A few weeks ago, we discussed the need to offer to consumers new preneed funding options, and outlined the various administrative hurdles faced by funeral homes that rely upon trust funding. (Preneed Trust Options: Administrative Limitations) With this post, we will examine how the non-guaranteed option impacts tax allocations and makes spreadsheet administration impractical.

In response to the need for funding options, an increasing number of funeral homes are exploring a combination of non-guaranteed contracts and guaranteed contracts that include a surcharge for price protections.  The non-guaranteed contract is necessary for the consumer that could not afford a preneed contract even before the surcharge was added.  The non-guaranteed option gives the consumer with limited finances the ability to establish a fund that may someday be converted to a guaranteed arrangement.  However, until that day, the fund will more closely resemble a savings plan (search this blog for “MyPA”).  Once the MyPA is included in the preneed program, both the funeral home and the trustee must give consideration to how income and expenses are allocated to individual trust accounts.

In our post, Qualified Funeral Trusts – once a simple concept, we discuss how investment diversifications have made tax allocations and the preparation of the Form 1041QFT more difficult.  To simplify the allocations of income and expenses, tax administrators often base allocations on the year end balances of individual accounts.   That allocation approach does not comply with Notice 98-66, where the IRS provided the industry a quarterly allocation method that avoided the burdens of monthly allocations.  While the IRS has had little reason to challenge the trust’s tax return when it was invested in fixed income securities, that approach becomes suspect when non-guaranteed contracts are added to the preneed trust.   With the non-guaranteed contract, the consumer bears both investment risk and the trust’s tax consequences.

When yearend account balances are used for tax allocations, a consumer purchasing a non-guaranteed contract on December 30th would be allocated income and expense as though he/she had been in the trust since January 1st, the same as the consumer that actually purchased a non-guaranteed contract on January 1st.   State regulators will ask how two contracts purchased almost a year apart have the same income.  Most trusts will be dominated by guaranteed contracts, which mean that the majority of serviced accounts will also be guaranteed.  If those contracts are omitted by the tax administrator, the active non-guaranteed accounts will bear a portion of the tax liability of the serviced accounts.

If a funeral home is considering whether to offer both term guaranteed contracts and non-guaranteed contracts, periodic allocations of income and expenses could eventually become a requirement.   Tax preparers and funeral homes will have to go beyond the current practice of making allocations based on year end account balances.