Posted: December 9, 2013
As part of the Health Care and Education Reconciliation Act of 2010, Congress enacted a new 3.8% "unearned income Medicare contribution" tax, which applies in addition to the regular income tax. At the time of its enactment, it was uncertain how this new tax would apply to certain special classes of trusts, including Internal Revenue Code Section 685 qualified funeral trusts ("QFTs"). In response to comments from NFDA and others, the IRS clarified in its recently issued final regulations that the new Medicare tax applies to QFTs, but on an individual beneficiary basis. NFDA is pleased to share information about this IRS ruling.
This information was prepared with the assistance of the law firm of Morgan Lewis & Bockius, LLP.
As part of the Health Care and Education Reconciliation Act of 2010, Congress enacted a new 3.8% "unearned income Medicare contribution" tax, which applies in addition to the regular income tax. Trusts, for tax years beginning after 2012, are subject to this new 3.8% tax on their "undistributed net investment income" (generally, accumulated non-active business or portfolio investment income), but only to the extent their "adjusted gross income" exceeds a threshold amount equal to the highest trust income tax bracket amount ($11,950 for 2013). Thus, for example, a trust recognizing $20,000 of taxable income attributable to the sale of investment securities in 2013 (which amount, for sake of simplicity, also constitutes the trust's adjusted gross income for the year) will have an additional $305.90 in tax (($20,000 - $11,950) x 3.8%).
At the time of enactment of the 3.8% Medicare tax, it was uncertain how this new tax would apply to certain special classes of trusts, including Internal Revenue Code Section 685 qualified funeral trusts ("QFTs"). In general, a QFT is a trust that arises as a result of a person entering into a pre-need funeral arrangement with a funeral or burial service provider for funeral services or merchandise. The QFT holds and invests the trust funds and uses the funds solely to make payments for the agreed-upon funeral services or merchandise. QFTs can also consist of a single state law trust that administers funds on behalf of multiple pre-need funeral service beneficiaries. As a common example, state funeral director Associations and professional trust companies often establish a so-called "master trust" as a single trust to hold and invest the QFT funds on behalf of a multitude (even thousands) of beneficiaries. While the income generated in the QFT attributable to each beneficiary may be relatively minimal, a single state law funeral trust may generate substantial aggregate levels of income.
On November 30, 2012, the IRS issued proposed regulations for the new 3.8% Medicare tax, which, in the preamble, explained that the tax would apply to QFTs, but sought taxpayer comments on the subject. The NFDA submitted comments with the IRS requesting that (1) QFTs be excluded from the new tax and (2) in the event QFTs were subject to the tax, the IRS clarify that the tax be imposed on an individual beneficiary, rather than an individual trust, basis. Specific to the clarification sought, the NFDA was concerned that the new 3.8% Medicare tax could apply on an aggregate trust-by-trust basis, in which case trusts holding the funds of a large number of QFT beneficiaries, such as "master trusts," could be considered to generate substantial aggregate levels of income and thus be subject to the tax. If, instead, the new tax applied on an individual QFT beneficiary basis as it does for the income tax, the yearly QFT income attributable to each beneficiary likely would not exceed the adjusted gross income threshold necessary to be subject to the new tax.
To illustrate the stakes involved, assume that a single QFT master trust holds the pre-need funeral expense funds of 100 individual beneficiaries and that the QFT's taxable investment income for 2013 attributable to each beneficiary equals $5,000 (which also constitutes the relevant adjusted gross income amount).
In response to the NFDA's and other comments, the IRS clarified in its recently-issued final regulations, effective December 2, 2013, that the new 3.8% Medicare tax applies to QFTs, but on an individual beneficiary basis. See Treas. Reg. § 1.1411-3(b)(2)(i) a copy of which can be found on the NFDA website. As illustrated in the individual beneficiary basis application example above, the tax therefore applies identically to QFTs holding funds on behalf of multiple beneficiaries and QFTs holding funds on behalf of a single beneficiary by, in both situations, applying to the income attributable to each beneficiary and each beneficiary's separate adjusted gross income threshold. The practical impact is that presumably the majority of QFTs will not be subject to this new 3.8% Medicare tax as the yearly investment income attributable to each beneficiary will not exceed the adjusted gross income threshold. However, this special individual beneficiary basis application rule only applies qualifying QFTs. Normal trusts that are not Internal Revenue Code Section 685 QFTs and are not otherwise subject to special rules under the 3.8% Medicare tax would not be eligible for this individual beneficiary basis application rule. These trusts likely would be subject to the new tax on an aggregate trust basis, as illustrated under the aggregate trust application example above.
Required Disclosure Under IRS Circular 230: To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. federal tax advice contained in this communication is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.
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