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

The 2010 calendar year proved a welcomed change for many trust funded preneed programs. The 2008 collapse of the home mortgage market triggered a melt down of bonds that lingered well into 2009. The press provided extensive coverage of how the situation impacted our 401k accounts. Stories about value declines of 25% to 33% were fairly common. But, most preneed trusts suffered a similar experience. Preneed fiduciaries were forced to examine fixed income portfolios for impaired assets, and some mortgage backed securities (long the staple of preneed trusts and endowed care trusts) had to be sold off.

In 2008 and 2009, many preneed trusts experienced capital losses that exceeded realized income. For the preneed trust reporting pursuant to a Federal Form 1041QFT, this black cloud had a silver lining: capital losses could be carried over to future years. With trusts seeing 2010 returns in the high single digits (and some double digit returns), the capital loss carry over provides fiduciaries an opportunity to reduce (or eliminate) the trust’s tax liability in 2010.

The manner in which a fiduciary applies the capital loss carry over (or CLCO) depends on how the 1041QFT was prepared in prior tax years. The QFT return contemplates individual trust accounts with a composite return, but IRS commentary suggests that a significant portion of QFT returns is prepared as a single, unified trust (see our August 9, 2008 post titled “The Section 685 QFT amendment: Supporting Soldiers’ Survivors”). With a composite return, the tax rate rarely exceeds 15%. With the unified trust, the tax rate will generally be 35% (when the trust income as a whole exceeds $11,200).

With the composite return, the CLCO is allocated among the individual accounts, and may be carried over in multiple years. With unified trust, the CLCO will be applied to the entire trust. In either case, the tax savings could be substantial.

Getting the 2010 return right may be more important than ever. As we will report in an upcoming post, the NPS collapse (and perhaps the IFDA/Merrill Lynch debacle) has caught the IRS’ attention. After twenty years of slumber, our tax regulator has reason to take a closer at how preneed is taxed.
 

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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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Many preneed trusts either experienced significant capital losses last year or are sitting on assets that have unrealized losses. For those trusts that have taken a Section 685 election, these losses may be carried into future years as a capital loss carryover. While everyone would prefer to avoid realizing those losses, that loss can be used to offset future trust income. With the proper individual contract accounting, the loss could be extended for a longer period than the aggregate reporting followed by many trustees. For an explanation of Section 685 and the differences between aggregate reporting and composite reporting see our August 9, 2008 post titled “The Section 685 QFT amendment: Supporting Soldiers’ Survivors”.

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If the President signs the Hubbard Act (H.R. 6580), the qualified funeral trust will have the capability to fund all of an individual’s final expenses. When enacted, Section 685 imposed a $7,000 cap on the preneed trusts that could elect special tax treatment. While the limitation increased annually, the cap was too low to permit funding of funeral and cemetery contracts. The cap also precluded cash advance related expenses from being included in many preneed contracts. The Hubbard Act may open the door to allow the Qualified Funeral Trust to become more of a final expense trust. 

The Hubbard Act would amend Section 685 for the 2009 tax year. We will need to wait for IRS guidance regarding any retroactive application of the amendment. However, the Hubbard Act would not impact the requirement that the trust must make a payout within 60 days of the beneficiary’s death.

It is interesting to note from the Congressional record that most trustees probably prepare the 1041 QFT without individual sub accounting. With regard to the Hubbard Act, the Congressional Budget Office reports that the Joint Committee on Taxation (the JCT) estimates the elimination of the QFT limitation will increase tax revenues $6 million over the next 9 years. This estimate is based on the assumption that trusts will produce more income that will be taxed at the higher rates. 

A 1041 QFT will be taxed at the lowest rate (15%) until its income exceeds $2,150. The next tax rate (25%) applies until the trust income exceeds $5,000. Assume the QFT maximum for 2008 ($9,000), and the trust has to have a return of nearly 24% before the second lowest tax rate is reached. If one were to assume the 1041 QFT has a trust of $25,000, the trust has to have a return of 8.6% (net of trustee fees).   Obviously, the JCT are looking at numbers that indicate that trustees are preparing the QFT without individual sub accounting. OUCH!

Assume a $3,000,000 preneed trust with 500 preneed contracts earns net income of 5%, or $150,000. With individual sub accounting, that trust’s 1041 QFT should have an approximate tax liability of $22,500. Without individual sub accounting, that same 1041 QFT will have an approximate tax liability of $51,543.50.   Even with the elimination of the Section 685 cap, the tax liability of the QFT with individual sub accounting will likely be taxed at 15%.   The difference equates to nearly 1% of the trust, or a good argument for better individual sub accounting.

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The National Funeral Directors Association has taken the lead in getting legislation introduced to eliminate the dollar cap imposed on qualified funeral trusts.  While I hope the NFDA succeeds, it won't be without a fight from the IRS. 

As the death care industry inches towards the non-guaranteed preneed transaction, the IRS will express its concerns over abusive trusts.  While funeral directors ponder whether consumers will embrace a preneed transaction that does not provide price guarantees, the IRS will question whether the transaction will be abused as a tax shelter. 

The Section 685 needs to be increased substantially, but I anticipate the Service will pull no punches while fighting the NFDA's efforts.   

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