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.