In has been almost twenty years since the Balanced Budget Act of 1995 introduced the concept of a simplified tax return for preneed trusts. Initially, the “Qualified Funeral Trust” concept called for a flat 15% tax on accounts with contributions of $5,000 or less. A conference committee succeeded in getting a higher contribution limitation ($7,000) but the Balanced Budget Act was eventually vetoed by President Clinton. The 1995 proposal was resubmitted to Congress, and passed, as free standing bill in 1997. However, the first Form 1041QFT was anything but a simple return with a flat tax.
Instead of a flat tax, the Form 1041QFT included the graduated tax rates imposed on other types of trusts. The initial tier of trust net income was taxed at 15%, but a preneed trust would quickly climb to the top tier of 39.6%. As with other trusts, the Form 1041QFT incorporated Schedule D for the reporting of capital gains. As an alternative to the simple return (and its higher tax liability), the Form 1041QFT allowed a composite return where tax liability was computed on an individual account basis. When income and expenses were allocated to individual accounts, the size of each such account assured that the lowest tax rate of 15% would be applied.
The Form 1041QFT hasn’t changed much since 1997 except that the Tax Rate Schedule has crept up. In 1997, when certificates of deposits were paying 5.5%, a modest preneed trust of $250,000 could expect to hit the highest tax rate of 39.6% if it filed a return as the industry had envisioned. For a trust of $500,000 that had a net return of 4.5%, the trust’s tax liability doubled when a simple return was used in lieu of the composite return.
The IRS hasn’t provided much guidance regarding the Qualified Funeral Trust other than that cemetery merchandise trusts are subject to Section 685 (Notice 98-6) and income and expense allocations to an individual account must cease within 60 days of the preneed beneficiary’s death (Notice 98-66). To comply with latter notice, many tax administrators use a spreadsheet to allocate income and expenses among the year end active accounts. So long as the trust was invested primarily in fixed income producing assets, there was no need to address the Schedule D requirements. Also implicit in this simplified allocation of income and expenses is that all accounts are guaranteed contracts where the seller ultimately pays the taxes. Serviced contracts have been excluded from income and expense allocations leaving active contract accounts to bear their tax liability.
As we suggested four years ago, trends towards non-guaranteed preneed and diversified investments will complicate the allocations required for Section 685 compliance. (See our prior post: Non-guaranteed preneed: time to review the duties .) QFT return preparers will need more than an Excel spreadsheet to properly allocate income and expenses.