The Illinois Department of Revenue made a revision to Schedule M of the 2014 IL-1041 form that may go unnoticed by many trust tax preparers.  The change is meant to clarify that preneed accounts established pursuant to the Illinois Funeral or Burial Funds Act may take an adjustment that will eliminate the preneed trust’s state tax liability.

Approximately a year ago, this author reviewed the tax returns prepared by one of the country’s largest tax prep firms and noted that income taxes were being paid on all accounts.   I provided that firm a copy of 2000 Practitioners’ Questions and Answers to suggest that the client trusts were overpaying taxes to the State of Illinois.  The tax prep firm did not feel the Q&A was sufficient to change its procedures.  The Q&A indicated that 86 Ill. Adm. Code Section 100.2470 would be amended to include the rule set out by the Q&A, but that action was never taken.  Consequently, the tax prep firm took the position that Illinois income taxes had to be paid on all QFT accounts.

What the tax prep firm failed to understand was that Section 100.2470 had been amended to exempt income earned by preneed trusts established under the Illinois Pre-Need Cemetery Sales Act.   For purposes of the Federal Form 1041qft, all preneed trusts are taxed the same regardless of which state preneed law has jurisdiction.  Accordingly, this author framed the issues in a request to the IDOR.  In a somewhat cryptic response, the IDOR issued a General Information Letter that agrees the two types of accounts are to be taxed in the same manner by the State of Illinois.  The General Information Letter failed to explain how the Il-1041 should be prepared, and in subsequent telephone conversations a procedure was agreed upon until Schedule M could be amended.   That procedure included a disclosure to the IDOR explaining why the Federal Form 1041QFT would differ from that to be attached to the Il-1041.

The end result should be that a Qualified Funeral Trust has no tax liability to the State of Illinois.  Most preneed trust have probably paid income taxes to the state because the IDOR’s General Information Letter points out that trustees can only go back three years to file for refunds when returns are amended.

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.

Since the onset of Covid, the death care industry has experienced an uptick in preneed sales.  As witnessed recently on the Bankrate website, the financial planning industry has taken notice.  Bankrate is a website that provides comparisons of various financial products, and recently posted an article titled “The pros and cons of funeral trusts”.  The article opens with a reference to the IRS code section defining a qualified funeral trust and discusses the advantages of a trust for final expenses.  Noting the risks of the conventional preneed contract, the article recommends a do it yourself approach to setting up a funeral trust.  We have long been a proponent of the financial industry offering a trust based product for final expense purposes.  This would be a preneed alternative that many small death care operators would welcome.   What mom and pop funeral home wouldn’t like to avoid the hassle of filing annual reports and monitoring state law compliance?  A final expense trust product could also be attractive to churches and hospices.  But the Bankrate article fails to grasp certain complexities of the preneed transaction that doom the DIY funeral trust.

Costs are the first hurdle to establishing a DIY funeral trust.  As the Bankrate article suggests, we agree that an independent trustee is needed.  Back in 2013 we explored the costs of individual funeral trusts.  We found a few boutique trust companies that offered up such types of trusts, but all charged minimum set up fees and/or minimum annual fees.   While most financial planners have trust templates for standard estate planning purposes, the funeral trust is a different animal.  As the Bankrate article hints at, an individual may have to seek the assistance of an attorney.  That means the trust instrument may cost several hundred dollars.  Between the trustee and a drafting attorney, the DIY funeral trust could cost more than $500 to set up.

The Bankrate article glosses over the challenge of investing a small trust account.  We addressed this same issue when posting in response to a 2018 New York Times article about funeral planning.  Like so many funeral home preneed trusts, fees will eat up small investment funds.  To be economically viable, financial institutions must embrace the funeral trust concept and offer it as one of their products.  As with the funeral master trusts we have written numerous times, the independent funeral trust will need economies of scale and diversification.

While the Bankrate article gave lip service to IRC Section 685, the DIY funeral trust can never satisfy the qualified funeral trust requirements.  Section 685 provides the death care fiduciary substantial tax reporting advantages that are key to administrative efficiencies.  The following hyperlink displays some of our posts on Section 685.  The DIY funeral trust is in essence a grantor trust under the tax code.

The Bankrate article includes comments from a financial advisor who acknowledges her industry is not geared to providing final expense products.  She suggests that accordingly, financial planners tend to build funeral expenses in as part of the overall estate plan (rather than set up a specific trust).  We saw similar advice in article a few years ago and posted about frequent estate planning mistakes and the need for a final expense trust (When a Will will be too late.)

The DIY funeral trust may seem a safer alternative to the cons of the conventional preneed trust: the lack of portability, poor refund rights, and vulnerability to fraud.  An independent funeral trust program could provide individuals the means to preplan and prepay their funeral and burials without being obligated or committed to a particular funeral home or cemetery.  But such a program would have to provide consumers the documents, fiduciary and legal services and expertise to carry out their funeral and burial decisions. This is too much to ask of a DIY funeral trust.

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.

They say that the devil is in the details, and that is proving true for the Obama definition of the “rich” (those families that earn more than $250,000) and the plan to fix the budget. The IRS provided some detail to the Obama plan last December when it published a proposed regulation that would increase the Medicare tax to 3.8% and impose the tax on the rich through their trusts and estates. The NFDA and ICCFA have been trying to get their respective members’ attention because the proposed regulation specifically includes their business trusts as ‘rich’ that are be subject to the Medicare tax. 

Sometimes it may seem that associations cry wolf to reinforce to the membership the need for the association. But, the proposed IRS regulation is somewhat unique in that it specifically identifies Section 685 qualified funeral trusts and Section 642 endowed care trusts as those which will be subject to the Medicare Tax. As both associations point out in comments submitted to the IRS, the proposal reflects how little the Service understands the purposes of these trusts.

To see each association’s comments click the following hyperlinks:NFDA           ICCFA 

There is a legitimate risk to qualified funeral trusts that do not make individual account allocations for composite filings. We would have thought most fiduciaries prepared QFTs in such a manner, but the Service’s comments from a few years ago suggests otherwise. And, what about those preneed trusts that have not taken the Section 685 election?

Even though the Service’s rationale for application of tax to Section 642 endowed care trusts is tenuous, these trusts lack the individual accounting ‘out’ that can save the QFT.

Both the Memorial Business Journal and the Funeral Service Insider commented last week on the Milwaukee Journal Sentinel’s February 7th article regarding the former executive director of the Wisconsin Funeral Directors Association. Several issues were raised that should be included in future industry debate, and in particular, I would agree with Mr. Isard’s questions whether association executives are qualified to manage a master trust. But the following comments beg an immediate response:

“The whole situation with [the] Wisconsin Preneed Trust went off the rails when the goal shifted from trusting funds to investing funds.”

“The assumption that these trust funds are in the investment business is a mistake. We’re not. We’re in the trust business. From my view, that is a presumption of a preservation of principle. With a trust, you have an obligation to be prudent.”

Those comments suggest that trusting funds and investing funds are somehow mutually exclusive. While the comments may reflect the views of much of the death care industry, they also reflect a failure to understand the fiduciary’s duties. When entrusted with the money of another, the fiduciary has a duty to invest those funds consistent with the purposes of the trust and the interests of the trust beneficiaries. The fiduciary’s investment duties are governed by other laws, and a majority of our states have adopted the Prudent Investor Act. Wikipedia provides the following explanation of that Act:

In enacting the Uniform Prudent Investor Act, states should have repealed legal list statutes, which specified permissible investments types. (However, guardianship and conservatorship accounts generally remain limited by specific state law.) In those states which adopted part or all of the Uniform Prudent Investor Act, investments must be chosen based on their suitability for each account’s beneficiaries or, as appropriate, the customer. Although specific criteria for determining "suitability" does not exist, it is generally acknowledged, that the following items should be considered as they pertain to account beneficiaries:

• financial situation;
• current investment portfolio;
• need for income;
• tax status and bracket;
• investment objective; and
• risk tolerance.

The majority of preneed trusts involve a single seller/provider and guaranteed preneed contracts. Under such circumstances, the funeral home operator has assumed the investment risk when the preneed contract is performed as written. Fiduciaries (and fund managers) have viewed the operator as the account beneficiary for purposes of the Prudent Investor Act. But depending upon state law, and whether the contract is ‘re-written’ at the time of death, the preneed purchaser may bear the investment risk. Accordingly, the fiduciary and fund manager should not completely ignore the preneed purchaser as the account beneficiary for purposes of the Prudent Investor Act.

Neither fiduciaries nor fund managers want to bring the preneed purchaser into the Prudent Investor equation for obvious reasons. But are suitability of investments for two that dissimilar? We would suggest not if the objective is to have investment performance track the prearrangement’s purchase price increases. As we noted in a March 2010 post about the IFDA master trust, the purchaser of a non-guaranteed contract was unhappy because the return on her non-guaranteed contract (1.7%) did not keep pace with the price increases of her planned funeral (4.2%).

Determining who to include as an account beneficiary in the Prudent Investor equation only gets more complicated when the preneed trust is an association master trust with dozens, or hundreds, of funeral home operators. If the master trust includes a healthy percentage of non-guaranteed contracts, the number of account beneficiaries could swell to the thousands. If the association is not the preneed seller (as is the case in Missouri, but not Illinois), what interest does the association have in the trust so as to justify being considered an account beneficiary? There are arguments in support of the association being such a beneficiary, but can those interests ever outweigh the funeral operator and the non-guaranteed contract purchaser?

One could argue that the Wisconsin Master Trust was never fully on the rails. The Association determined early on that a depository account could not keep up with rising funeral costs. Rather than seek legislation that would clarify the trust’s investment authority, the Association leadership sought regulatory permission to allow the master trust to embark on the path of investment diversification. The program derailed only after the executive director enmeshed his personal objectives with those of the association and then conspired with the fund managers to treat the association as the master trust’s primary account beneficiary.

Tax Code Section 685 has now been law for 21 years, and this marks our 20th year of preparing the Qualified Funeral Trust return.  (And more specifically, the composite QFT return)  The QFT return was meant to simplify income reporting for a trust that has hundreds, or even thousands, of contract beneficiaries.  Yet, we continue to be surprised to find so many fiduciaries who do not understand the income reporting requirements for these accounts.   During the past year we were engaged by two trustees to review their preneed trust returns.  With each, we found that the administrator had prepared complex 1041 returns that resulted in Federal and state tax liabilities in excess of ten thousand dollars.   A quick Google research should have alerted the administrators that a complex 1041 return cannot be used for a preneed trust.  Preneed trustees have two income reporting options: reporting income to the contract beneficiaries or filing a Fed. Form 1041QFT.  There are two ways to prepare a 1041QFT, and even a standard 1041QFT would have saved the trust thousands of dollars.  If the fiduciary has the requisite individual account administration, a composite 1041QFT can further reduce the trusts’ tax liabilities substantially.  Because these two trusts had diversified investments with substantial qualified dividends and long term capital gains, their tax liabilities were less than $1,000 each.

During the past year, we have also reviewed 1041qft returns that reflect confusion about the requirements of composite return.  We will address some of those issues in our next post.

Our recent post on similarities of the MyRA and non-guaranteed preneed concluded with references to how criticisms of President Obama’s new retirement account were applicable to preneed.  One such criticism relates to the lack of investment performance, but we will save that issue for a future date.  For this post we want to address the costs associated with implementing and maintaining the MyRA.

Bloomberg News noted in an article that fewer employers maintain a pension plan or 401(k) plan due to their costs.  The report included a quote indicating that research has shown middle and moderate income workers are likely to save for retirement when they can do so with a payroll deduction, and are unlikely to do so when they don’t have that option.   The report goes on to note that even though the MyRA would help avoid most administrative costs associated with formal retirement plans, small business groups have opposed basic savings plans because of costs associated with payroll deduction requirements.  If forced to provide payroll deductions for a voluntary retirement program, employers are fearful the accompanying costs will be wasted when employees do not follow through.

Trust funded preneed programs have many of the same administrative costs of a 401(k) plan.  Plan administrators must track individual purchaser accounts and make periodic allocations of income, expense and value.  With the guaranteed contract, preneed sellers have assumed the risks and rewards of investment performance.  Under many states’ preneed laws, the seller also controls income earned by the trust.  Consequently, the seller has been expected to bear excess costs associated with the trust funded preneed program.  While each preneed trust is a common trust fund for purposes of 12 CFR Part 9, Federal policies have been ‘modified’ to reflect the economic realities of the guaranteed contract. In states where trust income can be distributed prior to performance, the IRS and the OCC have been flexible regarding income, expense and value allocations.  In states where income is required to be accrued, trustees can also take comfort in the seller approving allocation procedures.

But when the price guarantee is eliminated from the preneed contract, the purchaser becomes the primary beneficiary of the arrangement, and assumes the risk and reward of investment performance.  There are fewer (if any) penalties to canceling the arrangement or transferring the funds to different funeral homes.  The purchaser can defer payments when emergencies arise, or make payments whenever convenient.  The arrangement has the portability features that consumers and regulators seek.  And, it comes with the tax benefits of the Qualified Funeral Trust (no messy 1099’s or Grantor statements).  The non-guaranteed preneed contract could be called the purchaser’s “MyPreneedAccount”.

But, the funeral home offering MyPA to consumers cannot collect a purchaser’s payments and hand them over to the Federal government for investment and administration.  Instead, preneed administrations arguably have greater administration duties than with the guaranteed contract.  Instead of a single seller, the trust now has multiple income beneficiaries.  The premise for Federal agencies granting administrative flexibility has changed.   And there is the new ‘voluntary’ nature of the MyPA.  Like the MyRA account holder, the non-guaranteed contract purchaser has less incentive to make payments on the preneed contract.  How should the account’s expenses be paid if purchaser has found payments inconvenient after only paying $25?

We are of the mind that non-guaranteed preneed will be beneficial to consumers that need flexibility in preparing for final expenses, and who want to retain greater controls over the account.  But, those benefits and rights come at a cost.  Locally, state regulators have given early indications that they expect the seller to continue to foot the expense of the non-guaranteed contract.   That position is difficult for this author to reconcile with the realities of the MyPreneedAccount.

 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.  

The Mississippi Secretary of State seems to be taking a very proactive approach to the regulation of preneed and perpetual care funds. Over the course of the last few years, the Regulation and Enforcement Division of the Secretary of State’s office has averaged an enforcement proceeding per month. We were curious what type of enforcement proceedings they were pursuing, and picked one at random. The luck of draw involved a situation where the Mississippi regulators alleged the preneed seller’s preneed contract form did not adequately disclose to the consumer the tax consequences of their preneed trust. While the preneed contract form stated that income taxes may be withheld by the trust, the seller’s trustee reported the income to the contract purchaser. This did not set well with the Mississippi regulators, particularly when the consumer had no right to cancel the contract and receive a refund of the trust income.

The Mississippi regulators are not alone in their perception of the inequities of this situation. Nebraska preneed regulators are also questioning why income should ever be reported to consumers when they may never receive it. The answer is that the Internal Revenue Service forced this issue with Rev. Rul. 87-127, with the goal of requiring a single method of income reporting for preneed trusts.

The Service struggled with the situation that troubles the Mississippi and Nebraska regulators: how can the purchaser be the grantor if he/she is never entitled to a refund of the income (or even trust deposits) upon the contract’s cancellation. But, as between the consumer and the funeral home, the funeral home’s right to the trust corpus is dependent upon performance of the contract. While the consumer may never receive a refund, he/she can choose a different funeral home to service the contract. The value of that service satisfies the grantor rules of the tax code, and supports the IRS’ conclusions in the Ruling.

The inequity of the situation may have led to the passage of IRC Section 685. Given an alternative is available to the seller, the Mississippi regulators sought to force the seller to either change its contract or require the trustee to change its income reporting. But in doing so, the Mississippi regulators misstate IRC Section 685. Irrevocability is not a key characteristic of an IRC Section 685 qualified funeral trust. While the Section 685 election is viewed as irrevocable, the irrevocability of the preneed contract has no impact on Section 685. The Mississippi regulators also fail to acknowledge that Section 685 is the trustee’s election to make, not the funeral home’s. While the two need to work in concert, it is the trustee that has ultimate control over the trust’s income reporting.