Preneed Funeral and Burial Trusts: A Tax Primer
by William Stalter

Preneed trusts come by many names: preneed funeral trusts; cemetery merchandise trusts; opening and closing trusts; funeral merchandise trusts; and vault trusts. A preneed trust may be established for a single funeral home, cemetery or third party seller (all of which will be referred to in this article generically as a “funeral home”), or it may be a “master” trust that is used by multiple funeral homes. The diversity of names, structures and purposes derives primarily from the fact these trusts are creatures of 50 different state laws.

A “preneed trust” is a trust which holds, administers and distributes those payments made by a preneed contract purchaser to a funeral home which the applicable state law requires the funeral home to deposit into trust as security for the performance of the preneed contract. A “preneed contract” is a written agreement between a consumer (a “purchaser”) and a funeral home in which the funeral home agrees to provide the funeral or cemetery merchandise or services described in the contract (a “prearranged funeral”) at the purchaser’s death.

Banks typically view the preneed trust as a single account belonging to the funeral home. In contrast, state preneed laws treat that preneed trust as a commingled trust comprised of a number of smaller individual trust accounts, one for each preneed contract sold by the funeral home. State preneed laws require that each purchaser’s deposited payments be accounted for in the preneed trust by maintaining a separate “purchaser trust account” for each purchaser’s payments (and subsequent income and expense items allocated to those payments).

Under most state preneed laws, the maintenance of each purchaser trust account is critical to the state’s statutory scheme in two primary ways. First, most states give the purchaser the right to cancel the preneed contract and receive some amount of a refund. Second, states restrict or limit the funeral home’s right to withdraw the preneed trust until the preneed contract is performed.

Taxation of Preneed Trust Income

The starting point for preneed trust tax compliance is Rev. Rule 87-127, 1987 - 48 I.R.B. 5. All preneed contracts sold subsequent to January 28, 1988, are subject to Rev.Rul. 87-127. Because most preneed contracts have relatively short life spans, most preneed trusts encountered by a bank will be subject to Rev.Rul.87-127. While this article addresses compliance with Rev.Rul. 87-127, preneed trusts that administer preneed contracts sold prior to January 1988 may be entitled to maintain their historic tax treatment. Whether a preneed trust is entitled to historic tax treatment depends upon several considerations.

Rev.Rul. 87-127 imposes on the funeral industry the universal requirement that the purchaser be taxed as the grantor (giving rise to the term “purchaser/grantor”) of the purchaser trust account. Prior to Rev.Rul. 87-127, many preneed trusts were taxed with the funeral home as the grantor (called a “seller/grantor” trust). Rev.Rul. 87-127 changed this tax treatment by requiring the preneed trust’s income and expenses be reported to the individual purchaser trust accounts. In subsequent guidance, the IRS explained that preneed trusts must report income and expenses to each purchaser pursuant to either Treas. Reg.§ 1.671-4(a) or Treas. Reg.§ 1.671-4(b)(3).

Both Treas. Reg. § 1.671-4 reporting alternatives require a “statement” to be sent to each individual purchaser, so the purchaser can report his or her share of the preneed trust income and expenses on Schedules B and D of the purchaser’s Form 1040. As is the case with any grantor trust, the statement must report each item of income, deduction and credit allocated to the purchaser trust account. As the Form 1041 instructions explain, a Schedule K-1 should not be used as the statement for reporting preneed trust income and expenses to each purchaser trust account. Prior years Form 1041 instructions emphasize that a grantor trust is required to report to the grantor each item of income, as opposed to each type of income. If a preneed trust holds both fixed income and equity investments, the purchaser/grantor statement will take the form of a hybrid combination of Schedules B and D of Form 1040.

Tax Penalty Exposure to Trustees

The purchaser tax statements required by Treas. Reg. §1.671-4 are subject to the accuracy requirements of IRC Section 6722. If the purchaser/grantor statements are wrong due to an inadvertent error, a $50 per purchaser statement penalty could be assessed with a maximum aggregate penalty of $100,000. Because the amounts of income and expenses allocated to an individual purchaser trust account are often very small, banks and funeral homes may be tempted to assume that the penalty can be avoided so long as the reported amounts are “close”. However, the regulations for IRC Section 6722 provide that errors or omissions relating to a dollar amount are never inconsequential and, therefore, the reporting of incorrect dollar amounts on the purchaser statements, regardless of how small, can be the basis for penalties.

The Compliance Alternative: Section 685 Reporting

Following the publication of Rev.Rul.87-127, preneed trustees attempted to comply with the Treas. Reg. §1.671-4 income reporting requirements by sending Form 1099s or Schedule K-1s to purchasers. Some preneed trusts switched to tax exempt investments in an unsuccessful attempt to avoid the income reporting requirements. The funeral industry’s difficulties in complying with Rev. Rul. 87-127 and Treas. Reg. §1.671-4 were made known to the IRS and Congress, and in 1997, Congress gave the funeral industry an alternative: IRC Section 685.

Section 685 allows the preneed trust to avoid the Treas. Reg. §1.671-4 reporting problems by allowing the trustee to elect 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 funding limit (thereby constituting a “qualified funeral trust”).

In 1997, the initial funding limit was set at $7,000 per preneed contract. While that funding limit is indexed for inflation ($8,500 for year 2006), Section 685 requires that each preneed contract administered for the benefit of a purchaser by the bank be aggregated for purposes of the limitation. In practical terms, the funding limitation works as follows.

The funeral home sells a purchaser one preneed contract to provide funeral merchandise and services, and another preneed contract for cemetery merchandise (a vault or a monument). The funeral contract has a sales price of $6,000, and the cemetery merchandise contract has a sales price of $2,400. The funeral home’s state law requires 90% of the preneed contract payments to be deposited in a preneed funeral trust. The state law also requires the funeral home to deposit 110% of the cemetery merchandise’s wholesale cost in a cemetery merchandise trust. The funeral contract’s trust requirement is $5,400 (90% x $6,000). If the wholesale cost of the cemetery merchandise is $1,000, then the cemetery merchandise contract’s trust requirement is $1,100. The purchaser’s aggregate funding requirement is $6,500, which allows the preneed trust to take a Section 685 election for either contract, or for both contracts.

Determining the funding limitation for preneed funeral contracts is fairly straightforward. State preneed laws typically apply a trusting percentage to the contract’s sales price to determine the required trusting obligation. That percentage will be used to determine the funding limitation unless the funeral home voluntarily trusts at a higher percentage. The funding limitation is calculated on the sale date of the contract by multiplying the contract’s sales price times the higher of the statutory percentage or the percentage used by the funeral home. The funding limitation does not include any 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.

While a purchaser’s preneed contracts are aggregated for purposes of the Section 685 funding 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 the types of income, deductions and credits to be allocated to the purchaser trust accounts on monthly or quarterly intervals. A preneed trust account will also lose its qualified funeral trust status upon the distribution of the trust’s assets (which is to occurred within 60 days of the purchaser’s death).

Summary

In Rev.Rul. 87-127, the IRS established an income reporting standard which few preneed trustees could satisfy. Consequently, Section 685 is most practical course of action for preneed trust tax compliance. It requires less administration than the reporting requirements of Treas. Reg. §1.671-4 and it eliminates the risk of the Section 6722 penalties associated with the purchaser/grantor statements.

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/Tax Primer.htm