷

For estimating the medical portion of an entrance fee, the actuarial method is better than the historical trend method.  Whereas the latter method estimates the medical portion from the average of the projected trend of medical costs obtained using the expense category method, the actuarial method draws on the actuarial estimate of the CCRCs’ long-term future medical costs.  Just as insurance premiums reflect the actuarial estimate of future costs,  CCRCs’ entrance fees include an estimate of the future medical costs.  The actuarial method is probably more defensible than historical trend analysis in the event of an IRS challenge because it is usually based on years of proven historical data that have been accumulated across a large number of CCRCs by an actuary specializing in the industry.

Although one drawback is the expense of an actuarial study, many CCRCs may already have the data readily available.  Generally, before building a CCRC, a feasibility study must be completed.  Such a study, which may have been done by an actuarial firm,²¹⁸ will project all of the expected future costs in operating a CCRC, including the costs of providing health care to the residents.  By using these medical cost projections as adjusted per the suggestions in section IV.C.1.e.(2)., a CCRC may reasonably estimate the deductible medical expense portion of the entrance fee for the initial cohort of residents and update the actuarial projections for subsequent cohorts of residents.

V. Conclusion

CCRC residents may deduct the portion of their entrance and monthly fees attributable to medical costs on their tax returns in the year paid per IRS rulings and court holdings.²¹⁹ Typical residents may deduct $20,000 or more in the year they pay their entrance fee and $3,000 or more annually for their monthly fees.  To do so, residents must obtain a statement from the CCRC advising them of the portions of their fee payments that are for medical care.  Most residents (those deemed chronically ill) in assisted living units (ALUs) and all nursing care residents should be able to deduct 100% of their monthly fees.  Depending on the calculation method used, however, the entrance fee medical expense deduction may be reduced by a CCRC’s promise to refund part or all of the fee when the resident moves out or dies.

Because residents bear the burden of proving that the deduction is valid, it behooves them to determine whether the CCRC has calculated the medical expense allocation of their fees properly.  We have found that the typical CCRC is not careful in its computations or is overly conservative in its advice to its residents.  One warning signal is if the CCRC assigns the same medical deduction percentage to both the monthly fees and the entrance fee.  There is little basis for this because the entrance fee provides long-term capital for the CCRC and is related to the guarantee of future medical care in an ALU or nursing care unit, whereas the monthly fees are related to the day-to-day medical costs such as front desk monitoring of emergency pull cords, transportation to the doctor, special dietary considerations, and having a nurse on duty.  We advise residents or their tax advisors to ask their CCRC for supporting documents to verify the size of the deduction and the reasonableness of the computational method.  If not satisfied, they should do their own calculations since they, not the CCRC, must defend the deduction to the IRS.

Specifically, we suggest the steps that CCRCs should follow in computing the medical cost portion of their residents’ entrance fees and we recommend that the CCRCs use data from an actuarially-based feasibility study.  Most CCRCs or their parent organizations have likely had such a study done during the planning stage of the facility.  The expected future medical costs of the CCRC are estimated actuarially and are undoubtedly figured into the fees.  To estimate the medical portion of monthly fees, we suggest analyzing each direct cost category²²⁰ in the CCRC’s annual operating statement to determine the percentage attributable to medical care.  The weighted average percentage across all the categories should then be multiplied by the total monthly fees paid by ILU residents for the year, and the result should be divided equally among them.  Care should be taken not to include ALU or nursing care expenses in the calculation.

The deductible amount of either type of fee should be the same per capita amount for each resident rather than a percentage of the fees paid unless the differences in fees are due to different levels of medical care rather than different residential unit sizes.  Unit size is unrelated to the expected medical costs per resident.

Entrance fee refunds pose a potentially serious tax problem for CCRC residents and the CCRCs themselves.  In particular, because the refunds are usually non-interest-bearing, they may be classified as below-market-rate loans under section 7872.  Based on our analysis of the law and judicial opinions, we conclude that few refunds will be so classified.  First, section 7872(g) exempts refunds below an inflation-adjusted amount, currently $134,800,²²¹ for residents at least 65 years old.   Second, we determine that refunds over that amount are term loans rather than demand loans and as such are discountable over the actuarial life of the resident.  Their discounted value in many cases will be less than half the face value.  Therefore, most entrance fee refunds of less than $250,000 will be exempt from the section 7872 rules.

For larger refunds that are not entirely exempt, only the portion of the discounted value in excess of the exemption amount will be subject to the imputed interest rules.  In that case, the residents will have to report imputed interest income, and the CCRCs, imputed interest expense, on their tax returns.  Examples of these computations are provided in section III.B.4., supra.

Entrance fee refunds also have tax implications regarding the medical expense deduction.  The IRS has ruled that if a medical expense deduction has been taken on the full entrance fee, a subsequent refund would trigger recapture of the previously deducted medical expense associated with the refund.  The recaptured amount is taxable income mitigated by the tax benefit rule.  Only CCRC residents who move out prior to death will be affected, whereas estates and beneficiaries of decedent residents get a tax break.  Because CCRC contracts are normally written such that the estate or other beneficiary will receive the refund, the previously deducted medical expense associated with the refund is not income with respect of the decedent under section 691 since the right to receive it did not arise until death.

If the CCRC advises a resident that a percentage of the entrance fee is for medical care, we are apprehensive that there is a risk in taking the medical expense deduction on the full entrance fee if part of the fee is guaranteed refundable.  Because the refund is treated as a loan, and loans are not tax deductible, the medical expense attributable to the refundable portion may not be deductible.  Neither the IRS nor the courts have addressed the treatment of guaranteed refunds as yet.  Although we would not discourage a resident from taking this more aggressive position, we recommend taking the deduction on the net entrance fee — the fee less the discounted present value of the guaranteed refundable portion.  We believe a better approach for CCRCs, though, is to advise their residents that a lump sum rather than a percentage of the entrance fee is for medical care.  The CCRC then may assert on behalf of the residents that the per capita, lump-sum medical expense portion is fully deductible because it will be paid out of the non-refundable part of the entrance fee.

There is gold at the end of the rainbow for CCRC residents.  The tax savings from deducting the medical

expense portion of CCRC fees may be great, as in the case of Mrs. W who received a tax refund of more than

$5,000 on the entrance fee alone.  To uncover the full pot of gold, though, residents have a duty to better inform

themselves about the issues, and CCRCs have a fiduciary responsibility to help their residents get the greatest

and most accurate deduction possible.

ENDNOTES

²²¹ Rev. Rul. 97-57, 1997-52 I.R.B. 16.

SO YOUR EMPLOYER MADE YOU AN INDEPENDENT CONTRACTOR AND DIDN’T PAY ANY FICA TAX:

HOW TO HAVE YOUR CAKE AND EAT IT TOO

by Robert Atkins Walker and Clifton L. Kling

We focus on four employee-related employment tax and benefit issues:  (1) how misclassified workers may avoid paying any self-employment tax (SECA), (2) how they possibly may avoid paying the employee’s half of FICA tax as well, (3) how they may secure reclassification as employees through the help of the IRS – in recent years, about 90% of the Private Letter Rulings addressing the issue have classified workers as employees rather than independent contractors,⁵ and (4) how they may have their earnings record updated to obtain maximum Social Security benefits after retirement despite paying neither self-employment nor FICA tax on the misclassified earnings.  The proper action for misclassified workers is to report their independent contractor earnings as wages and pay no self-employment tax.  The following is an example of one such worker that one of the authors met during the writing of this article.

B. An Example

Officer B, a security guard at Georgetown University, moonlighted in 1993 for a laundry firm driving a delivery truck.  The company treated him as an independent contractor and reported his earnings of $7,041 on a Form 1099-MISC instead of a W-2.  B realized that he had been misclassified by his employer and was preparing to seek an IRS determination of his status.⁶ He had already drafted but not yet mailed his amended 1993 Federal income tax return including $995 of self-employment tax liability.  After discussing his situation with one of the authors, B reclassified the self-employment income as wages and saved the self-employment tax.  His next step will be to contact the Social Security Administration to have his earnings record updated for the missing wages.  Failing to do this could cost him about $1,100 in eventual Social Security benefits.⁷ Had B been a full-time worker for the delivery firm, the effect would have been more dramatic.  He would have earned about $30,000, saved about $4,300 in self-employment tax, and lost about $4,700 in Social Security benefits for each year of employment.

C. Employer Incentives and Employee Consequences

Employers have an incentive to classify their employees as self-employed independent contractors because they avoid paying employer FICA, federal and state unemployment, worker compensation, medical insurance, vacation and holiday pay, pension contributions, and other fringe benefits.⁸ Employers are in a position to do so because prospective workers are usually at a disadvantage in negotiating terms of employment.  Even if employees do have some bargaining power, they often do not realize the financial impact of their classification.  As a result, employees are misclassified as independent contractors and rarely are aware of the procedures for correcting the misclassification.

The most immediate financial impact on misclassified workers face is having to pay 15.3% in self-employment taxes on their earnings.⁹ Misclassification may have other serious consequences which are not covered in this analysis.  Independent contractors are typically not eligible for the employer’s fringe benefits such as health insurance, although they have recourse against the employer for those benefits if they have been misclassified.  Additionally, independent contractors are not eligible for unemployment and workers’ compensation coverages, unless obtained privately.  They also lack the protection of other laws for employees including, for example, the Age Discrimination in Employment Act, and the Fair Labor Standards Act which governs overtime pay as well as other wage and hour issues.¹⁰ Nonetheless, misclassified workers can obtain unemployment and workers’ compensation coverage through state review boards and may assert their rights as de facto employees for the other legally mandated employee protections.

D. Organization

This analysis is structured as follows.

! Part II briefly addresses the legal issues involved in determining worker status.

! Part III analyzes recent court decisions along with the relevant statutory law and administrative pronouncements.  The court cases, all of which hold that a misclassified employee does not have to pay self-employment tax, are divided as to whether the misclassified employee is liable for the employee’s share of FICA taxes.¹¹

! Part IV explains the administrative steps necessary to avoid paying self-employment tax and to update one’s Social Security earnings record.  If neither the employee nor the employer has paid FICA tax, the IRS will not forward the earnings data to the Social Security Administration.  The employee must contact a Social Security office to update their earnings record for the reclassified wages.  Failure to have one’s Social Security earnings record updated for the misclassified earnings usually will mean less Social Security benefits after retirement.

! Part V summarizes the findings and recommends strategies for misclassified employees.

II. Is a Worker an Employee or an Independent Contractor?

Determination of a worker’s correct status is a necessary first step.  The law is well established on this issue.  The primary test of employee status is whether the employer has the right to control and direct the worker.¹² It is not a requirement that the employer actually controls and directs; merely the right to do so indicates an employer-employee relationship.  Based on the facts and circumstances of each case, the courts decide whether sufficient direction and control exist to establish an employer-employee relationship.  Considerable case law now exists in which the courts have considered a variety of factors in determining the level of direction and control.¹³

In the absence of statutory guidelines for most types of employment,¹⁴ the IRS has sought to issue regulations for clarifying the common law rules that govern classification.  Fearing the retroactive tax assessments that could result from reclassification (the IRS has estimated that $2 billion in income and employment taxes is lost each year as a result of employer misclassification of 3.4 million employees),¹⁵ small businesses and independent contractors successfully lobbied Congress to bar the IRS and the Treasury from issuing such regulations.¹⁶ Consequently the IRS resorted to issuing a Revenue Ruling that emphasizes the direction and control issue, and lists 20 additional factors distilled from court opinions for use in deciding worker misclassification disputes.  These factors, taken together, are known as the common law test of employee-versus-independent-contractor status.  As listed in Rev. Rul. 87-41,¹⁷ the factors consider a worker an employee if the worker:

1.         Must comply with the employer’s instructions

2.         Receives employer sponsored training

3.         Provides services that are an integral part of the business

4.         Renders services personally

5.         Hires, supervises, and pays assistants for the employer

6.         Has a continuing relationship with the employer

7.         Must follow set hours of work

8.         Works full time for the employer

9.         Works on the employer’s premises

10.       Performs tasks in an order of sequence set by the employer

11.       Must submit oral or written reports

12.       Is paid by hour, week, month

13.       Is paid for business and/or travelling expenses

14.       Is furnished with tools and materials

15.       Does not have a significant investment in the service-providing facilities

16.       Cannot realize a profit or loss

17.       Works for only one employer at a time

18.       Does not make services available to the general public

19.       Can be fired, and

20.       May quit without incurring liability to the employer.

Employing this non-objective approach, the Revenue Ruling further states that, “[t]he degree of importance of each factor varies depending on the occupation and the factual context in which the services are performed.”¹⁸

Both the courts and the IRS have set a low threshold for determining the necessary level of direction and control to establish employee status.¹⁹ A worker that is treated as an independent contractor and who thinks there is evidence supporting employee status has a good chance for reclassification through the IRS or the courts.²⁰

III. Can the Misclassified Worker Avoid Paying Both

Self-Employment and FICA Tax?

A. Recent Court Decisions

Recent court decisions involving misclassified workers establish that self-employment tax does not have to be paid, but are in conflict as to whether the employee’s half of FICA tax must be paid.  Most recently, Casety (1993)²¹ and Laraway (1992)²² released misclassified workers from paying self-employment tax.  The third case, Myers (1992),²³ held that the IRS cannot collect the employee’s portion of FICA tax directly from the employee unless either the IRS is statutorily prevented from collecting from the employer or the IRS can offset the tax against an overpayment owed the taxpayer.  The fourth case, Navarro (1993)²⁴ is consistent with Casety by exempting the reclassified worker from self-employment tax but conflicts with Myers by requiring that the employee pay their half of FICA tax even if the employer remains fully liable.

1. Casety.  In Casety,²⁵ the Tax Court allowed a misclassified employee’s non-payment of self-employment tax.  Ed Casety earned $18,661 working as a paralegal during the 1988 tax year.  His attorney employer treated him as an independent contractor and reported his earnings on Form 1099-MISC.  Casety believed that he was an employee based on the common law definition and did not report self-employment tax on Form 1040.  The IRS issued a $2,452 deficiency notice for the self-employment tax due on his earned income for 1988.  The Court concluded that he was not liable for self-employment tax, ruling that he was an employee.  The judge determined that the employer retained the right to control the manner in which Casety’s services were performed.

The issue of whether Casety was liable for the employee’s share of FICA tax was not raised at trial²⁶ because the Tax Court does not have jurisdiction over FICA tax issues per I.R.C. Sec. 7442.²⁷ As stated in Purdy v. Commissioner,²⁸ the Tax Court’s jurisdiction “is normally predicated upon issuance of a notice of deficiency.”²⁹ Per I.R.C. Secs. 6211-6214, “Subtitle C – Employment Taxes” of the I.R.C. (Secs. 3401 et. seq.) is not among the types of tax for which a deficiency notice may be issued.  Self-employment (SECA) taxes, however, are covered under I.R.C. Subtitle A (Sec. 1401) and are within the Tax Court’s jurisdiction.

If the IRS determines that a taxpayer has underpaid FICA taxes, the IRS may issue a tax due notice per I.R.C. Sec. 6303 but not a deficiency notice (see I.R.C. Sec. 6155(b)(1)).  Because the Tax Court has no jurisdiction over FICA tax issues, the taxpayer generally must pay the tax liability and sue for a refund in a U.S. District Court or in the U.S. Claims Court.³⁰ If the taxpayer does not pay the FICA tax liability shown on the tax due notice, the IRS may enforce its own tax lien (I.R.C. Sec. 6321) by levying on the taxpayer’s property (I.R.C. Secs. 6331 et seq.).  In Casety’s case, once the IRS had lost on the self-employment tax issue, sending a tax due notice for the employee’s share of FICA taxes was barred because the statute of limitations had expired.

2. Laraway.  The facts in Laraway,³¹ decided by a different Tax Court judge than Casety, are very similar to Casety.³² An automobile mechanic whose earnings were reported on Form 1099 by the employer was held by the judge to be an employee based on the common law definition and was not liable for self-employment taxes.  As in Casety, the issue of whether he was liable for the employee’s FICA tax share was not raised in the court hearing because it was outside the Tax Court’s jurisdiction.³³ Also the statute of limitations had passed for sending a tax due notice.

3. Myers.  In Myers,³⁴ the issue was whether the IRS can collect the employee’s share of FICA tax directly from the employee rather than from the employer when the employer had not paid the tax.  Although nothing prevented the IRS from attempting to collect from the employer, e.g., the statute of limitations or another law, the Service instead offset the employee’s share against a tax refund the Myers were expecting.  The judge ruled in favor of the Myers because he could find no authority allowing the IRS to collect FICA tax directly from the employee unless some other statute relieved the employer of liability.  The judge quoted I.R.C. Sec. 3102(a) which establishes employers’ FICA liability to the IRS and says nothing about employee’s liability:  “The [FICA tax] shall be collected by the employer of the taxpayer, by deducting the amount of the tax from the wages as and when paid.”³⁵ He then pointed out, according to Treas. Reg. Sec. 31-6205-1(b)(3), that the employer is liable even if no deduction is made from the employee’s wages.³⁶ I.R.C. Sec. 3102(b) states it succinctly:  “Every employer required so to deduct the [FICA] tax shall be liable for the payment of such tax [to the IRS] ….”

In Myers,³⁷ the IRS contended “that an employee is jointly liable with the employer for FICA taxes not collected from the employer,” relying on Stewart v. United States³⁸ and Rev. Rul. 86-111,³⁹ discussed below.  In each, the employers had misclassified the employees as self-employed and had not deducted FICA tax, yet the employees were required to pay their portion of the FICA tax.  In Stewart,⁴⁰ the judge held that because the employer qualified for release from all FICA tax liability for the misclassified worker under Sec. 530(a)(1) of the Revenue Act of 1978,⁴¹ the employee was liable for his share of the FICA tax.  In such cases where a law such as the above mentioned Sec. 530, or a rule of law such as the statute of limitations,⁴² relieves the employer of the employee’s FICA tax liability, I.R.C. Sec. 6521 allows the IRS to offset the employee’s FICA tax share against a refund sought by the employee for self-employment (SECA) tax erroneously paid.  If the misclassified employee has not paid SECA tax, Sec. 6521 is inapplicable and does not grant the IRS the authority to collect FICA tax directly from the employee.

Rev. Rul. 86-111⁴³ was the second authority relied on by the IRS in Myers.  In the ruling, an employer’s liability for the employee’s FICA tax liability was reduced under I.R.C. Sec. 3509,⁴⁴ and the employee was determined to be fully liable for the employee’s FICA tax share, unreduced by the amount paid by the employer.  The IRS’s ruling did not rely on I.R.C. Sec. 6521 to make the employee liable.  Because I.R.C. Sec. 3509(d)(1)(C) makes I.R.C. Sec. 6521 inapplicable to Sec. 3509, the IRS has no authority for shifting FICA tax liability to the employee in situations where Sec. 3509 reduces the employer’s liability.⁴⁵ Instead, the Service inferred that the employee “remains fully liable for the [employee's share of the FICA] tax,” citing I.R.C. Sec. 3509 (d)(1)(A) which reads, “the employee’s liability for tax shall not be affected by the assessment or collection of the tax so determined [under Sec. 3509].”

There is no basis for the IRS’s inference that a misclassified employee is fully liable for their FICA share either in the passivity of the Code’s wording itself or in the Congressional Committee Reports at the time of enactment in 1982.⁴⁶ I.R.C. Sec. 3509(d)(1)(A) seems to apply to the misclassified employee’s income tax liability rather than the FICA tax liability.  In reclassification cases as explained in the Joint Committee Print,⁴⁷ absent Sec. 3509, the IRS would reduce an employer’s liability for unwithheld income taxes by the amount of income tax the employer could prove had been paid by the misclassified employees.  This was not the case for the employer’s FICA tax liability even if the employee incorrectly had paid SECA tax.  In other words, Congress intended to prevent misclassified employees from claiming a credit for income tax withheld equal to the amount the employer was required to pay under I.R.C. Sec. 3509(a)(1).

Despite the holdings and dicta in Rev. Rul. 86-111⁴⁸ and in Stewart⁴⁹ that the employees are liable to the IRS for their share of the FICA taxes, the judge in Myers limited the holdings’ applicability by emphasizing that they only “indicate that the government can collect FICA taxes from the employee in circumstances in which the government is unable to collect the employee’s FICA taxes from the employer.”⁵⁰ The judge concluded:  “Neither [the ruling nor the case] answers the question whether the government can collect FICA taxes from an employee where the employer is fully liable for payment of such taxes and before any attempt is made to collect the taxes from the employer.”⁵¹

Based on the lack of legal authority supporting the IRS’s collection of FICA taxes from the employee first before attempting to collect from the employer when the employer is fully liable, the judge held that the IRS had to refund the FICA taxes it had held back from the Myers’ refund.  Specifically, the judge took I.R.C. Sec. 3102 as prima-facie evidence that Congress intended employers to collect and pay the employee’s share of FICA taxes in the first place.

4. Myers reconsidered. Subsequently, the IRS moved for reconsideration.  In its brief, the IRS contended that “one set of circumstances in which the government may assess the [employee's share of FICA] taxes directly against the employee is where the government already is in possession of funds belonging to the employee by virtue of an overpayment on other taxes assessed for the same tax year.”⁵² The IRS’s contention was based on the Supreme Court’s holding in Lewis v. Reynolds⁵³ that a taxpayer claiming a refund bears the burden of proving they overpaid their taxes for the particular tax year.  Because the Myers were suing for a refund rather than being sued for payment, the judge agreed with the IRS in light of this newly-introduced precedent, reasoning that the focus of the case changed from the method of FICA tax payment to the “employee’s underlying liability for the FICA taxes.”⁵⁴

Although the judge reversed his prior determination and held in favor of the IRS, he did so on other grounds which do not diminish the reasoning and holding in the original decision.⁵⁵ In the revised opinion, the judge carefully worded the holding so as not to negate any of the reasoning that the IRS must first try to collect from the employer if the employer is fully liable for the employee’s share of FICA taxes.  He wrote, “… the fact that the government already holds taxpayer funds takes the analysis beyond the provisions of payment of the tax and into the realm of ultimate liability for the taxes owed.”⁵⁶

5. Navarro. In Navarro,⁵⁷ the U.S. District Court judge declined to follow Myers⁵⁸ and held that an employee is jointly liable with the employer for FICA taxes not collected from the employer regardless of whether the employer has been released from any of the liability.  Even though the employer had not been released from his liability, the judge concluded that the IRS did not first have to seek payment for the employee’s share from the employer.  As a consequence, the misclassified worker, Navarro, was liable for approximately one-half the self-employment tax, i.e., the FICA amount that would have been withheld from her paychecks had she been treated as an employee in the first place.  The judge allowed the IRS to offset Navarro’s FICA tax liability against the tax refund she had coming from the earned income credit, using reasoning similar to Myers⁵⁹ and citing Lewis v. Reynolds.⁶⁰

The Navarro decision contains four misinterpretations, we believe.  First, the judge supported his joint employer-employer liability holding by citing Rev. Rul. 86-111⁶¹ and various cases,⁶² all of which found misclassified employees liable for their share of FICA taxes because the employers had previously been released from liability.

Second, in deciding whether an employee is directly liable to the IRS for FICA taxes, the judge went beyond the clarity of I.R.C. Secs. 3101 and 3102 in relying on Treas. Reg. Secs. 31.3101-3 and 31.3102-1(c).  Despite the judge’s quote, “… when [a] statute leaves room for two interpretations, Courts must only look to see if [the] agency’s interpretation is reasonable,”⁶³ we believe, consistent with the opinion in Myers,⁶⁴ that the relevant I.R.C. sections are sufficiently clear to spare the need to rely on the Treasury Regulations.  Taken together,  I.R.C. Secs. 3101, 3102(a) and 3102(b), state that the employer is liable for paying FICA taxes whether the employer actually withheld from the employee or not, unless, according to I.R.C. Sec. 6521, another statute such as the statute of limitations relieves the employer of FICA tax liability.⁶⁵ In addition to his misplaced reliance on the Regulations, the judge misconstrued their meaning, as discussed next.

Third, the judge bolstered his holding in Navarro⁶⁶ that the employee is ultimately and directly liable to the IRS for FICA tax by altering the meaning of the language in Treas. Reg. Sec. 31.3102-l(c), inferring the word “him” as meaning “the employer”:  The Regulation reads, “Until collected from him the employee also is liable for the employee tax with respect to all the wages received by him.” (Emphasis added.)  The judge in Myers⁶⁷, however, correctly interpreted the Regulation:

[The IRS] inserts the words “the employer” in this excerpt from the regulation as the antecedent for “him.”  The employee’s liability ends, however, when a deduction is made from his wages for FICA taxes, even if the government does not collect the tax from the employer.  Purdy Co. of Illinois v. United States, 812 F.2d 1183, 1186 (7th Cir. 1987).  Thus the correct interpretation of this provision would appear to be that the employee remains liable for payment of FICA taxes on his wages until the taxes are collected from the employee.  The IRS’s interpretation of this provision as stated in Revenue Ruling 86-111 is in accord.⁶⁸ (Emphasis added.)

In other words, the employee remains liable to the employer until the tax is collected from the employee by the employer.

Based both on the context of Treas. Reg. Sec. 31.3102-1(c) and on Treas. Reg. Sec. 31.6205-1(b)(3) which provides that the FICA tax deduction from wages is “… a matter for settlement between the employee and employer”, we believe that the sentence in Treas. Reg. Sec. 31.3102-1(c) merely reinforces the employer’s right, and not the IRS’s right, to collect FICA taxes from the employee.

Fourth, the judge in Navarro also erroneously interpreted Treas. Reg. Sec. 31.3101-3 to the IRS’s advantage.  The segment of the Regulation quoted in the case discussion reads, “[the] employee tax attaches at the time the wages are received by the employee.”  The judge concluded that this made Navarro liable to the IRS for employee FICA tax “at the moment she received her pay …, regardless of the fact her employer did not withhold the tax.”⁶⁹ We believe that the correct interpretation of the Regulation’s text is consistent with the interpretation of Treas. Reg. Sec. 31.3102-1(c) that the employee becomes liable to the employer, and not to the IRS, at the time the employee’s wages are received.  In support of our interpretation, Treas. Reg. Sec. 31.3101-3 refers to Treas. Reg. Sec. 31.3121(a)(2) which establishes when wages are deemed received from the employer.  Throughout the Regulations, employees’ FICA tax liability is consistently linked to the employer and not to the IRS.

In summary, we believe that the judge in Navarro erred in ruling that the IRS may collect the employee’s share of FICA taxes first from the employee before trying to collect from the employer when the employer is fully liable for the taxes.  The judge’s holding is unfortunate especially considering that misclassified employees typically are less well-paid, less skilled, and less able to assert their legal rights.  In contrast, the employer typically has more economic power and is more knowledgeable than the employee in negotiating terms of employment.  It makes sense that Congress would expect the IRS to collect first from the employer because the employer must bear the responsibility for misclassifying employees as self-employed.  To permit the IRS to collect either from the employer or the employee does not accord well with our sense of equity.⁷⁰ The judge in Navarro seemed more concerned about protecting the Federal Treasury than the pocketbooks of disadvantaged, misclassified workers, as suggested by the following portion of his opinion:  “Moreover, the Court finds that requiring the IRS to first seek payment from employers in every case, even in such cases where the IRS’s efforts would obviously not be productive, would result in the waste of Government assets.”⁷¹

B. Myers should be followed.

The Myers⁷² holding, we believe, is better reasoned than Navarro and should be followed.  In other words, the IRS may not collect the employee’s FICA tax share directly from the employee unless the Service either is prevented from collecting from the employer because the statute of limitations has expired or because another law released the employer from liability.⁷³ This is not to say that the employee is not liable, but merely that the IRS must first seek to collect on the employer’s liability if the employer remains fully liable.  Undoubtedly the misclassified employee with circumstances similar to Myers or Navarro can expect a fight with the IRS if audited, considering the amount of resources the government expended in blocking the Myers’ recovery of $137 in employee FICA taxes.⁷⁴

C. They who hold the tax dollars win.

Regardless of the strength of the misclassified employee’s case for avoiding paying their share of FICA tax, possession of the tax dollars appears to be, as the saying goes, nine-tenths of the law.  Even though the employee only has secondary liability for their FICA tax share if the employer is fully liable, the employee will most likely lose if they have an overpayment outstanding with the IRS, based on the holdings in Myers and Navarro citing the Supreme Court’s decision in Lewis v. Reynolds.⁷⁵ If no overpayment is outstanding, it appears that the employee will stand a reasonable change of winning, based on the well-reasoned holding in Myers⁷⁶ if the employee were able to contest the IRS’s notice of a tax liability in the Tax Court.  Unfortunately the Tax Court has no jurisdiction over FICA taxes.⁷⁷ Hence, the employee will either have to pay the tax due and sue for a refund in a U.S. District Court or the U.S. Claims Court or likely suffer the consequence of an IRS tax lien and subsequent levy.  Because the law implies rather than clearly stating that the IRS must first try to collect the misclassified employee’s share of FICA taxes from the employer before assessing the employee, the employee may be in a Catch 22.  Once the tax is paid, the IRS may succeed in keeping it by invoking Lewis v. Reynolds,⁷⁸which put the burden the taxpayer of proving an overpayment of taxes, as was done in Navarro⁷⁹ and Myers.⁸⁰ Although we believe that the misclassified employee is not liable for the their share of FICA taxes, the best chance of success are simply not to receive a tax due notice for their share or, if sent a deficiency notice for self-employment tax, challenge it by following the procedures for getting into Tax Court as happened with Casety⁸¹ and Laraway⁸² By the time their cases came to trial, it was too late for the IRS to attempt to collect the employee’s share of FICA taxes because the statute of limitations had expired.  This is getting into the area of administrative procedures and strategies, discussed next.

IV. Administrative and Reporting Procedures and Strategies

To redress an incorrect classification, misclassified workers have two objectives:  avoidance of self-employment tax and obtaining full credit for their earnings from the Social Security Administration.

A. Avoidance of Self-Employment Tax

Based on our legal analysis, misclassified workers will be able to avoid all of the self-employment tax and possibly the employee’s half of FICA tax as well.  The misclassified earnings should be reported as wages on Form 1040, line 7, rather than on Schedule C.  Because the employer did not issue a W-2 form, but probably sent a Form 1099-MISC, the worker should attach a sheet to the back of the tax return containing a photocopy of the 1099-MISC form along with an explanation that the wage amount shown on line 7 includes wages that were incorrectly reported as self-employment income on the 1099.⁸³ An arrow should be drawn from the wage amount entered on Form 1040, line 7, to a note advising, “Please see attached explanation.”

Also, because the worker will not have received a W-2 form from the employer, Form 4852, “Employee’s Substitute Wage and Tax Statement,” may be filed with the tax return even if the worker received a 1099-MISC form.  Form 4852 ordinarily is used when a correctly classified employee did not receive or has lost a W-2 form.⁸⁴

To strengthen one’s case that the earnings are in fact wages and not self-employment income, a copy of Form SS-8 titled, “Determination of Employee Work Status for Purposes of Federal Employment Taxes and Income Tax Withholding,” and obtainable from the IRS should be attached to the tax return.  Reference to Form SS-8 should be made on the attachment containing the wage explanation and photocopy of Form 1099-MISC.  Form SS-8, which is the procedural equivalent of Rev. Rul. 87-41⁸⁵ discussed earlier,⁸⁶ requests answers to the twenty factors the IRS uses in determining whether the employer has sufficient direction and control over the worker to identify the worker as an employee rather than an independent contractor.

Despite these precautions, the IRS may automatically issue a deficiency notice for self-employment tax computed on the 1099-MISC income.⁸⁷ In this event the worker should reply with an explanation and attach a copy of Form SS-8, but send no check.

To get a formal determination of whether one has been misclassified, the worker should file a separate copy of Form SS-8 with the IRS District Director.⁸⁸ Within ninety days the IRS District’s Examination Division will contact the employer to clarify the answers on Form SS-8 and will then notify the worker as to the correct employment status.  Although precise data were not available regarding SS-8 reclassifications, Private Letter Rulings often are issued in response to SS-8 request.  In recent years about 90% of these classified the workers as employees.⁸⁹

Sending a separate SS-8 form to the District Director may not be advisable if the worker is concerned about jeopardizing their job when the IRS contacts the employer.⁹⁰ The worker could either wait and file the SS-8 form after leaving the job (but before the three-year statute of limitations has elapsed) or, if their tax return is audited, discuss the situation with the IRS auditor and file it at that time.  Obtaining a formal SS-8 determination of employee status will strengthen one’s case for getting proper credit with Social Security for the income earned as a misclassified worker, as discussed in the next section.

Taking the IRS’s advice as to how to report the misclassified income will be costly.  The IRS Manual Handbook⁹¹ instructs Taxpayer Service Representatives to send the worker a Form SS-8 and to tell the worker in the meantime to either:

a.         Report the income wages on Form 1040 and pay the employee’s portion of FICA tax (using Form 4137, discussed in the next section) if the employee permits the IRS to contact the employer regarding proper classification once Form SS-8 has been filed, or

b.         Report the income as self-employment income on Schedule C and pay the self-employment tax using Schedule SE if the worker is unwilling to have the IRS contact the employer regarding proper classification.

The IRS’s instructions contrast with our advice to pay no self-employment tax and at most pay the employee’s half of the FICA tax.

B. Updating One’s Social Security Earnings Record

Avoiding self-employment tax is “having one’s cake,” but “to eat it too,” a worker must have their Social Security earnings record updated for the misclassified earnings to ensure full Social Security benefits on retirement.  Reclassifying the earnings on Form 1040, line 7, as wages will not automatically result in updating one’s Social Security earnings record.  Social Security accounts are updated automatically in three ways:  direct receipt of employers’ copies of Form W-2, IRS magnetic tapes of all Schedules SE,⁹² and IRS magnetic tapes of all Forms 4137, titled “Social Security … Tax on Unreported Tip Income.”⁹³

Correcting one’s Social Security earnings record has important long-run benefits.  For example, under current law and using today’s dollars, a worker who earns under $30,000 per year and whose earnings record for 1995 is understated by $10,000 will receive about $100 less per year from Social Security if retiring at age 65.  If earnings were understated $10,000 per year for ten years, the annual Social Security benefit would be $1,000 less.

To update one’s account, the misclassified worker should wait at least until mid-year of the year following the year of misclassification to request an “Earnings and Benefit Estimate Statement” from the Social Security Administration.  To do so, the worker should submit the request using Form SSA-7004-SM, obtainable through any Social Security office or by calling 1-800-772-1213.  On reviewing this statement, the worker will find that their earnings have not been credited.  The next step is to contact a local Social Security office to arrange for proper credit for income earned as a misclassified worker.  The local office will require evidence of the earned income such as pay stubs, copies of paychecks, and Forms 1099-MISC, and will use the common law test to determine if the earned income is indeed wage income.  Of course, if the worker has already received a ruling via Form SS-8, the Social Security office will abide by the decision of the IRS.  The key fact is that the Social Security office will update the worker’s earnings record regardless whether FICA tax was paid on the earnings.  As discussed in the legal analysis based on I.R.C. Sec. 3102 and according to the Social Security Administration,⁹⁴ the collection of FICA tax from the employer or the employee is the IRS’s responsibility.

Should misclassified workers prefer to update their Social Security earnings record automatically and avoid any difficulties with the IRS (despite our belief that a more aggressive position may be warranted), they may pay their share of the FICA tax by filing Form 4137, mentioned above, and the attached Schedule U, “U.S. Schedule of Unreported Tip Income,” with their tax return.  Form 4137 is ordinarily used only by employees receiving tips, but the word “tips” should be crossed out and “wages” written in where appropriate on both Form 4137 and the attached Schedule U.⁹⁵ Filing Form 4137 and Schedule U with Form 1040 will automatically update the Social Security earnings record for the worker.

V. Conclusion

Our analysis finds that no court has held employees who have been misclassified as self-employed independent contractors liable for the self-employment tax on their earnings.  Whether misclassified employees are liable for the employee’s share of FICA tax depends on whether they have a tax refund pending.  In Tax Court cases⁹⁶ where the IRS sued to collect self-employment tax from the misclassified employee because no tax refunds were pending, the IRS not only lost but was prevented from raising the issue that the employee was still liable for the employee’s share of the FICA tax because the Tax Court has no jurisdiction over FICA tax disputes.⁹⁷ In Federal District Court cases⁹⁸ where the employee sued the government for a refund of self-employment tax already paid to the IRS, however, the results have been less clear.

The courts are split as to whether the employee is liable for the employee’s FICA tax share if the employer is fully liable as well at the time of trial.  The IRS takes the position that a misclassified worker is liable for the employee portion of the FICA tax (one-half of the self-employment tax) until it is collected from the errant employer.⁹⁹ To date, only two U.S. District Courts have decided cases on the issue.  One held that an employee is not liable unless the IRS has tried to collect from the employer¹⁰⁰ but the other held that the employee is liable for the employee’s FICA share regardless of any action against the employer.¹⁰¹

Despite the split in rationale as to when the employee is liable, both courts, based on a Supreme Court case,¹⁰² allowed the IRS to offset the employee’s share of FICA tax against tax refunds the employees were expecting.  Possession, as the saying goes, appears to be nine-tenths of the law in this situation.  If the employee has no pending refund due from the IRS, the outcome depends on the strategy taken by the IRS.  If the misclassified employee has a tax refund pending, including a refund from mistakenly paying self-employment tax in the first place, the IRS has the common law right to offset the FICA tax against the refund.  If the misclassified employee pays no self-employment tax, the IRS may decide to dispute this position, issue a deficiency notice, and pursue it in Tax Court as they did in the cases mentioned above.  The employee will win on the issue of self-employment tax liability if they indeed have been misclassified, and the IRS will not be able to raise the FICA tax issue.  Furthermore, the statute of limitations will likely have expired by the time of trial, thus preventing the IRS from attempting to collect the employee’s FICA tax share by levy and lien.  If the IRS instead issues the employee a tax due notice for their share of the FICA tax, the employee will be constrained to pay the liability and sue for refund in a U.S. District Court or the U.S. Claims Court.  This may be a Catch 22 because the IRS apparently then has the right as mentioned above to offset the employee’s share of the FICA tax against the refund.

Pending resolution of this question by the courts, we recommend that misclassified employees take an aggressive position and resist paying their half of FICA tax on their misclassified earnings, with two exceptions:  (1) when the employer has statutorily been relieved of some or all FICA tax liability other than by I.R.C. Sec. 3509, and (2) when the employee has an outstanding tax refund (other than from paying their FICA tax share) against which the IRS may offset the employee’s half of FICA tax.  In either of these cases the courts will undoubtedly hold the employee liable for their half of the FICA tax.¹⁰³

In addition to avoiding employment taxes, we recommend that misclassified workers secure reclassification as employees through the IRS by filing form SS-8.¹⁰⁴ Because workers’ Social Security earnings records will not be automatically updated for the misclassified earnings if employment taxes have not been paid, we recommend contacting a local Social Security office to arrange for proper credit.  Failure to do so will, in most cases, result in lower Social Security benefits on retirement.

Also, misclassified employees have recourse against the employer for fringe benefits normally accorded

the employer’s employees such as health insurance.  Moreover, they are eligible for unemployment and workers’

compensation benefits, along with coverage under Federal employment laws such as the Fair Labor Standards

Act and the Age Discrimination in Employment Act.  All states and the Federal Government have review boards

or a related process for assisting potentially disenfranchised, misclassified workers in obtaining their full rights as

employees.

104 See pp. 19-20 supra for a discussion of Form SS-8.