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

For the past few years, some Kansas cemeteries have been getting nasty grams from their regulator about their care fund trustee’s treatment capital gains taxes. Kansas, like most states, requires a portion of each grave space sale (interment right) to be contributed to a fund or trust for the future care of the cemetery. Kansas law calls that fund a permanent maintenance fund. Missouri law calls it an endowed care trust. In some states it is defined as a perpetual care trust.

Despite what the fund is called, these state laws universally seek to provide the cemetery a source of income to pay for the upkeep of graves (while keeping the contributions in tact). That latter objective, protecting the contributions, brings cemeteries and regulators into conflict when the fund realizes capital gains and losses. The Kansas cemetery regulator has been taking the conflict a step further by interpreting the law to preclude the trustee from paying taxes or fees out of capital gains.

The Kansas regulators (like many of their peers) perceive a ‘looming’ problem with cemeteries: abandonment and the eventual transfer to the municipality or county. Cemeteries are dependent upon the cash flow that comes from space sales (and the accompanying interment fees and marker sales). When a cemetery runs out of spaces, grave maintenance will be completely dependent upon income from the care fund. To minimize the financial burden placed on the county, the Kansas regulator has adopted a very strict interpretation of the law for the purpose of preserving the care fund for the day the cemetery transfers to the government. This interpretation not only precludes the fund from distribution capital gains earnings, but also the trustee’s payment of taxes and fees from the earnings. The regulator reasons that capital gains must be allocated to principal, and the law forbids all distribution of principal.

This puts the cemetery into a bind. The staple of care fund investments, the fixed income security, has been bearing returns of less than 2% for years. When trust expenses are netted from those returns, there is little left to distribute to the cemetery. Necessity has dictated that these funds begin investing in equities. But, the Kansas philosophy would penalize the cemetery. Not only is the cemetery prohibited from using the equity earnings, the cemetery must also pay the taxes incurred on those earnings (reducing what is received from the care fund). The only ‘winner’ is the county. Or is it? If the eventual abandonment takes years, and the cemetery has been deprived income for upkeep and repairs, isn’t the county getting the property in worse shape?
 

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When news of the indictment of 6 National Prearranged Service officers was reported last November, many newspapers picked up the AP version that included a quote from the Internal Revenue Service criminal investigator. The fact is that the Federal investigation of NPS involves investigators from the IRS, the FBI and the U.S. Postal Inspection Service. An FBI press release regarding the NPS indictments includes comments from investigators with the three Federal agencies. To understand how NPS’ actions triggered the jurisdiction of the three agencies, a 2009 FBI press release concerning the indictment of Randall Sutton provides an explanation of the underlying facts.

The main thrust of the IRS investigation will be to determine whether the NPS officers committed income tax evasion with regard to what they individually received, or with regard to what the company received. The investigation will need to determine how the distributions from insurance, and from trusts, should have been reported by NPS. The investigation will also need to examine how NPS’ sister corporation, Lincoln Memorial Life, reported its income. And, the investigation will look at how the preneed trusts controlled by NPS reported their income.

Shortly after the Federal investigation of NPS was initiated, the Springfield Journal-Register reported that a Federal investigation of the Illinois Funeral Directors Association master trust had been initiated. As with NPS, Federal investigators will look closely at whether the reports mailed to funeral homes, and the statements mailed to consumers, were fraudulent, and thereby, violated mail fraud statutes. However, another line of investigation will be whether the master trust violated the Federal tax code.

What does the IRS’ role in these investigations mean to funeral homes and consumers? If these entities failed to accurately report income, the IRS (and state authorities) will view the unreported income as lost revenue to government. Preneed trust income must either be reported to the consumer or taxed by the trust. NPS trusts may have had annual tax liabilities in the tens of millions of dollars. No small potatoes considering the plight state coffers currently face.

Consequently, consumers and funeral homes may see taxing authorities become more aggressive in the enforcement of preneed income reporting requirements. With fewer agents due to budget constraints, the IRS may begin promoting its whistleblower program. If the situation reported this past weekend is an indicator of the future, non-compliant preneed companies may have more to fear from the disgruntled employee than being selected for a random audit by the IRS or state department of revenue.
 

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The financial fallout from the failures of NPS and IFDA regarding compliance with state and federal laws has accelerated the decision of many funeral directors to switch to the non-guaranteed preneed contract. That non-guaranteed contract represents a fundamental change in the relationship that is established between the consumer, the funeral home and the preneed fiduciary.

The trust-funded preneed contract establishes a fiduciary account that has two beneficiaries: the funeral home and the consumer. It is quite common for fiduciaries to administer trusts with beneficiaries with competing interests. With competing beneficiary interests, the fiduciary must look to the trust provisions, and applicable state law, to determine who may exercise discretionary authorities regarding the trust.

State preneed laws are written in response to existing practices, and historically, the guaranteed contract defined preneed practices. When the funeral home sells a guaranteed contract it is the funeral home that assumes the risk of the trust’s investment performance. With that risk, preneed statutes typically vest in the funeral home the authority to establish the trust, to hire and replace the fiduciary, and to participate in decisions such as investments. State preneed laws have generally been vague or silent about administrative and accounting issues, and fiduciaries have turned to the funeral home for instructions regarding accounting and income reporting.

With the non-guaranteed contract, the funeral home has both deferred the sale of the funeral (until death) and transferred the risk of investment performance to the consumer. Appropriately, the consumer may have questions to put to the funeral home, the fiduciary and the preneed regulator:

• Must the fiduciary follow a different investment policy with regard to funds held for guaranteed contracts versus non-guaranteed contracts?
• How is trust asset value allocated to the contracts?
• How is income and expenses allocated among the types of contracts?
• How will income and expenses be reported?

For many funeral homes, the latter issue (the reporting of trust income) drove both investment policies and accounting procedures. No one likes to get a tax statement on a preneed contract, and so many funeral homes went to tax exempt bonds in belief this relieved the trust from reporting income to the consumer. But, the IRS requires tax-exempt income to be reported because it impacts the taxability of social security benefits. If the consumer hasn’t received an accurate statement of income and expenses, his account has exposure for a $50 penalty if the trust isn’t being reported pursuant to a Form 1041QFT. (This accuracy reporting penalty more than likely led the IFDA corporate fiduciary to effect a Section 685 election for all master trust accounts.)
 

For the upcoming wave of non-guaranteed contracts, there are only two permissible methods of reporting income: grantor statements to the consumer or a Section 1041qft. Regardless of which income reporting method is used, the funeral home and fiduciary can not simply park the consumer’s funds in a tax-exempt fund. The preneed trust’s allocation of income and expenses for tax reporting will be similar for both approaches, thus making the trust’s tax return a tool for regulators when evaluating the fiduciary’s administration and accounting.
 

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