There are two methods for preparing a Federal Form 1041QFT. One method has the trustee applying the QFT tax rate schedule to the preneed trust’s net income. For larger preneed trusts, this method will likely trigger the highest tax rate (37%). The other method is called the composite return, where trust income and expenses are allocated to the individual purchaser accounts. The trust’s tax liability is then computed at the individual purchaser levels (with their respective capital gains and qualified dividend tax rates) and aggregated for purposes of the return. The individual purchaser accounts would have to realize $2,600 of capital gains and qualified dividends before a capital gains tax liability is triggered. For diversified trusts, capital gains and qualified dividends can comprise a substantial percentage of the trust’s gross income. One of the trusts mentioned in our last post reported gross income of about $41,000. 93% of that trust’s income came from long term capital gains and qualified dividends. When using the composite return method, the trust does not have a tax liability. Using the other method, the trust had a tax liability of about $6,600.
We have reviewed returns where the tax administrator grasped the benefits of the composite return but the trustee lacked the administration to make periodic allocations to the individual purchaser accounts. Frequently, the tax administrator will use a spreadsheet to make a year end allocation of income and expenses to the purchaser accounts. While the QFT instructions state that a trust may use any reasonable method for determining the individual purchasers’ interest in trust income and expenses, periodic allocations are generally required. The IRS has taken the position that income and expenses cannot be allocated more than 60 days after a purchaser’s death. This would rule out a year end allocation when contracts have been serviced and paid out of the trust prior to November. At a minimum, composite return allocations should be made at least quarterly.