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Washington Report
March 2000
Tax Commission Asks ICFA to Draft Model Law
On State Income Taxation of Funeral Trusts
by Robert M. Fells, Esq., General Counsel
The Multistate Tax Commission (MTC), an organization of state governments, has asked the ICFA to draft a model law regulating the method of taxing the income from preneed funeral trusts for state income tax purposes. The MTC is composed of 44 states, including the District of Columbia, and it encourages states to adopt uniform tax laws and regulations that apply to multistate and multinational enterprises.
According to the MTC, "Greater uniformity in multistate taxation reduces compliance burdens for multistate businesses, helps insure that interstate commerce is neither undertaxed nor overtaxed, and lessens the possibility that Congress will intervene in state taxation."
For some time, the MTC Uniformity Subcommittee on Income Tax has been exploring the feasibility of drafting a model law on the taxation of funeral trust income. This issue developed when Congress passed Section 685 of the Internal Revenue Code in 1997. This new section, which was supported by the industry, permits trustees of qualified funeral trusts (QFTs) to elect to pay the federal tax on earnings. If this Sec. 685 election is made by the trustee, then the preneed purchaser is relieved from reporting and paying any federal income tax on the trust income.
However, this development raised an issue from the viewpoint of the state income taxation of QFT income. If the trust assumes responsibility for preneed purchasers' state income tax liability, then in which state(s) is the trust income taxable? The original language developed by the MTC Subcommittee sought to impose a state income tax filing requirement for each qualified funeral trust based on the residence of the customer at time of funding. This language was developed because the Subcommittee felt it was the method least susceptible to manipulation. Specifically, there was concern that if the trust's state of residence was used to determine which state is entitled to tax the trust earnings, trusts would "forum shop" and move to states with no income tax. This distinction is an important one impacting both local and national operations by potentially forcing trustees to compute trust earnings based on a customer's state of residence at the time of each installment payment. This would add a substantial administrative burden to an already complicated process.
Among other issues involved, the MTC subcommittee considered the following:
1) The grantor, that is, the purchaser, (a resident of State A) is different from the beneficiary of the funeral trust (resident of state B), such as where an adult child funds a funeral trust for his/her parent.
2) Two or more grantors (residents of State A and State B) are different from the beneficiary of the funeral trust (resident of State C), such as where two children fund a funeral trust for a parent.
3) The grantor funds the funeral trust in two installments with an intervening change in residence.
4) A beneficiary asks his/her child living in a state without a personal income tax (Nevada, Texas, Washington, Wyoming) to fund the funeral trust with a tacit understanding that the beneficiary will reimburse the child.
5) The qualified funeral trust derives source income from the taxing state, even though it is not a resident of the taxing state; for example, an investment interest in a partnership that derives source income from the taxing state.
It was pointed out that the state of Iowa decided to exempt qualified funeral trusts from its state income tax "because it viewed the administrative costs of collecting the tax to be greater than the amount of tax collected. While states may be reluctant to go to that extreme, maybe the rules that are developed should favor simplicity even though gaps in application may appear."
MTC Subcommittee members discussed these issues with members of the ICFA Tax Subcommittee during a recent conference call. Representing the ICFA were industry tax specialists Robert Topp, Alex Trostorff and Paul German, and ICFA general counsel Bob Fells.
The industry representatives expressed their belief that "forum shopping" by trusts would be difficult if not impossible in most states due to various legal requirements already in existence. They also discussed the administrative complexities in attempting to keep track of the residences of literally hundreds of thousands of preneed purchasers over a period of years and decades.
At that point, the MTC subcommittee invited the ICFA to develop language for a model law that taxed funeral trust income based on the state residence of the trust. This project is currently in progress, and further developments will be reported to ICFA members.
Copyright ICFA 2000.
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