Introduction
Is it possible that the Internal Revenue Service is helping you? Making something easier? The IRS has provided some relief to the trusts established by funeral homes and cemeteries when they sell preneed merchandise and services. Now, the preneed trusts may choose to report the income earned on the trust principal as income taxable to the trust. Until now, preneed trusts in most if not all states have been technically required to report to each preneed purchaser the taxable income earned on his or her portion of the trust, and each purchaser must include this income on his or her tax return. This article will summarize the eligibility requirements, election procedures, and simplified reporting method for a Qualified Funeral Trust ("QFT").
The Internal Revenue Service takes the view that each consumer who purchases preneed merchandise or services is establishing a trust for his or her own eventual benefit. This is a result of the 1987 IRS determination that such preneed trusts were so-called "grantor trusts," which means that any and all income earned by the trust must be included in the taxable income of the person establishing the trust (the "grantor"). The money paid to the preneed dealer by the purchaser earns income in the trust. Each trustee should then report on an annual basis to each individual purchaser the amount of income the individual purchaser's share of the preneed trust earned during the trust's taxable year. To comply with these reporting requirements can be a difficult accounting problem for the trustees of the preneed trusts since each trust has a steadily increasing number of beneficiaries, each of whose account is legally required to be accounted for separately. The problem is compounded by the fact that, while the trust's income as a whole might be significant, the annual taxable income of each purchaser's share of the trust is usually minimal. Reporting to numerous individual purchasers their respective amounts of minimal income is too much for some trusts, which simply ignore the requirements and do not attempt to report the income to the purchasers.
Taxpayer Relief Act of 1997 and QFT's
The Taxpayer Relief Act of 1997 addressed this issue and offered relief from the reporting requirements. However, this change also shifts the burden for paying the tax to the trust. Now the trustees of these preneed trusts can choose to have the trust treated as a "Qualified Funeral Trust ('QFT')." As such, the trust will not be required to report each beneficiary's share of income separately as taxable to the beneficiary. Instead, all of the taxable income will be taxable to the trustee. Further, a trustee may report all income from all trusts for which it acts as trustee on one single return: Form 1041-QFT.
QFT status may be elected for tax years beginning after August 5, 1997. For calendar year taxpayers, this means 1998. To qualify for QFT status and in order to take advantage of this simplified approach to income taxation, a preneed trust must meet certain qualifications. These qualifications are set forth in the new §685 of the Internal Revenue Code.
First, the trust must be the result of a contract between a person engaged in the trade or business of providing either funeral or burial services or the merchandise necessary for such services on the one hand, and an individual purchaser who is to have such services or property provided upon the individual's death, on the other hand. This is a basic definition of preneed trusts.
Second, the sole purpose of the trust must be to hold, invest, and reinvest funds in the trust so that the principal is maintained to be used to pay for funeral services or merchandise on behalf of the beneficiary at the beneficiary's death.
Third, the only beneficiaries of the trust are individuals who have entered into contracts to have such services or property provided at their death.
Fourth, the only contributions to the trust are contributions by or for the benefit of the beneficiaries.
Fifth, the trustee must affirmatively elect for the trust to be treated as a QFT.
And sixth, if it were not for the QFT rule, the trust would be treated as wholly owned by the individual purchasers of the preneed contracts.
Most preneed trusts can easily qualify under these rules, since most preneed trusts are established along these very guidelines. There is one possible pitfall, however. After a preneed trust has qualified as a QFT for federal income tax purposes, it must be careful not to accept more than $7,000 in aggregate contributions for any one beneficiary or it will lose its QFT status. However, this $7,000 limit is adjusted annually for inflation during each calendar year after 1998.
It should also be noted that if a single individual has more than one preneed contract with a trustee, then all such contracts are treated as one and their amounts are aggregated for purposes of the $7,000 limit. Also, if the IRS determines that a purchaser has entered into more than one preneed contract with different trustees to avoid the $7,000 limit, then it can treat all such trusts as one.
Procedure to Elect QFT Status
To elect QFT status, the trustee simply files form 1041-QFT no later than the due date, with extensions, for filing the trust income tax return for the year of election. If no election is made for the first year that a trust is eligible to make the election, it can be made in later tax years. However, once the election to be treated as a QFT is made, it cannot be revoked without the permission of the IRS.
Considerations
The obvious advantage to QFT status is that a trustee may file one aggregate income tax return for all preneed trusts. This is a major relief to trustees who have to report each purchaser's income from the trust on an annual basis. It is important to note that nothing in the QFT legislation replaces or repeals the legal requirement that each purchaser's interest in the trust be tracked separately, but only that the reporting requirement for income tax purposes is waived.
A basic disadvantage to the QFT is that trust must pay the tax, rather than the customer/beneficiary. The trustee must elect to treat each trust as separately taxed to avoid rates on trusts that are progressively higher than individual tax rates.
Another disadvantage to QFTs may very well be that they end up being mandatory by stealth, although they arise solely at the trustee's discretion. First consider that preneed providers may elect the QFT to avoid the customer relations headache of reporting this income to their customers. Then consider that, while the QFT provisions of the TRA may make income tax reporting simpler for death care providers, they may also end up being a means of raising federal revenue. "What the taxman gives the taxman takes!" On an individual purchaser basis, the annual income from the trust is very small. It is so small, in fact, that many trusts do not report the income to the purchasers, and the IRS has not bothered to be concerned about it. The income to the entire preneed trust, however, will be greater and the IRS might begin to examine these trusts more closely to ensure that they are either properly reporting income to the individual purchasers or are filing form 1041-QFT. Such a crackdown would force trustees to decide between the previous onerous reporting requirements and the relative ease of QFT status with its obligation for the trustee to pay the tax. If the IRS believes that the new QFT provisions should encourage better compliance with the tax laws and begins to examine the preneed industry more closely, then those preneed dealers who have not previously reported income to their purchaser/beneficiaries will either have to begin reporting the income to them or they will have to elect QFT status and pay the taxes themselves.
Jed Beardsley is a partner, and Harold Arnwine is an associate, with the law firm of Gomel & Davis, LLP in Atlanta, Georgia. Walter Gomel's input for this article is also appreciated. Gomel & Davis is active in business, tax, and transaction planning for funeral homes, cemeteries, and their owners. Mr. Gomel and Mr. Beardsley are members of the Alliance Editorial Board.