Death Care Law Blog : Kansas Death Care and Preneed Lawyer & Attorney : Stalter Legal Services Law Firm : Funeral Law, Elder Law : Kansas City

The Mississippi Secretary of State seems to be taking a very proactive approach to the regulation of preneed and perpetual care funds. Over the course of the last few years, the Regulation and Enforcement Division of the Secretary of State’s office has averaged an enforcement proceeding per month. We were curious what type of enforcement proceedings they were pursuing, and picked one at random. The luck of draw involved a situation where the Mississippi regulators alleged the preneed seller’s preneed contract form did not adequately disclose to the consumer the tax consequences of their preneed trust. While the preneed contract form stated that income taxes may be withheld by the trust, the seller’s trustee reported the income to the contract purchaser. This did not set well with the Mississippi regulators, particularly when the consumer had no right to cancel the contract and receive a refund of the trust income.

The Mississippi regulators are not alone in their perception of the inequities of this situation. Nebraska preneed regulators are also questioning why income should ever be reported to consumers when they may never receive it. The answer is that the Internal Revenue Service forced this issue with Rev. Rul. 87-127, with the goal of requiring a single method of income reporting for preneed trusts.

The Service struggled with the situation that troubles the Mississippi and Nebraska regulators: how can the purchaser be the grantor if he/she is never entitled to a refund of the income (or even trust deposits) upon the contract’s cancellation. But, as between the consumer and the funeral home, the funeral home’s right to the trust corpus is dependent upon performance of the contract. While the consumer may never receive a refund, he/she can choose a different funeral home to service the contract. The value of that service satisfies the grantor rules of the tax code, and supports the IRS’ conclusions in the Ruling.

The inequity of the situation may have led to the passage of IRC Section 685. Given an alternative is available to the seller, the Mississippi regulators sought to force the seller to either change its contract or require the trustee to change its income reporting. But in doing so, the Mississippi regulators misstate IRC Section 685. Irrevocability is not a key characteristic of an IRC Section 685 qualified funeral trust. While the Section 685 election is viewed as irrevocable, the irrevocability of the preneed contract has no impact on Section 685. The Mississippi regulators also fail to acknowledge that Section 685 is the trustee’s election to make, not the funeral home’s. While the two need to work in concert, it is the trustee that has ultimate control over the trust’s income reporting.
 

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As new allegations surface about the Merrill Lynch broker associated with the IFDA master trust, some may appropriately ask why a preneed trust would ever invest in an insurance product. There was a time when the twain shall never meet. That all changed in January 1988, and specifically when the IRS and Treasury decided to apply Rev. Rul. 87-127 retroactively to states ‘that should have known’ the funeral home/grantor method of income reporting was inappropriate.

Prior to the ruling, preneed trustees were taking different approaches to reporting the income earned by the trust. With regard to states such as California and Illinois, the trust was required to accrue income and the Service believed trusts from those states lacked authority for electing the grantor method with the preneed seller as grantor.

Consequently, the Service leveled the boom by serving notice that the ruling would be applied retroactively in certain states. This posed a genuine problem for existing trusts because most lacked the requisite consumer information to report income in compliance with the ruling. Thus started a mad scramble to find an alternative to income reporting, and thus began the exodus to insurance.

Today, preneed trustees can avoid the burden of Rev. Rul. 87-127 by electing taxation pursuant to IRC Section 685. While a few legitimate reasons for preneed trusts to hold an insurance product remain, the insurance transaction merits close scrutiny, particularly when a conversion of existing assets to insurance is involved (NPS and its Missouri trusts).

The preneed trustee should ask certain fundamental questions of those who seek to have the trust invest in insurance:

· How will this product be taxed upon maturity?
· Does this product provide the requisite liquidity to fund cancellations?
· Is a commission paid, and to whom?
· How strong is the policy’s issuer?
 

To the extent a life insurance policy is utilized, the decision invariably becomes an irrevocable election. The policy’s cash value generally precludes getting back out.

Generally, annuities provide a more flexible alternative to life insurance, but pitfalls still exist. In recent years, funeral directors have received solicitations to have their preneed trusts invest in a group, variable annuity product. Trustees still need to ask these fundamental questions, particularly when an investment broker is advising the funeral director.

With regard to the taxation of the insurance product, few seem to realize that the trust is dependent upon Rev. Rul. 87-127 for the desired tax consequence.

For those interested in the history of Rev. Rul. 87-127, and its alternative reporting method (Section 685), Professor Joel Newman provided a fair and accurate account in 80 Tax Notes 711.

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