Section 685 Reporting
Definition of a “qualified funeral trust”
Section 685 was enacted with the Taxpayer Relief Act of 1997 to allow a preneed trustee to avoid the reporting problems of Treas. Reg. §1.671-4 by electing to have each purchaser trust account become a taxable entity. The election is taken on a preneed contract by preneed contract basis, and may be taken with regard to any preneed contract that does not exceed a contribution limit.
Determining the contribution limitation for preneed funeral contracts requires multiplying the state preneed law trusting percentage by the contract’s sales price. If the funeral home/cemetery voluntarily trusts at a higher percentage, that percentage is used. The contribution limitation is calculated on the contract sale date. The contribution limitation does not include income that accrues to the purchaser trust account. It is also irrelevant whether the contract is paid in full on the sale date or is paid by installments over time. For a contract sold during calendar year 2006, the contribution limitation was $8,500. For 2007 contracts, the aggregate contribution limitation is $8,800.
The trustee has responsibility for ensuring compliance with the contribution limitation, and must aggregate all preneed contracts for a single beneficiary.
Section 685 Administration Requirements
While a purchaser’s preneed contracts are aggregated for purposes of the Section 685 contribution limitation, each purchaser trust account is taxed separately. Section 685 provides for a composite Form 1041QFT, allowing all preneed contracts administered under the same trust instrument to be reported on a single return. The composite return requires a schedule that reports by line item: each purchaser’s name; the purchaser’s proportionate share of income (by type); deductions (by type and deductibility); credits; the purchaser’s taxable income and income tax liability; and the account termination date (if applicable). The Form 1041QFT must be filed with the IRS by April 15th. Under Section 685, there is no reporting made to the individual purchasers.
Section 685 requires that each type of income, deduction and credit realized by the preneed trust be allocated to the purchaser trust accounts on monthly intervals. Trust accounts must be distributed no later than 60 days after the purchaser’s death. Allocations of income and expense must cease with the distribution of the purchaser’s account.
If a trust account has a single purchaser (owner) and multiple beneficiaries, the trust must be separated among the beneficiaries.
The IRS anticipates that the QFT schedule will identify capital gains by: a) net short-term, b) net long-term, c) 28% rate gain and d) unrecaptured section 1250 gain.
Expenses that are directly allocable to tax-exempt income may not be allocated to taxable income. Furthermore, certain expense deductions are subject to a 2% floor. One such expense is third party investment advisory fees. A special computation is required for the allocation of ‘allowable miscellaneous itemized deductions’.
Administrative Certifications
From a practical approach, many of the Section 685 requirements are burdensome and inapplicable. It is virtually impossible for a single QFT trust to ever produce income that would trigger a tax rate higher than 15%. Most trustees lack the individual contract data to determine when contracts should be aggregated or separated. Accordingly, the administration has to be simplified through certifications regarding compliance with the contribution limitation. These certifications should also protect the trustee when the contribution limitations are exceeded.
Cooperation between the trustee and the funeral home is necessary to avoid investment advisor fees being characterized as allowable miscellaneous itemized deductions subject to the 2% floor.
Agreements regarding the classifications of trust income should be made to eliminate the income types that are unlikely to be encountered, thus simplifying the administration.
PRC Preneed Resource Company
9300 Metcalf, Suite 202
Overland Park, KS 66212
(913) 378-9922 or (800) 449-0030
(913) 378-9924
wastal@swbell.net
http://preneedresource.com/Section685.htm