The general rule is that benefit payments received under a qualified long-term care policy are tax-free [IRC §7702B(a)(2)]. However, some qualified policies pay a designated daily benefit regardless of actual costs. For 2007, benefits under such per-diem policies are automatically tax-free up to $260 per day (Rev. Proc. 2006-53). When benefit payments exceed those caps, they are still tax-free if actual costs for qualified long-term care services equal or exceed the payments.
Daily benefit payments are always tax-free if the insured is terminally ill, as defined by IRC §101(g)(4).
When benefits are paid during a year, the insured should receive a Form 1099-LTC reporting the gross amount of the benefit payments. The insured then uses Form 8853 to calculate whether any of the benefits are taxable.