The Tax Implications of Pre-Need Interest for Funeral Homes

Understanding Pre-Need Trust Fund Structure

Before diving into tax implications, it's crucial to understand how pre-need trusts work. When families purchase pre-need funeral arrangements, they typically place money into a trust account rather than directly paying the funeral home. This structure exists to protect consumers and ensure funds are available when services are needed.

The trust fund itself is a separate legal entity. The money earns interest as it sits in the account—sometimes for years—waiting for the family to need services. This interest is where tax complications arise. Unlike the principal (the original pre-need payment), which is generally not immediately taxable to the funeral home, interest generated by the trust fund has specific tax treatment that varies significantly based on state law, federal regulations, and your funeral home's business entity structure.

Federal Tax Treatment of Pre-Need Trust Interest

At the federal level, the IRS generally classifies pre-need trust fund interest as ordinary income for tax purposes. This means it's taxable to whoever has beneficial ownership or control of the account. The challenge is determining who that is—and that's where things get complicated.

According to IRS Publication 598 (Tax on Individuals Receiving Lump-Sum Distributions), the tax treatment depends on whether the trust is a "qualified funeral trust," which has specific requirements under Section 685 of the Internal Revenue Code.

For most funeral homes, trust interest is taxable as ordinary income in the year it's earned. This is treated similarly to interest earned on any business bank account. The interest must be reported on your federal income tax return—either on Schedule C (for sole proprietors), Form 1120 (for C-corporations), or Form 1120-S (for S-corporations).

State-by-State Variations: A Complex Landscape

While federal tax law treats pre-need interest fairly consistently, state laws vary dramatically. This is one of the most confusing aspects for funeral home operators, especially those operating multi-state operations.

States that tax trust interest: Most states treat pre-need trust interest as taxable income similar to federal treatment. If you're operating in states like California, Florida, Texas, or New York, you generally must report this interest as state taxable income.

States with specific pre-need regulations: Some states mandate that trust interest be handled in specific ways. For example, some states require that interest must be used to fund the services (reducing the amount customers need to pay), while others require interest to be distributed to families, and still others allow funeral homes to retain a portion.

Your state matters enormously. Before accepting your first pre-need contract, consult both your state's funeral board regulations and your state's tax authority. Many small funeral homes have made costly mistakes by not understanding their specific state's requirements. The National Funeral Directors Association (NFDA) maintains state-by-state funeral law resources that can point you in the right direction.

Trust vs. Insurance: Different Tax Treatment

A critical distinction exists between trust-funded pre-need and insurance-funded pre-need arrangements. Many funeral homes use insurance policies instead of trusts to fund pre-need contracts, and these have dramatically different tax implications.

With a trust-funded arrangement, the funeral home or designated trustee holds the money directly, and interest accumulates in that account. With insurance-funded arrangements, the funds go into insurance policies, and the tax treatment is completely different—death benefit proceeds from life insurance are generally not taxable income.

For more information on this distinction, see our article on Pre-Need Trust vs. Insurance Requirements.

Entity Structure Implications: C-Corp vs. S-Corp vs. LLC

Your business structure affects how trust interest is taxed at your funeral home level. A C-corporation, S-corporation, and LLC all have different tax treatment:

• C-Corporations: Trust interest is taxed at the corporate level. The corporation pays tax on the interest income, and then if dividends are distributed to owners, those are taxed again at the individual level (this is "double taxation").
• S-Corporations: Trust interest passes through to shareholders and is reported on their individual returns. This typically results in lower overall tax burden than C-corps.
• LLCs (taxed as partnerships): Similar pass-through treatment as S-corps. Interest flows through to members' personal tax returns.
• Sole Proprietors: All trust interest is reported directly on your personal Schedule C and taxed at individual income tax rates.

This is one area where working with a CPA who understands funeral home accounting is genuinely valuable. The right entity structure choice can save thousands in taxes annually.

Reporting Requirements: Where and How to Report Trust Interest

Once you understand that the interest is taxable, you need to know exactly where to report it:

• Federal: Schedule C (sole prop), Form 1120 (C-corp), or Form 1120-S (S-corp). The interest is reported as "Other Income" or within your business income section.
• State: On your state income tax return in the same way you'd report any other business income. Most states follow federal classification.
• Bank Reporting: If trust interest exceeds $10, your bank will issue a 1099-INT (Interest Income form) in your name or your funeral home's name, which is sent to the IRS and to you.

The 1099-INT is crucial. Your reported interest income must match what the IRS receives from the bank, or you'll trigger an audit notice.

Can You Deduct Trust-Related Expenses?

A natural question: if trust interest is taxable income, can you deduct the costs of maintaining the trust account? Generally, the answer is yes—but only certain expenses qualify.

Deductible: Trust account maintenance fees, trustee fees (if you pay an external trustee), accounting costs specifically related to trust administration, and legal fees for trust setup.

Not deductible: The principal amount of pre-need payments (this is set aside for services you'll provide), payments to families that are made from trust funds, or marketing costs for pre-need services.

This is where record-keeping becomes critical. You must clearly separate trust-specific expenses from general funeral home expenses.

The Interest Disposition Question: Who Gets to Keep It?

In some states, the law is explicit about what must happen with trust interest. In others, it's negotiable. Here are the common scenarios:

• Funeral home retains it: Some states allow the funeral home to keep all trust interest as revenue. This creates a small but meaningful profit center for pre-need operations.
• Interest funds services: Other states require that interest be used to enhance or upgrade the pre-need funeral services at no additional cost to the family.
• Interest distributed to families: Some states require interest to be returned to families (either at service time or annually), which means it's not the funeral home's taxable income.
• Interest to perpetual care: Some pre-need arrangements include perpetual care provisions, where interest is specifically set aside for ongoing cemetery or facility maintenance.

This is absolutely critical: if state law requires interest to be distributed to families, it's not your taxable income. Check your state regulations before assuming trust interest is a profit center. For guidance on your state's specific requirements, see State Regulations for Pre-Need Trust Funds.

Audit Risk and Compliance: Mistakes to Avoid

Because pre-need trust accounting is complicated, the IRS has flagged this area for increased scrutiny. Funeral homes that mishandle trust interest taxation face audit risk and potential penalties. Here are the most common mistakes:

• Reporting trust interest as personal income: If you own the funeral home but the trust is in a business name, you must report it on the business return, not your personal return.
• Ignoring 1099-INTs: The bank reports what it sent you. If your reported income doesn't match, you'll get an audit notice. Always reconcile.
• Failing to deduct legitimate trust expenses: Many funeral homes pay trustee fees but don't deduct them, overpaying taxes unnecessarily.
• Mixing trust interest with regular business income: Keep separate ledgers. This makes tax time simpler and audit defense stronger.
• Not understanding state law: Assuming federal treatment applies when state law says something different. This creates tax liability errors.

Record-Keeping Best Practices

Proper documentation is your best defense against audit complications. Maintain:

• Monthly bank statements showing trust account activity and interest earned
• Separate general ledger accounts for "Pre-Need Trust Interest Income"
• Documentation of how interest is used (retained, distributed, or funding services)
• Trustee fee receipts and payment documentation
• State regulatory correspondence confirming your state's requirements
• Annual reconciliation between 1099-INTs received and reported income

Key Questions for Your CPA

Related Reading on Pre-Need Compliance

Understanding trust interest tax treatment is one piece of the pre-need puzzle. You should also understand:

• State Regulations for Pre-Need Trust Funds – The regulatory framework governing where your funds must be held
• Pre-Need Trust vs. Insurance Requirements – How these different funding mechanisms differ legally and fiscally
• Pre-Need Fund Audits and Reporting Best Practices – How to prepare for regulatory audits and maintain compliant records

Bottom Line

⚠️ FOUNDER NOTE: Pre-need trust interest tax treatment varies by state, by business entity structure, and based on what your state law says must happen with the interest. Interest is NOT automatically your taxable income—in some states, it must be distributed to families or used to enhance services.

Action items: (1) Contact your state funeral board and confirm your state's interest disposition requirements. (2) Meet with a CPA who understands funeral home accounting and review your current pre-need setup. (3) Implement separate accounting for trust interest. (4) Reconcile annually with 1099-INTs. Incorrect treatment can trigger IRS audits and state regulatory penalties—both expensive and time-consuming.