Over the past few years, preneed trust administrators have been wondering whether a Section 685 qualified funeral trust could look to each individual trust’s income and apply the lower tax rates for long term capital gains and qualified dividends.  The issue has taken on more relevance as preneed trusts look to diversify out of fixed income securities.  For trustees that have the administration required for periodic allocations of income by character, the effective tax rate of the QFT would drop significantly as trust returns shift from interest income to dividend and capital gains income.  But, the Form 1041QFT is a short document that provides no guidance on whether the 15% tax rate is the lowest possible rate.  Consequently, I was pleasantly surprised with the IRS’ recent publication of the new Medicare tax regulation.   

The Medicare tax is intended to fund ObamaCare by imposing a 3.8% tax on individuals that are in the higher tax brackets. Everyone was a little surprised when the initial IRS proposal would apply the tax to many types of trusts, including preneed trusts and cemetery care trusts.  Representatives from both the funeral industry and the cemetery industry submitted comments to the IRS.  This author expected the IRS to exclude both types of trusts from Medicare tax because neither pays income to individuals.  The final regulation was published in December, and the IRS took the expected position towards cemetery care funds.  The IRS acknowledged that while care fund contributions are made by individuals when purchasing grave spaces, these trusts should be excluded from the tax on the rationale that the cemetery corporation is the beneficiary of the trust income. 

Qualified Funeral Trusts are trusts where the trustees have taken the IRC Section 685 election to have income taxed to the trust rather than to the individual purchasers.  Unless the Section 685 election is made, Revenue Ruling 87-127 would require the trustee to report income to individual consumers.  Since QFTs do not report income to consumers, we expected the IRS to exclude the QFT from the Medicare tax, and to provide guidelines for Pre-88 trusts that report income to funeral homes and any Post-88 trust that report income to consumers.  Instead, the IRS ignored Pre-88 trusts and Post-88 trusts, and applied the tax to QFTs

In applying the Medicare tax to QFTs, the IRS advises that each purchaser’s trust income will determine whether the Medicare tax has to be paid.  For the 2013 tax year, a trust would have to realize taxable income of $11,950 before triggering the Medicare tax.  If a QFT is prepared on a composite basis (where income is allocated monthly by character, and computed by individual purchaser trust accounts), it is inconceivable that any preneed contract should ever incur the Medicare tax.  We assume that composite QFT returns have become the industry norm, but the IRS has previously published comments that suggest a substantial number of QFTs are prepared on the gross basis.  For each such QFT, the Medicare tax will take a significant bite out of the trust.

For the composite QFT preparers, this IRS position follows the same approach that preneed administrators have sought with regard to capital gains and qualified dividends.  Even though income will not be reported to the preneed purchaser, the individual trust’s income should determine whether capital gains and qualified dividends are taxable to the trust.  The logic may be difficult to follow but we welcome that approach.