CRS EXPLAINS TAX TREATMENT OF INTEREST ON PRENEED FUNERAL TRUSTS.

                          December 17, 1990

THE ISSUE

Pre-need funeral trusts are monies set aside for the future payment of the grantor's funeral arrangements. Through the use of pre-need funeral trusts, interest earnings on purchaser monies were not taxed at the individual income tax level to the grantor. The IRS has ruled that such interest earnings should be imputed and taxed to the individual setting up such trust arrangements. Since the Federal individual income tax is progressive, the value of the excluded interest income depended on the grantor's marginal tax rate. Many taxpayers who have set up pre-need funeral trusts since the issuance of Revenue Ruling 87-127 have complained that the interest earnings are more properly attributable to the funeral home than to the individual who has funded the trust.

PERSONAL EXPENDITURES AND TAXABLE INCOME

Funeral expenses are generally viewed to be personal expenditures. As such, under the U.S. income tax laws these expenses are not deductible in determining taxable income. These expenses may, however, be deductible in determining any Federal estate tax that might be due.

In general, the U.S. Federal tax law is structured so that all income is taxable unless a specific exclusion is provided. Examples of such exclusions are the interest on State and local bonds, the $125,000 exclusion of gain from the sale of a principal residence by an individual over the age of 55, employer provided fringe benefits, or the rental value of a parsonage.

The Congress has not provided an exclusion for interest on prepaid funeral expenses and won't allow it by the stratagem of a "trust" either.

RATIONALE FOR CHANGE

In recent years, the Internal Revenue Code has evolved to be more inclusive of income. For example, the impetus behind the Tax Reform Act of 1986 (Public Law 99-514), was to broaden the tax base so that income tax rates could be lowered.

Prior to restrictions in several tax acts, large prepayments (such as entrance fees to elderly care facilities) were often collected by business firms that had offsetting expenses. Thus, those interest earnings on the prepayment subsequently were not imputed as income to the client and that income was not included in determining the client's Federal individual income tax. While the interest earnings were included in the firm's taxable income, offsetting business expenses allowed the interest income to escape taxation at that level.

The Congress provided that such shifting would result in the interest being imputed back to the taxpayer and included in the individual's income. More simply stated, current tax law does not allow interest income to escape taxation by pretending the money belongs to someone else when dominion over those monies is still retained by the taxpayer. The rationale for this tax treatment is that if reductions in the tax base were allowed to take place by shifting, it would contribute to high marginal rates of tax on the smaller tax base of income that remained taxable. Since all taxpayers would not avail themselves of this provision it would violate horizontal equity principles in that all taxpayers with the same purchasing power or similar incomes would not be treated equally. Additionally, those taxpayers most able to take advantage of such a provision would be those of higher income and the least likely to need the tax benefit. Likewise, since higher income taxpayers are generally in a higher tax bracket the benefit would be provided inversely to need.

These same principles have been applied in Revenue Ruling 87-127 issued by the Internal Revenue Service on pre-need funeral trusts. The basic findings under this ruling are that the purchaser is the grantor of the trust, since the monies placed in trust belong to the person setting up the trust, and are placed in the trust soon after purchase. State laws generally provide that the funeral parlor does not have control over the trust and may not use the funds other than for their specified and intended purposes. Dominion over the funds held in trust is further shown by the fact that the purchaser monies are received by the seller and the disposition (both initial amount and interest earnings) reflects the wishes and desires of the purchaser and not the seller. Thus, IRS ruled that the interest income really belongs to the purchaser.

GRANDFATHER CLAUSE

The ruling under Revenue Ruling 87-127 is applied prospectively with what is commonly known as a grandfather clause. The grandfather clause provides that those pre-need funeral contracts entered into before January 29, 1988 will not be affected by Revenue Ruling 87- 127. Thus, those taxpayers who are writing their congressional representatives, are those who have set up such pre-need funeral trusts since 1988 whose interest earnings are now being reported to both them and the Internal Revenue Service.