At its April meeting, the Missouri State Board of Embalmers and Funeral Directors discussed the formation of a “Phase 3 Committee” that would provide input for the revision of the Board financial examination handbook.  The Board staff is about half way through the second round of preneed examinations (“Phase 2”), and the Board wants to adopt new examination guidelines that can be implemented when Phase 2 Exams are completed.   However, there is an immediate need for a Phase 2.5 Committee.   Exception comments from the Board’s preneed examiners suggest there is still confusion on how the Section 436.425 should be applied to certain types of preneed contracts.

Section 436.425 begins with the statement that “All preneed contracts ……shall clearly and conspicuously” and then sets out 16 subparagraphs that require certain contract disclosures.  Shortly after the passage of Senate Bill No. 1, the Board’s staff recommended a regulation that required a specific disclosure statement be given to each preneed consumer.  That ‘mandatory disclosure’ recited all of the Section 436.425 disclosures.  In preparing the mandatory disclosure regulation, the staff had applied a very literal interpretation of Section 436.425 to conclude that all disclosures must be included in a preneed contract regardless of its funding source.  In doing so, the staff violated one of the basic doctrines of statutory construction:  avoid a literal interpretation of a law when such would produce an absurd result.  The Missouri Legislature did not intend for trust funded contracts to include insurance disclosures, or insurance funded contracts to make trust disclosures.  Such disclosures would only confuse elderly consumers. The State Board eventually came to appreciate this and rescinded the proposed regulation before it was formally promulgated.

While the Board’s examination staff is no longer requiring each preneed contract to include all Section 436.425 disclosures, examiners are still confused about certain disclosures.  For example, the Board needs to take a position on the disclosures required for spend down contracts.  The examiners are under the impression that consumers making insurance assignments for spend downs must receive a contract that contains disclosures about cash surrender values and policy cancellations.  Those types of disclosures are intended when the consumer purchases an insurance policy to fund a preneed contract.   When the consumer seeks to assign an existing life insurance policy, the funeral director will not know the policy’s cash surrender value, or the owner’s rights under the policy.  As reflected in the State Board’s own recommendations to the Legislature, Senate Bill No. 1 was intended to regulate preneed contracts issued in conjunction with the purchase of a life insurance policy.  The Section 436.425 disclosures reflect that intent.  The spend down contract funded by an insurance assignment do not pose the same risks as the contract funded by an insurance purchase.

In the next post, we will look at Section 436.425 and trust funded contracts.

We continue our discussion of the composite Federal Form 1041QFT with a post about the individual account statement.

With the composite return, income and expenses are allocated to the individual preneed account and taxes are computed at that level rather than at the trust level.  To allow the IRS to test the composite tax liabilities, the trustee is required to attach a statement to the Form 1041QFT that reflects each individual account’s share of income and expenses.  The statement is required to set out each type of income, the gross amount of each type, each type of capital gain, each type of deduction or credit, the account’s gross and net income, the account’s tax liability and termination date if contract beneficiary died during the tax year.   With qualified dividends and long term capital gains taxed at lower rates, the individual account statement must set out each type of income so that the IRS agent can confirm each account’s effective tax rate.

The QFT form has a composite box on line 12 that must be checked.  The composite box puts the IRS agent on notice that the tax liability is not to be computed using the income and expenses entered into the 1041QFT form.  (We have had IRS agents miss the box and attempt to increase the trust’s tax liability by using the 1041QFT form numbers.  In each case, the issue was resolved by referencing the composite election and the individual account statement.)

We have reviewed 1041QFT returns where the individual account statement referenced a percentage, a single gross income number and the tax liability.  The tax preparer obviously used a year end allocation of income and tax liabilities.  Although this method does not comply with the 1041QFT instructions, the IRS may not challenge because the method frequently computes the tax liability at the higher trust tax rates.

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.

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.

The Missouri State Board of Embalmer and Funeral Directors met this past December to discuss changes to the Preneed Examination Handbook, and former Board Chairman Don Lakin made a proposal that has merit.

The State Board has licensed approximately 315 preneed sellers.  The current preneed examination procedures contemplate an onsite visit to each seller.  Many of those sellers are small funeral homes that sell less than a handful of preneed contracts in a month.  Mr. Lakin has suggested to the State Board that the examination process could be made more efficient if travel to smaller funeral homes could be eliminated.  This could be done by the State Board giving a reporting option to funeral homes that sell 35 or less preneed contracts during the annual reporting period.  Such funeral homes would be defined as a “small seller”, and in lieu of an on-site examination, a small seller would fax copies of preneed contracts as they are sold and  periodic funding agent reports to the Board.  The examiner could review the small seller documents once each year from their desk to ensure contracts are in compliance and consumer funds are timely deposited with the funding agent.  Using a desk top review of smaller sellers would probably save the Board time and expense spent traveling to dozens of funeral homes.

Our next criticism of Missouri’s pending Exam Handbook is its violation of the Four Corners Rule, which requires a document to stand on its own when being interpreted and applied.  Common law precludes parties from going to outside sources when applying the document to different situations.  While the Handbook gives lip service to the Four Corners Rule in Paragraph 13, other sections of the Handbook send examiners to various sections of law, to rules that have never been promulgated, and to other “Board directives” for directions when reviewing seller contracts or records.

The Handbook needs to be the examiner’s procedure bible that stands alone, and without incorporating statutes, rules or Board directives that exist only in a minute from a prior meeting.

The newest edition of the Missouri Preneed Exam Handbook has some significant problems.  The one we will discuss today is ambiguous instructions regarding the review of preneed contracts.  Paragraph 13 of the Handbook’s scope of financial examination states:

13) Staff shall look at 100% of all active preneed contracts that have been sold since the period covered under the last financial examination and may look at a sampling of other active and fulfilled preneed contracts, at the direction of the executive director and examiner supervisor, as required to assure fulfillment of the general directives of the board as set forth in these guidelines.

The Handbook then sets out the paragraphs of §436.425.  While an earlier part of the Handbook indicates that a seller’s contract form will be requested for review as part of the pre on-site process, Paragraph 13 indicates the examiner will repeat §436.425 review on each contract sold since the last exam.  And then that same type of review will also be conducted on a sampling of contracts that were also part of the seller’s prior exam.

The vast majority of the requirements of §436.425 pertains to contract form disclosures.  Three paragraphs of §436.425 pertain to how the contract must be completed by the seller.  With regard to §436.425 contract disclosures, why should examiners first review the contract form and then all outstanding contracts?  And then, why do the same type of review on contracts reviewed in the seller’s prior exam?  Do the contracts change over time?

As the highlighted language of Paragraph 13 indicates, the Handbook will be the Board’s directives on how to conduct exams.  Those directives need to be complete and clear.  So, if a 100% review is necessary for consumer protection, the Handbook needs to be clear about what that review entails.  Is the consumer’s $25 fee being well spent by having examiners double and triple check contracts for the required disclosures?

“Nitpicking” was one of the terms frequently used by Missouri funeral directors when referencing their preneed exam exceptions report.  (Other descriptions are not appropriate for print.)  The initial exam guideline provided no guidance to examiners for prioritizing problems found in preneed contracts and records.  It was common to see exception reports with dozens, even hundreds, of technical ‘violations’.   The original guidelines did not distinguish certain types of preneed contracts, and that led examiners to erroneously cite numerous contracts with a disclosure violation.   Sellers were then required to respond to these erroneous exceptions.   These responses were frequently bounced back and forth between the Board staff and the seller, without giving the Board or its attorney a chance to weigh in.   Examinations could drag on for several months over insignificant issues.

The State Board eventually took its first step to address this problem a year ago October when a resolution was adopted to have the Examination Committee review each exceptions report before a Board letter would be sent out to the funeral home.   However, the Board’s then Chairman allowed the staff to continue to send exception letters without Board oversight.  Those subsequent exception letters continued to cite some of the same erroneous issues to sellers.

The format of the exceptions report can also be challenging to the State Board’s Examination Committee.  An exceptions report that is several pages long might suggest a funeral home might have some serious problems.  But, as it was with one of our clients, the exception report could be citing problems for contracts which the funeral home is not the seller.   It took multiple letters to the State Board’s Executive Director to resolve that issue.

The Board’s October exam handbook would bring the staff back to the path approved last October.   All exception reports would have to be reviewed by the Examination Committee before a letter is sent to the funeral home.   The examiners would have to prepare the exception report with a summary that classifies problems as legal, recordkeeping or financial.   The first round of examinations focused on contract form compliance and recordkeeping.  As a consequence, most exceptions tended to fall into one of those two categories.  Going forward, the Board should be focused on the financial issues, and the Examination Committee should turn to the exception report’s summary to see how many financial issues are listed.

While the State Board will remain diligent to see that preneed contract forms comply with Chapter 436, this can be the easiest of the industry’s problems to fix.  A seller can be required to revise its contract form and to agree to administer outstanding contracts in compliance with Chapter 436.

Recordkeeping could be a little more difficult to address.  Compliance could mean implementing new procedures or software, or obtaining professional assistance.  But generally, this means prospective changes to how records are created and maintained.   But that may not be necessarily be true when the seller has not maintained adequate records to document Section 436.031 distributions.

Financial exceptions could be one of several issues: the seller is underfunded, the seller is receiving improper distributions, the seller is not making timely deposits, the seller does not maintain adequate records to determine the adequacy of funding, or the seller does not main adequate records to determine compliance with Section 436.031.   Per the handbook, the exception report should explain whether financial problems appear to be isolated or systematic.   The examiner should also provide his/her assessment whether the financial problem is an obvious error.

The handbook’s instructions to prioritize and summarize the exception report are intended to help the Examination Committee with its own assessment when issuing an exceptions letter to the funeral home.  The exception letter could take different courses based on the Exam Committee assessment.   Minor exceptions could be noted to the funeral home with suggestions on how to address the issues, but that the Board is closing the examination file.  Funeral homes with recordkeeping problems and multiple financial errors may get an exception letter that seeks input from the funeral home regarding how it would propose correcting the problems.  Funeral homes with significant recordkeeping issues, significant underfunding or systemic financial issues would receive an exception letter seeking a detailed explanation to be given to the State Board.

 

The Missouri State Board’s proposed exam handbook would have examiners perform more of their review before an onsite visit is scheduled at the funeral home.  By performing a desk top review, the examiner would be better prepared when visiting the funeral home.  This should expedite the examination process.   There would be four stages to the desk top exam that starts with an information and document request.

Depending upon the sampling to be used by the Board, the examiner sends out an initial examination notification to the seller explaining the sampling process and requesting:  1) all preneed contract forms used since Seller’s previous exam, 2)an outstanding contracts report, 3)a serviced/canceled contract report, 4) copies of specified months of financial transactions (consumer receipt and funding agent transmissions), 5) identification of all funding agents, and 6) whether Section 436.031 income distributions were taken, and supporting documentation.   The seller would have 30 days to provide the contract form and contract reports, and 60 days to provide the other requested information and documents.

The second stage would involve a review of the seller’s annual reports for consistency in assigning sequential contract numbers, and for gaps in reported contracts review could be performed while the examiner waits for the contract forms and reports.

The third stage begins when the examiner receives the seller’s contract forms and contract reports.  Depending on the sampling that applies to the seller, the examiner will specify which outstanding contracts and performed/canceled contracts are to be made available for review during the on-site visit.  After sending a notification letter with the specified contracts, the examiner would then proceed to review the contract forms for Section 436.425 compliance.  This should save the examiner substantial time since the prior exam procedures required that he/she review each outstanding contract for disclosures compliance.

The fourth stage of the desk top exam would begin when the examiner receives the funding agent information, financial transaction reports and Section 436.031 distribution documents (if any).   From the seller’s consumer receipt records, the examiner will reconcile those with the corresponding transmission records and funding agent reports.   If there are any Section 436.031 distributions, the examiner will determine if the records are sufficient to confirm compliance with the statute.

During all four stages, the examiner will note issues or exceptions to discuss with the seller.  When the fourth stage is complete, the examiner will contract the seller to schedule the on-site visit.

Missouri’s pending preneed exam handbook will establish a new record keeping requirement for the state’s preneed sellers: monthly records of consumer payment receipts and the transmission of those funds to the preneed funding agent.  Seller record keeping proposals are not new to the Board.   (Missouri Seller Records: The State Board Proposal) The Board’s staff proposed a record keeping regulation three years ago, but both Board members and the industry objected.   (Missouri Preneed Seller Records: the Third Time did not prove a Charm) The staff proposal attempted to dictate the format of seller records, and would have subjected licensees to discipline for “inadequate seller records”.    The proposal did not explain the purpose for most of its requirements, and included provisions to allow the Board to expand the record requirements as it saw fit.  Those latter provisions invited abuse by the Board’s staff, a problem that eventually led to the ouster of the Board’s previous Executive Director.

The monthly receipt and transmission records differ from the staff effort in a couple of major ways.  First, the handbook does not dictate a format to sellers.  A seller may document each month’s consumer payment activity in any format so long as examiners can track a consumer payment from receipt by the funeral home to deposit with the funding agent.  But contrary to what one Board member has repeatedly suggested, a copy of the consumer check in the preneed file is a sufficient record.  Sellers would be required to create a record of all consumer payments received each month, and a corresponding record of all payments transmitted to each applicable funding agent.  The Board member opposing all forms of record keeping requirements has cited his own experiences with the IRS, which did not seek such types of records.  Such comments are misleading for several reasons.  First, the IRS actually does have record requirements for audits, and those requirements differ by industry (IRS hyperlink to industry audit guidelines).  The IRS audits for a different purpose than the State Board preneed audit.    And since the Board member’s IRS audit is confidential, no one knows where his representations are accurate.

Monthly deposit and transmission records would allow Board examiners to track consumer payments without having to wade into each preneed contract file.  The monthly records would also allow the exam staff to adopt different procedures for testing a seller’s compliance with Chapter 436’s main purpose: protecting consumer funds.

While the receipt and transmission record requirements may appear to impose two types of records, some Missouri funeral homes have been complying for years with a single record. Excel worksheets can document both the receipt of funds and their transmission to the funding agent.  (Hyperlink to the sample spreadsheet)