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Pre-Need Cemetery Trusts

September 13, 2000

by Richard A. Neuman, CPA
Weil, Akman, Baylin & Coleman, P.A.

The Taxpayer Relief Act of 1997 contains many significant provisions affecting all taxpayers. Perhaps one of the lesser known, but an exceptionally important area contained within these provisions, involves money that is kept in a Preneed Funeral Trust used for purposes of paying for one's funeral. Pursuant to IRS Notice 98-6, the tax treatment of income earned on funds held in Pre-Need Cemetery Merchandise Trusts is the same as that of Qualified Funeral Trusts. This article is to help understand the significant change that transpired pursuant to the 1997 Act relating to the tax treatment of the income earned on the deposits which are being kept in these Pre-Need Cemetery Merchandise Trusts.

There are several different types of Pre-Need Cemetery Merchandise Trust deposit contracts. Prior to January 29, 1988, the income earned on many of these preneed trusts was taxed to the seller, i.e., the owner of the cemetery or the trust. Revenue Ruling 87-127 made a dramatic change in the method of taxation for the income earned on these deposits. This revenue ruling basically stated that in most cases, for contracts entered into after January 28, 1988, and for certain retroactive contracts, the purchaser was required to recognize such earnings on his or her tax return.

The Taxpayer Relief Act of 1997 essentially reverted (upon election of the trustee) back to the methodology used prior to January 29, 1988. The trustee of the pre-need trust may elect to create a "Qualified Pre-Need Cemetery Merchandise Trust." This trust is not treated as a grantor trust, and as such the trustee pays the tax on the earnings. The Joint Committee Conference Reports indicate the reason for this change is that numerous individual taxpayers were required to account for the trust earnings on their tax returns even though the earnings with respect to the taxpayer may have been minimal. As such, the committee indicated that the record-keeping burden on individuals could be simplified if the trusts instead were taxed at the entry level, with one "simplified" annual return filed by the trustee reporting the income from all such accounts administered by the trustee. As we will discuss, there are advantages to the trustee as well as the purchaser of the contract in making the election to pay the tax at the trust level.

For the elections to be made by the trustee, several criteria are required. These include:

• The trust must arise as a result of a contract with a person engaged in the trade or business of providing funeral or burial services.
• The sole purpose of the trust is to hold, invest and reinvest the funds in the trust and to use the funds solely to make payments for the services or property for the benefit of the beneficiaries of the trust.
• The only beneficiaries of the trust are individuals to whom services or property are to be provided at their death.
• The only contributions to the trust are contributions by or for the benefit of the beneficiary.
• The trustee must make an election which is done by timely filing the Form 1041-QFT (see below).
• The trust, except for the election stated above, would otherwise be treated as owned by the purchaser of the contract and, as such, the income would be recognized by the purchaser of the contract.

In addition to the above, a Pre-Need Cemetery Merchandise Trust may not accept contributions from a purchaser in excess of $7,000 ($7,200 for the calendar year 2000). Contributions for this purpose includes all amounts transferred to the trust, but do not include income or gain earned with respect to the property in the trust. However, pursuant to IRS Notice 98-6, a contract may not be included in a Pre-Need Cemetery Merchandise Trust if it is projected that the contract over the life of the trust will receive contributions exceeding $7,000. This means that not only must the trustee look today to see whether there is $7,000 in the trust, but it must project whether contributions in the future will cause the amount to exceed $7,000. In such a case, that account may not be included in the election discussed above.

Also, for purposes of applying the $7,000 contribution limit, if a purchaser creates more than one contract with a trustee, all the trusts are aggregated as one trust. As such, creating more than one contract will not avoid the $7,000 ceiling mentioned above.

A significiant advantage to the trustee for making the election to be treated as a Pre-Need Cemetery Merchandise Trust is that the numerous Form K-1's and Form 1099's would not have to be sent to the purchasers of the contracts. The trustee may accumulate all of the names of those qualified purchasers and file one form, called Form 1041-QFT. Each contract is treated as a separate trust; this means that the accelerated rates that exist for trusts are applied on an individual trust level. To illustrate, lets assume that a particular trust has 10 trust accounts. If the total taxable income of the trust accounts were $4,000, the regular Federal tax based upon the accelerated rates would be $893. However, as stated above, each one of the contracts is taxed as its own trust. Therefore, in the prior example, if we were to assume that the 10 trust accounts each earned $400, each trust would be taxed on $400 of income which would create a total tax of $600. This difference in tax is because the tax rates accelerate quickly for trusts. As such, if the income were reported in the aggregate, the tax rate would reach the 28% bracket. But because of the provision in the new law which allows each trust to be taxed individually, the rate for each trust never reaches past the 15% bracket.

In addition, Form 1041-QFT instructions state that estimated tax is only required if the Trust expects to owe $1,000 or more in tax in a prospective year. However, as stated above, since the tax liability is figured for each individual purchaser, and not the total tax liability for all of the accounts reflected on the Form 1041-QFT, a single account would have to be expected to produce $1,000 or more in tax for estimates to be required. Considering that the contributions to the account are limited to $7,000 (as adjusted yearly), a somewhat significant rate of return would have to exist for any particular account to produce $1,000 in tax on a contribution limit of $7,000. As such, it appears that in the overwhelming majority of cases, estimated taxes would not be required.

Another interesting area of Pre-Need Trusts is the response of each state relating to the Federal legislation. One of the important benefits of the Federal legislation is that each contract within a Pre-Need Trust is treated as a separate trust. This means that the accelerated tax rates which exist for most trusts are applied on an individual trust level. In general, this allows the federal tax rate to be limited to the 15% tax bracket on income earned by the trust. To date, I have been very pleased with the response received from the various states for which I have prepared trust tax returns that have made the Pre-Need Trust election. The states appear to be allowing the trusts to be treated individually and as such the income is generally limited to the lowest tax bracket.

In conclusion, the election to be treated as a Pre-Need Cemetery Merchandise Trust is a major decision that should be carefully studied and considered. The effective date for this election is for taxable years ending after August 5, 1997. The advantages can be significant, however the costs associated with the trustee paying the tax on the earnings, as well as the necessary competent preparation of the Form 1041-QFT and the necessary state filings, must also be part of the decision process in making this election.

- Richard A. Neuman, CPA

Richard A. Neuman, CPA is a Principal with Weil, Akman, Baylin & Coleman, P.A., in Timonium, Maryland. He is a member of the Maryland State Funeral Suppliers Association and has significant experience in the death care industry. Mr. Neuman provides seminars regarding taxation issues and can be reached at: (410) 561-4411.