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Trust & Estate Association Comments on Qualified Tuition Plans

FEB. 25, 2003

Trust & Estate Association Comments on Qualified Tuition Plans

DATED FEB. 25, 2003
DOCUMENT ATTRIBUTES
  • Authors
    McCaffrey, Carlyn S.
  • Institutional Authors
    American College of Trust and Estate Counsel
  • Cross-Reference
    For a summary of Notice 2001-55, see Tax Notes, Sep. 17, 2001,

    p. 1539, Doc 2001-23435 (3 original pages) [PDF], 2001 TNT 175-

    10 Database 'Tax Notes Today 2001', View '(Number', or H&D, Sep. 10, 2001, p. 2295. For a summary of

    Notice 2001-81, see Tax Notes, Dec. 17, 2001, p. 1563; for the

    full text, see Doc 2001-30416 (7 original pages) [PDF], 2001 TNT

    237-8 Database 'Tax Notes Today 2001', View '(Number', or H&D, Dec. 10, 2001, p. 2493. For the full text

    of the EGTRRA, see Doc 2001-15198 (158 original pages) [PDF], or

    2001 TNT 104-6 Database 'Tax Notes Today 2001', View '(Number'.
  • Code Sections
  • Subject Area/Tax Topics
  • Jurisdictions
  • Language
    English
  • Tax Analysts Document Number
    Doc 2003-10312 (22 original pages)
  • Tax Analysts Electronic Citation
    2003 TNT 84-32
February 25, 2003

 

Internal Revenue Service

 

CC:ITA:RU (Notice 2001-55)

 

Room 5226

 

P.O. Box 7604

 

Ben Franklin Station

 

Washington, D.C. 20044

 

Re: Comments of the American College of Trust and Estate Counsel on Section 529 Plans

 

Dear Sir or Madam:

[1] I am the President of The American College of Trust and Estate Counsel (the "College"), a professional association of over 2,600 lawyers from throughout the United States. Fellows of the College are elected to membership by their peers on the basis of professional reputation and ability in the fields of trusts and estates and on the basis of having made substantial contributions to these fields through lecturing, writing, teaching, and bar activities.

[2] This submission constitutes the response of the College to your request for public comment concerning qualified tuition programs under section 529 of the Internal Revenue Code of 1986, as amended (the "Code"), including the amendments made by the Economic Growth and Tax Relief Reconciliation Act of 2001 (Pub. L. No. 107-16, 115 Stat. 38) ("EGTRRA"), and to matters described in Notice 2001-55, 2001-39 I.R.B. 1 and Notice 2001-81, 2001-52 I.R.B. 1. We have identified a number of issues that we believe are either unclear or otherwise problematic and should be addressed. These issues are discussed below, along with suggestions for their resolution. For purposes of convenience, we shall refer to qualified tuition plans established under Code section 529 simply as "529 Plans."

1. Treatment of Sponsor-Imposed Penalties and Fees. Does any penalty or do any fees imposed by the sponsor of a 529 Plan reduce the amount of any payment or distribution subject to ordinary income tax?

[3] Code § 529(b)(3) formerly provided "A program shall not be treated as a qualified State tuition program unless it imposes a more than de minimis penalty on any refund of earnings from the account" with three exceptions. To comply with that statutory requirement, all states that enacted 529 Plan enabling legislation imposed a penalty, typically 10% of the amount of the earnings refunded. EGTRRA deleted that requirement and substituted a 10% additional tax on refunded earnings. However, many states have not repealed their penalties yet, and some may choose to retain them indefinitely. Does the amount of any sponsor-imposed penalty reduce the amount of the earnings subject to ordinary income tax under Code § 529(c)(3) (thereby reducing the additional 10% tax under Code § 529(c)(6))? Or, if the sponsor-imposed penalty does not reduce the amount of the earnings subject to ordinary income tax, is the sponsor-imposed penalty deductible under Code § 212?

[4] Ordinarily, the Code disfavors deductibility of penalties. On the other hand, since the additional 10% tax imposed by Code § 530(d)(4) -- which was intended to replace the sponsor-imposed penalty requirement -- will apply to any such distribution, should any sponsor-imposed penalty be treated as reducing the amount of the earnings subject to ordinary income tax? Alternatively, can the sponsor-imposed penalty be treated as an amount deductible under Code § 212? Clarification on this issue would be helpful to taxpayers.

[5] Furthermore, some 529 Plans may impose administrative or termination fees or costs that are clearly not penalties, but instead intended to defray the sponsor's costs of administering the 529 Plan. Do such fees reduce the amount of earnings subject to ordinary income tax under Code § 529(c)(6) or are they deductible under Code § 212? Clarification on this issue would also be helpful to taxpayers.

2. Safe Harbor for Prohibition Against Excess Contributions. Can the current regulation regarding the safe harbor on the prohibition on excess contributions be revised to include provisions for graduate school?

[6] Code § 529(b)(6) provides that "A program shall not be treated as a qualified tuition program unless it provides adequate safeguards to prevent contributions on behalf of a designated beneficiary in excess of those necessary to provide for the qualified higher education expenses of the beneficiary." Proposed Regulations § 1.529-2(i)(2) provides a safe harbor for programs that limit the amount of contributions to that "necessary to pay tuition, required fees, and room and board expenses . . . for five years of under-graduate enrollment . . ." At present, many 529 Plans allow for contributions in excess of the five-year safe harbor amount, presumably allowing funding for not only for undergraduate expenses, but some graduate school expenses as well.

[7] It would be helpful to taxpayers to know whether 529 Plans that allow for contributions in excess of the five-year safe harbor risk losing their status as a qualified tuition plan. A seven-year or eight-year safe harbor would adequately address this issue. Alternatively, the regulations could provide for a dollar amount, to be recalculated annually, that would serve as a safe harbor. Such amount could be indexed to the cost of eight years of education at the highest cost eligible educational institution.

3. Rollovers Within 12 Months of Establishing Account. Will a rollover to another state plan within 12 months of establishing the original account be treated as a non-qualified distribution?

[8] Code § 529(c)(3)(C)(iii) states that Code § 529(c)(3)(C)(i)(I) (permitting a rollover without changing the beneficiary) "'shall not apply to any transfer if such transfer occurs within 12 months from the date of a previous transfer to any qualified tuition program for the benefit of the designated beneficiary." A rollover within 12 months of establishing the account or within 12 months of making a contribution to an account should not fall within the language of Code § 529(c)(3)(C)(iii), but clarification on this issue would be helpful.

4. Aggregation in the Case of Certain Rollovers. Will accounts with different account owners for the same designated beneficiary be aggregated for purposes of applying Code § 529(c)(3)(C)(iii)?

[9] An account owner could roll over an account for a designated beneficiary without realizing that another account for the same designated beneficiary, but with a different account owner, had been rolled over within 12 months. Guidance stating that accounts with different account owners for the same designated beneficiary will not be aggregated for this purpose would be helpful.

5. Excess Contribution Limitations for Multiple Account Owners When the Beneficiary Is the Same in All Accounts. Are separate 529 Plan accounts with different account owners but the same designated beneficiary subject to the excess contribution limitation?

[10] Although similar to the preceding question, this question poses different policy considerations. Aggregation would seem to be even less appropriate in this context, because each account owner (not just one) will generally have the power to change the designated beneficiary, and there is no reason to assume that they would act in concert. If aggregation is required, the determination and reporting will be easier, because all relevant information would be available to a single 529 Plan administrator. No access would be required to the database of another 529 Plan.

[11] The policy considerations inherent in this situation are made clear by the following example: A establishes a 529 Plan account for B, who is A's child. A's account is currently worth $50,000. C establishes a 529 Plan account for B, who is C's grandchild. C's account is currently worth $150,000. The 529 Plan has a maximum contribution limitation of $200,000. If the 529 Plan administrator disallows any further contributions from A or C, and C subsequently decides to revest the balance in the account, then B will be severely short-changed, and A will have been precluded from making additional contributions. Moreover, privacy of information concerns suggest that aggregation is not appropriate. Both taxpayers and 529 Plan administrators need clarification on this issue.

6. Excess Contribution Limitations When Account Growth Exceeds the Maximum Contribution. Does the prohibition against excess contributions apply to 529 Plan account balances?

[12] The clear wording of Code § 529(b)(6) is that contributions cannot exceed the amount determined by the 529 Plan to be necessary for the designated beneficiary's qualified higher education expenses. The statute is silent with respect to account balances. In other words, even if contributions do not exceed the maximum, will accumulated earnings in a 529 Plan account that cause the account balance to exceed the maximum in turn jeopardize the status of that 529 Plan as a qualified tuition plan. It would be useful to both taxpayers and 529 Plan administrators to know how the Service will treat this issue, because certain 529 Plans currently require that any growth in an account above the maximum contribution amount be refunded.

7. Gift Tax Consequences. Who is the donor for gift tax purposes when there is a change in designated beneficiary or rollover of a 529 Plan account?

[13] Code § 529(c)(5) states as follows:

 

(B) TREATMENT OF DESIGNATION OF NEW BENEFICIARY. -- The taxes imposed by chapters 12 and 13 shall apply to a transfer by reason of a change in the designated beneficiary under the program (or a rollover to the account of a new beneficiary) only if the new beneficiary is a generation below the generation of the old beneficiary (determined in accordance with section 2651).

 

[14] Nowhere does the statute identify the identity of the donor for purposes of chapter 12. Yet Proposed Regulations § 1.529-5(b)(3)(ii) states in pertinent part:

 

A transfer which occurs by reason of a change in the designated beneficiary, or a rollover of credits or account balances from the account of one beneficiary to another beneficiary, will be treated as a taxable gift by the old beneficiary to the new beneficiary if the new beneficiary is assigned to a lower generation than the old beneficiary, as defined in section 2651, regardless of whether the new beneficiary is a member of the family of the old beneficiary.

 

[15] It is clear under the tax law that the Service cannot legislate through regulations. Yet that is what the Proposed Regulations seek to do. The Proposed Regulations seek to make the old beneficiary the donor for gift tax purposes, even though there is no statutory basis for doing so. There are both legal and practical problems with the position taken by the Proposed Regulations.

[16] First, the gift tax has been determined to be an excise tax imposed on the privilege of transferring property. Otherwise, it would be an unconstitutional direct tax. However, in the case of a 529 Plan account, unless the designated beneficiary is also the account owner, the designated beneficiary has no power to change the designated beneficiary or to effect a rollover. At most, the designated beneficiary possesses a mere expectancy. But clearly the old beneficiary has no power to transfer anything. Lacking any legally cognizable property interest, the old beneficiary cannot have actually transferred anything for gift tax purposes.

[17] Second, apart from the constitutional issue, there are very real practical problems with treating the old beneficiary as the donor. A designated beneficiary may not even know of the existence of the 529 Plan account for his or her own benefit, let alone whether and when the designated beneficiary has been changed by the account owner. Therefore, how will the old beneficiary know if a gift has been made and, if so, the amount of the gift, whether a gift tax return is required to be filed by the old beneficiary, and whether five-year averaging is appropriate. If the old beneficiary does not know that a change in designated beneficiary requires filing of a gift tax return, five-year averaging may not be available, and the old beneficiary will have his or her applicable credit amount used involuntarily. In rare cases involving very large 529 Plan account balances, the old beneficiary may actually owe gift tax without ever knowing it.

[18] Therefore, the regulations should either require the account owner to notify the old beneficiary of the transfer or instead permit the account owner to file the requisite return and make the five-year averaging election on the old beneficiary's behalf. In that case, however, the account owner presumably will have to determine what, if any, other gifts the old beneficiary has made to the new beneficiary and also appraise the old beneficiary of the gift and the election. This approach poses its own obvious problems, because the account owner will not necessarily have access to information from the old beneficiary concerning other gifts made.

[19] If the 529 Plan account is worth less than five times the annual exclusion amount and the old beneficiary is young, it is unlikely that the old beneficiary will be using his or her gift tax annual exclusion with respect to actual annual exclusion gifts to the new beneficiary. Perhaps a de minimis rule can be incorporated into the regulations with respect to gifts of less than five times the annual exclusion amount when the gift is deemed to be made by an old beneficiary who is a minor. Some exceptions may be necessary, however, to cover the possibility that the old beneficiary is the deemed donor with respect to transfers to the same new beneficiary from more than one 529 Plan account, the account owners of which are not the same and do not confer with each other. For example, suppose it becomes apparent that old beneficiary B will not be able to attend college due to some disability. Separately and without conferring with each other, upon learning of the disability, B's maternal grandmother and B's paternal grandmother name B's newborn niece as the new beneficiary of the 529 Plan account with respect to which each grandmother is the account owner.

[20] If, as may very well be the case, the 529 Plan account exceeds five times the annual exclusion amount at the time of the transfer, the five-year averaging election will not shelter the entire deemed gift from tax. Given the probable youth of the old beneficiary, it is likely that his or her applicable credit amount will be available to shelter any such gift. It would be helpful if the regulations address how the use of the old beneficiary's credit is to be handled, especially if it will be the account owner and not the beneficiary who reports the deemed gift.

[21] One possibility may be for the regulations to provide for any tax due on the value of the account in excess of five time the annual exclusion amount to be paid from the 529 Plan transfer itself, on a net basis taking into account the amount actually transferred to the new beneficiary after payment of such gift taxes and any income taxes generated as a result thereof. This solution would be particularly appropriate if the account owner is unable or unwilling to (i) furnish the requisite information to the old beneficiary to enable him or her to file the return, or (ii) obtain sufficient information from the old beneficiary as to his or her available applicable credit amount.

[22] By treating the old beneficiary as the donor for gift tax purposes, the Service will be undermining the voluntary reporting system central to the enforcement of our entire tax system. However, even this approach is likely to reduce use of 529 Plans because it will cause disclosure of more information to designated beneficiaries than account owners typically desire.

8. Election to Apply Maximum Annual Exclusion Each Year. If a donor elects to use the five-year averaging election, can the donor elect to apply the maximum amount of annual exclusion to the gift each year?

[23] Code § 529(c)(2)(B) provides as follows:

 

TREATMENT OF EXCESS CONTRIBUTIONS. -- If the aggregate amount of contributions described in subparagraph (A) during the calendar year by a donor exceeds the limitation for such year under section 2503(b), such aggregate amount shall, at the election of the donor, be taken into account for purposes of such section ratably over the 5-year period beginning with such calendar year.

 

[24] Currently, Proposed Regulations § 1.529-5(b)(2) provides guidance on how excess contributions are treated. The Proposed Regulations, however, do not address the situation where a donor makes a gift of less than $55,000. For example, if A, the donor, makes a contribution of $25,000 in year 1 and elects Code § 529(c)(2)(B) treatment, is the donor required to treat the contribution as $5,000 per year, or can the donor elect maximum annual exclusion treatment, so that the donor would utilize $11,000 of annual exclusion in years 1 and 2 and $3,000 in year 3?

[25] Averaging of Taxable Amount. If the gift exceeds five times the annual exclusion and the five-year averaging election is made, when is the excess reported?

[26] Code § 529(c)(2)(B) appears to require that the entire gift, including any excess over five times the annual exclusion, be reported ratably over the five-year period. Proposed Regulations § 1.529-5(b)(2), however, requires that the excess be reported as a taxable gift in the first year.

[27] Repeat Averaging Elections. Can the five-year averaging election under Code § 529(c)(2)(B) be made more than once in a five-year period?

[28] The Proposed Regulations provide:

 

Under section 529(c)(2)(B), a donor may elect to take certain contributions to a QSTP into account ratably over a five year period in determining the amount of gifts made during the calendar year. The provision is applicable only with respect to contributions not in excess of five times the section 2503(b) exclusion amount available in the calendar year of the contribution. Any excess may not be taken into account ratably and is treated as a taxable gift in the calendar year of the contribution. . . . If in any year after the first year of the five year period described in section 529(c)(2)(B) the amount excludible under section 2503(b) is increased as provided in section 2503(b)(2), the donor may make an additional contribution in any one or more of the four remaining years up to the difference between the exclusion amount as increased and the original exclusion amount for the year or years in which the original contribution was made.

 

[29] The five-year averaging election should be permitted to be made more than once in every five-year period so long as the election in any year does not apply to an amount greater than five times the annual exclusion for that year less five times the amount treated as a gift for such year by reason of a prior five-year averaging election. For example, if in year 1 donor contributes $30,000 to an account for a designated beneficiary and makes the five-year averaging election, the donor will be treated as making a gift of $6,000 for each of years 1 through 5. If in year 2 the gift tax annual exclusion is $10,000 and the donor makes an additional contribution of $20,000 to the account for the designated beneficiary, the donor should be allowed to make the five-year averaging election, which would treat the donor as having made an additional gift of $4,000 per year for each of years 2 through 6. However, any contribution in year 2 in excess of $20,000 must be treated as a gift in year 2 (assuming no election is made to split the gift with the donor's spouse). If in year 3 the annual exclusion is increased to $11,000, the donor may make an additional contribution of $5,000 and make the five-year averaging election to treat it as an additional gift of $1,000 for each of years 3 through 7.

                    Year 1  Year 2  Year 3   Year 4 Year 5  Year 6  Year 7

 

 

Gift Tax Annual

 

Exclusion           10,000  10,000  11,000

 

 

Actual Gift         30,000  20,000   5,000

 

 

Year 1 Deemed Gift   6,000   6,000   6,000   6,000   6,000

 

Year 2 Deemed Gift           4,000   4,000   4,000   4,000  4,000

 

Year 3 Deemed Gift                   1,000   1,000   1,000  1,000  1,000

 

Total Deemed Gifts   6,000  10,000  11,000  11,000  11,000  5,000  1,000

 

 

[30] Split Gift Election. If a person makes a contribution to a 529 Plan account, makes the five-year averaging election, and that person's spouse makes the split gift election in year 1, do the husband and wife have to qualify to make and, in fact, make the split gift, election in years 2 through 5 in order to continue treating the gift as if each spouse had made one-tenth of the gift in each year?

[31] For example, if the couple divorces during year 1, but still qualify to make and do, in fact, make the split gift election in year 1, is the portion of the gift attributable to years 2 through 5 still split? Or, alternatively, if the spouse simply refuses in year 2 to make the split gift election, is one-tenth of the gift still attributed to him for year 2? This is a "which comes first: the chicken or the egg?" issue. Does the five-year averaging election come first, in which case the split gift election must be made each year? Or, does the split gift election come first, in which case all that matters is whether the split gift election is made in year 1?

[32] The Instructions to Form 709 state: "If you are electing gift splitting for contributions, apply the gift splitting rules before applying these rules." This would seem to imply that husband and wife first decide whether to split year 2002 gifts. If they do, then they each report one-half of the gift, and each can decide independently whether or not to make the five-year averaging election with respect to his or her portion of the gift. If they both decide to make the five-year averaging election, they each have to file a gift tax return making the election. Under this construction they only have to qualify to make the split gift election in 2002. This position is consistent with (a) the Proposed Regulations, which require that if a gift is split and five-year averaging is desired, both spouses have to file gift tax returns and make the election, (b) the position that if one spouse dies during the five-year period, only that spouse's portion of the gift is brought back into the deceased spouse's gross estate, and (c) with the desire expressed in the Proposed Regulations (not clearly mandated by the statute) to require that the taxable portion of the gift be reported entirely in year 1.

[33] The position that the split gift election comes first and is made only in year 1 has some interesting, but not necessarily troubling, consequences. First, presumably one spouse could elect five-year averaging and the other could not. Second, the portion of the gift attributable to one spouse in any future year would itself be split if a split gift election is made for that year. This would be relevant if one spouse elected five-year averaging and the other did not. It would also be relevant if one spouse remarried during the five-year period. If the split gift election was made separately for each of the five years, and the non-donor spouse did not qualify to make the election or refused to make the election in a subsequent year, the tax results would be unduly complicated.

[34] Assume wife contributes $110,000 to a 529 Plan account, makes the five-year averaging election and husband agrees to split gifts in year 1. For year 1 each is treated as having made a gift of $11,000 to the beneficiary. If the gift splitting election must be made separately for each year, and husband and wife divorce in year 2 and neither remarries before the end of the year, they are eligible to split gifts. But if husband refuses to split gifts, then presumably wife would have an $1 1,000 taxable gift in year 2. In years 3 through 5 they would not be eligible to split gifts (unless they remarry each other), so wife would have a taxable gift of $11,000 in each of those years.

9. Contribution to Account Owned by Another Individual. If a person (the "Contributor") makes a contribution to a 529 Plan account with respect to which another individual is the account owner and a third individual is the designated beneficiary, and the account owner has the power to receive distributions from the account under the 529 Plan, is the Contributor or the designated beneficiary treated as having made a transfer to the account owner for purposes of chapters 12 and 13?

[35] Code § 529(c)(2) provides that any "contribution to a qualified tuition program on behalf of any designated beneficiary . . . shall be treated as a completed gift to such beneficiary which is not a future interest in property. . . ." Code § 2612(c)(1) defines a "direct skip" to mean a "transfer subject to a tax imposed by chapter 11 or 12 of an interest in property to a skip person."

[36] Absent Code § 529, a contribution to an account over which a third party account owner had a power of withdrawal, and over which the Contributor retained no powers, would constitute a gift from the Contributor to the account owner and potentially a GST transfer if the account owner was a skip person with respect to the Contributor. However, because Code § 529 clearly states that the contribution is to be treated as a completed gift to the designated beneficiary, it would be illogical and inconsistent also to treat the contribution as a gift to the account owner. If the contribution is not treated as a gift to the account owner, it cannot be treated as a direct skip to the account owner for GST purposes even if the account owner is a skip person with respect to the Contributor.

[37] In order to treat the contribution as a gift to the account owner consistent with Code § 529(c)(2), the transfer would have to be treated either (1) as a completed gift to the designated beneficiary under Code § 529, followed by a gift from the designated beneficiary to the account owner, as in the case where a designated beneficiary is changed to someone who is not a member of the family of the old beneficiary, or (ii) as a completed gift by the Contributor to the account owner followed by a transfer from the account owner to the designated beneficiary under Code § 529. Neither analysis reflects the reality that only one transfer occurred.

[38] Further, because Code § 529 is unique in allowing changes of beneficial interests not to be treated as subsequent gifts, for example, where the designated beneficiary is changed to a member of the family of the old designated beneficiary who is not in a lower generation or where a refund is made to the Contributor/account owner, the possibility of a future distribution to an account owner who is not the Contributor should not be troubling, at least so long as the account owner (i) is a member of the family of the old designated beneficiary who is not in a lower generation than the old beneficiary, (ii) is a fiduciary for the designated beneficiary, such as a trustee or a custodian under a Uniform Transfers to Minors Act, (iii) is a fiduciary for the Contributor, such as a trustee of the Contributor's revocable trust, or (iv) has no power to distribute the account to himself or herself

[39] In abusive situations traditional doctrines such as the step transaction doctrine or the sham transfer doctrine may apply.

10. Change in Account Owner. If an account owner has the right to receive distributions from the account, the account owner is changed and the new account owner has the right to receive distributions from the account, has a transfer occurred for purposes of chapters 12 and 13?

[40] Code § 529(c)(2) provides that any "contribution to a qualified tuition program on behalf of any designated beneficiary . . . shall be treated as a completed gift to such beneficiary which is not a future interest in property. . . ."

[41] Code § 529(c)(5)(A) provides that for purposes of chapters 12 and 13, "Except as provided in subparagraph (B), in no event shall a distribution from a qualified tuition program be treated as a taxable gift." Subparagraph (B) provides that "The taxes imposed by chapters 12 and 13 shall apply to a transfer by reason of a change in the designated beneficiary under the program (or a rollover to the account of a new beneficiary) only if the new beneficiary is a generation below the generation of the old beneficiary. . . ."

[42] The Proposed Regulations appear to impose an additional requirement that the new designated beneficiary be a member of the family of the old designated beneficiary. Proposed Regulations § 1.529-5(b)(3)(i) provides:

 

A transfer which occurs by reason of a change in the designated beneficiary, or a rollover of credits or account balances from the account of one beneficiary to the account of another beneficiary, is not a taxable gift and is not subject to the generation-skipping transfer tax if the new beneficiary is a member of the family of the old beneficiary, as defined in section 1.529-1(c), and is assigned to the same generation as the old beneficiary, as defined in section 2651.

 

[43] The Proposed Regulations define "distribution" to include "a refund to the account owner." Proposed Regulations § 1.529-1(c).

[44] Because Code § 529 states that a contribution is treated as a gift to the designated beneficiary, any gift that occurred upon a change in the identity of the account owner would necessarily be a gift from the designated beneficiary to the new account owner. However, the designated beneficiary's interest in the 529 Plan account has in no manner changed merely because the identity of the account owner has changed, and, therefore, no gift should be deemed to have occurred when the identity of the account owner changes. In addition, treating the change of the account owner as a gift would have the anomalous result of producing yet another gift from the account owner to the designated beneficiary if distributions are later made to the designated beneficiary. Further, because under Code § 529 a distribution to the account owner cannot be treated as a gift, as discussed in Question 11 below, it would be inconsistent to treat a change in the identity of the account owner as a gift. Nonetheless, in abusive situations traditional doctrines such as the step transaction doctrine or the sham transfer doctrine may apply.

11. Transfer Tax Consequences of Distribution to Account Owner. Under what circumstances, if any, is a distribution from a 529 Plan account to the account owner, where the account owner is not the designated beneficiary, treated as a transfer for purposes of chapters 12 and 13?

[45] The statutory and regulatory background for analyzing this question is set forth in the comments to the preceding question. The statute is clear that a distribution to an account owner cannot be treated as a taxable gift or a GST transfer because there is no change in the designated beneficiary. Confirmation of this position would be helpful to taxpayers and their advisers. Furthermore, clarification would be helpful if the Service believes the result might be different in abusive situations.

12. Gift Tax Annual Exclusion for Contribution to Trust-Owned Account. Contributor contributes to a 529 Plan account with respect to which an irrevocable trust is the account owner. Assuming contributions made directly to the trust would not qualify for the gift tax annual exclusion, would the contribution to the 529 Plan account qualify for the gift tax annual exclusion? Can the five-year averaging election under Code § 529(c)(2)(B) be made by the Contributor?

[46] Code § 529(c)(2) provides that any "contribution to a qualified tuition program on behalf of any designated beneficiary . . . shall be treated as a completed gift to such beneficiary which is not a future interest in property. . . ."

[47] Code § 2642(c)(3) provides that a "nontaxable gift" means any transfer of property to the extent such transfer is not treated as a taxable gift by reason of Code § 2503(b).

[48] Code § 529(c)(2)(B) provides: "If the aggregate amount of contributions described in subparagraph (A) during the calendar year by a donor exceeds the limitation for such year under section 2503(b), such aggregate amount shall, at the election of the donor, be taken into account for purposes of such section ratably over the 5-year period beginning with such calendar year."

[49] Because a contribution to an account is treated as a completed gift to the beneficiary that is not a gift of a future interest, the contribution should qualify for the gift tax annual exclusion, notwithstanding that contributions directly to the trust would not qualify for the gift tax annual exclusion. Further, the Contributor should be permitted to make the five-year averaging election under Code § 529(c)(2)(B).

13. Distributions to Account Owner of Trust-Owned Account. Under the scenario described in Question 12, if the trust subsequently receives a distribution from the account, is the distribution treated as a gift?

[50] For the reasons described in Question 12, the distribution to the Trust should not be treated as a gift.

14. GST Annual Exclusion for Contributions to Trust-Owned Account. The facts are as described in Question 12, except that the designated beneficiary of the account is a grandchild of the Contributor. In addition, contributions directly to the trust would not qualify for the GST annual exclusion. What are the chapter 13 consequences of Contributor's contribution to the account? What are the chapter 13 consequences if a distribution is later made from the account to a designated beneficiary who is a skip person with respect to the Contributor?

[51] Code § 529 provides that any "contribution to a qualified tuition program on behalf of any designated beneficiary . . . shall be treated as a completed gift to such beneficiary which is not a future interest in property. . . ."

[52] Code § 2642(c)(3) provides that a "nontaxable gift" means any transfer of property to the extent such transfer is not treated as a taxable gift by reason of Code § 2503(b). Code § 2642(c)(1) provides that in the case of a direct skip which is a nontaxable gift, the inclusion ratio shall be zero. Code § 2642(c)(1) does not apply to a transfer to a trust for the benefit of an individual unless the trust meets certain requirements which are not met in this hypothetical.

[53] Because the contribution qualifies for the gift tax annual exclusion, as described in Question 12 above, and because the contribution is treated as a gift to the designated beneficiary and not as a gift to the trust, as described in Question 12 above, the contribution should qualify for the GST annual exclusion. Further, because the inclusion ratio is zero, a subsequent distribution from the account to a designated beneficiary who is a skip person with respect to the Contributor should have no GST tax consequences.

15. Inclusion in Designate Beneficiary's Estate. If the designated beneficiary of an account dies, is the account balance included in the beneficiary's gross estate?

[54] Code § 529(c)(4)(A) provides that: "No amount shall be includible in the gross estate of any individual for purposes of chapter 11 by reason of an interest in a qualified tuition program." Code § 529(c)(4)(B) provides: "Subparagraph (A) shall not apply to amounts distributed on account of the death of a beneficiary."

[55] Proposed Regulations § 1.529-5(d)(3) states that "[t]he gross estate of a designated beneficiary of a QSTP includes the value of any interest in the QSTP."

[56] Except with respect to the five-year election if the donor dies during the five-year period, Code § 529 does not set forth a special rule for including an account in the estate of any individual. Code § 529(c)(4)(A) provides a special rule excluding an account from the estate. Absent this rule, an account would be included in the estate of the account owner if the account owner had the right to approve or disapprove distributions, to select or change the designated beneficiary, to designate any person other than the designated beneficiary to whom funds may be paid from the account or to receive distributions from the account. However, under most 529 Plans, a designated beneficiary who is not the account owner has none of these rights. Therefore an account should not be included in the beneficiary's estate except to the extent the designated beneficiary has a power over the account that would cause inclusion in the beneficiary's estate under general estate tax principles or the account is distributed to the beneficiary's estate. If, on the other hand, the account owner withdraws the funds or changes the beneficiary upon the death of the designated beneficiary, and the change of beneficiary is not treated as a distribution, no part of the account should be included in the designated beneficiary's estate.

16. Deemed Estate Tax Disposition of Amount Included in Contributor's Estate. C contributes $50,000 to an account it for the benefit of B, C's child, makes the 5-year averaging election and dies in year 3 of the election period. C's spouse S is the successor account owner and has the power to distribute the account to herself. Who is deemed to be the recipient of the portion of the account included in the Contributor's estate? Does the portion of the account included in C's estate qualify for the marital deduction?

[57] Code § 529(c)(4)(A) provides "No amount shall be includible in the gross estate of any individual for purposes of chapter 11 by reason in an interest of a qualified tuition program." Code § 529(c)(4)(C), however, provides that "In the case of a donor who makes the election described in paragraph (2)(B) and who dies before the close of the 5-year period referred to in such paragraph, notwithstanding subparagraph (A), the gross estate of the donor shall include the portion of such contributions properly allocable to periods after the date of the death of the donor."

[58] If the successor account owner is deemed to be the recipient of the portion of the account included in the Contributor's estate, in this case C's spouse, the includible portion should qualify for the marital deduction, because the spouse would have the power to revest the assets of the 529 Plan account in his or her capacity as successor account owner. However, treating the designated beneficiary as the recipient of the portion included in the estate is most consistent with the gift tax treatment of a contribution under Code § 529, which treats a contribution to an account as a completed gift to the designated beneficiary. Under this analysis the marital deduction would not apply even though the successor account owner is the Contributor's spouse.

[59] However, the Service should consider permitting the deemed transfer to be to the distributee to the extent that prior to the time for filing the federal estate tax return, a distribution is made from the account. Thus if the Contributor's spouse were the successor account owner and had the power to distribute the account to herself, she could make such a distribution to qualify the included portion for the marital deduction. Similarly, the Service might permit the beneficiary of the included portion to be changed prior to the time for filing the federal estate tax return, and treat the new designated beneficiary as the recipient of the included portion.

17. Deemed GST Disposition of Account Includible in Contributor's Estate. C contributes $50,000 to an account for the benefit of B, C's grandchild, makes the five-year averaging election and dies in year 3 of the election period. C's child A is the successor account owner. Is C's death a GST transfer? Are future distributions to B GST transfers?

[60] Code § 529(c)(2)(A) provides that for purposes of chapters 12 and 13, "Any contribution to a qualified tuition program on behalf of any designated beneficiary . . . shall be treated as a completed gift to such beneficiary which is not a future interest in property . . .". Code § 529(c)(2)(B) provides that "If the aggregate amount of contributions described in subparagraph (A) during the calendar year by a donor exceeds the limitations for such year under section 2503(b), such aggregate amount shall, at the election of the donor, be taken into account for purposes of such section ratably over the 5- year period beginning with such calendar year." Code § 529(c)(4) provides that "No amount shall be includible in the gross estate of any individual for purposes of chapter 11 by reason of an interest in a qualified tuition program." Code § 529(c)(4)(C) provides "In the case of a donor who makes the election described in paragraph (2)(B) and who dies before the close of the 5-year period referred to in such paragraph, notwithstanding subparagraph (A), the gross estate of the donor shall include the portion of such contributions properly allocable to periods after the date of the death of the donor."

[61] Code § 2612(c) provides that the term "direct skip" means "a transfer subject to a tax imposed by chapter 11 or 12 of an interest in property to a skip person." Code § 2613(a) defines "skip person" to mean either "a natural person assigned to a generation which is 2 or more generations below the generation assignment of the transferor" or "a trust if all interests in such trust are held by skip persons, or if there is no person holding an interest in such trust, and at no time after such transfer may a distribution (including distributions on termination) be made from such trust to a non-skip person." Code § 2652(b) defines the term "trust" to include "any arrangement (other than an estate) which, although not a trust, has substantially the same effect as a trust."

[62] One manner of analyzing this issue would be to conclude that although $20,000 will be included in C's estate pursuant to Code § 529, no "transfer" occurs at C's death, and therefore no direct skip occurs as a result of C's death and a subsequent distribution from the account does not result in a taxable termination or taxable distribution for GST purposes. This analysis avoids the complicated tax problems that would be created for a donor wishing to make a five-year averaging election where the donor does not have sufficient GST exemption remaining at the time of death to allocate to the included portion and that may discourage grandparents from making large gifts to accounts for their grandchildren.

[63] On the other hand, if the portion of the account included in C's estate is deemed to be a "transfer" for GST tax purposes, the transfer should be deemed to be to the designated beneficiary and thus would be a direct skip if the designated beneficiary is a skip person with respect to the Contributor. This would be consistent with Code § 529(c)(2), which for gift tax purposes treats a contribution to a 529 Plan account as a completed gift to the designated beneficiary notwithstanding the fact that the designated beneficiary later may be changed or that the account may be distributed to the account owner. However, absent the adoption of such a special rule, the transfer would not be a direct skip if the designated beneficiary could be later changed to a non-skip person or if the account could be distributed to the account owner and the account owner is not a skip person with respect to the Contributor.

[64] Code § 529(c)(4)(d) should be construed strictly as requiring estate tax inclusion of the portion of the contributions allocable to periods after the date of death of the donor, but not as constituting a new transfer for GST tax purposes. However, the Service should consider permitting the deemed transfer to be to the distributee to the extent that prior to the time for filing the federal estate tax return, a distribution is made from the account. Thus if the Contributor's spouse were the successor account owner and had the power to distribute the account to herself, she could make such a distribution to qualify the included portion for the marital deduction. Similarly, the Service might permit the beneficiary of the included portion to be changed prior to the time for filing the federal estate tax return, and treating the new designated beneficiary as the recipient of the included portion. Thus the beneficiary could be changed to a member of the family of the old beneficiary who is not a skip person with respect to the Contributor, in order to avoid GST tax consequences.

18. GST Transfer from Trust. An irrevocable trust contributes funds to an account, naming B, who is a beneficiary of the trust, as the beneficiary of the tuition savings account. B is a grandchild of the grantor of the trust, and the trust has an inclusion ratio of 1. Is the contribution a GST transfer?

[65] A trust investing its own assets in a tuition savings account is only making an investment of trust assets. An irrevocable trust cannot make a gift, and therefore Code § 529(c)(2) is inapplicable to such a contribution. If the trust authorizes a distribution from the tuition savings account to B, then the distribution should be treated as a trust distribution for GST purposes. The contribution by the trust to an account should not be considered a GST transfer.

19. Distributable Net Income ("DNI") Consequences for Trust-Owned Accounts. If a trust funds a 529 Plan account, will the contribution of trust cash to the 529 Plan account carry out DNI of the trust for the taxable year in which the contribution is made? If a distribution is made from a trust-owned 529 Plan account for qualified higher education expenses, does such distribution carry out DNI of the trust for the taxable year in which the distribution is made? If a non-qualified distribution is made from a trust-owned 529 Plan account to the designated beneficiary, does such distribution carry out DNI of the trust for the taxable year in which the distribution is made? Or does the general rule of annuity treatment of a non-qualified distribution apply?

[66] A contribution by a trustee to a 529 Plan account has all the hallmarks of any other trust investment. There appears to be no sound policy reason why a contribution of trust cash to a 529 Plan account should have any effect on the DNI of the trust for the taxable year in which the contribution is made. It would be helpful to confirm that this is the case.

[67] The entire legislative history of Code § 529 (particularly with the amendments made by EGTRRA) strongly suggests that the intent of Congress was to provide a tax-advantaged manner in which to defray qualified higher education expenses of the designated beneficiary. If a distribution made for qualified higher education expenses from a 529 Plan account with respect to which a trust is the account owner carries out DNI of the trust for that taxable year, the legislative intent will be defeated. The designated beneficiary will have to include in gross income a pro rata share of each category of income earned by the trust outside the 529 Plan. In order to know how to complete the trust's fiduciary income tax return and any applicable Schedule K-1, it is absolutely critical that a trustee know whether a distribution for qualified higher education expenses will or will not carry out DNI of the trust for the taxable year in which the distribution is made. The policy behind Code § 529 strongly suggests that a distribution for qualified higher education expenses should not carry out DNI of the trust for the taxable year in which the distribution is made.

[68] Whether or not a non-qualified distribution should carry out DNI of the trust for the taxable year in which the distribution is made is not suggested by the history of Code § 529. Therefore, the Service needs to decide whether to treat a nonqualified distribution from a trust-owned 529 Plan account as carrying out DNI of the trust for the taxable year in which the distribution is made. An example, particularly if there are both qualified and non-qualified distributions in the same taxable year, would be helpful.

[69] There is another possibility. The general rule regarding income taxation of distributions from a 529 Plan is stated in Code § 529(c)(3): "Any distribution under a qualified tuition program shall be includible in the gross income of the distributee in the manner provided under section 72 to the extent not excluded from gross income under any other provision of this chapter." Therefore, the federal income tax treatment of a non-qualified distribution from a 529 Plan account to the designated beneficiary may be determined entirely by Code § 529(c)(3) and not by the rules under Subchapter J. Trustees and designated beneficiaries must know the answer to this question in order to report a non-qualified distribution from a trust-owned 529 Plan account properly.

20. Income Taxation of Non-Qualified Distribution to Third Party. If the account owner directs a non-qualified distribution to a third party, who pays the income tax?

[70] Some state 529 Plans permit the account owner to direct the distribution to a third party. It is unclear who would pay the income tax and penalty tax in this case. Code § 529(c)(3) states that any "distribution under a qualified tuition program shall be includible in the gross income of the distributee." The Proposed Regulations define "distributee" as "the designated beneficiary or the account owner who receives or is treated as receiving a distribution from a QSTP." Proposed Regulations § 1.529-1(c). Thus, under the Proposed Regulations, a distribution to a third party could be construed as a distribution to the account owner, followed by a gift from the account owner to the third party.

21. Abusive Situations. What uses of 529 Plans will be considered abusive?

[71] Code § 529 is a statute with singular transfer tax characteristics. An account owner may retain or possess powers over a 529 Plan account, such as the power to revest the assets and the power to control the beneficial enjoyment, without adverse transfer tax consequences. Furthermore, the gift and GST tax consequences resulting from a change in designated beneficiary fall on the designated beneficiary. Yet Code § 529 imposes no restrictions on the identity or number of persons for whom 529 Plan accounts may be established or to which contributions may be made. These unique transfer tax characteristics of Code § 529 permit use of the statute in ways that the Service could consider abusive.

[72] For example, consider an individual who employs 100 people. Assuming the particular 529 Plan or Plans he selects do not prohibit this, he could create a 529 Plan account for each of his 100 employees initially designating himself as the account owner of each account. Under Code § 529(c)(2)(A)(i), these transfers will be treated as completed gifts which are not future interests in property. Therefore, all 100 gifts would qualify for the gift tax annual exclusion under Code § 2503(b). Further assume that he funds each 529 Plan account with $10,000, which gifts would not be required to be reported on a gift tax return (assuming the individual made no gifts in excess of the annual exclusion in the same calendar year). At some time subsequent to establishment of the 529 Plan accounts, he changes the account owner on each account to his son, who subsequently exercises the account owner's power to revest the assets of all of the 529 Plans, which would be treated as a distribution under Code § 529(c)(3) and subject the son to income tax (and the additional 10% tax) on the earnings. However, Code § 529(c)(5) states that a distribution from a 529 Plan is not treated as a taxable gift, except in the case of designation of a new beneficiary. Therefore, it appears that a literal interpretation of Code § 529 to the facts posed permits the father to transfer $1,000,000 gift tax-free to his son.

[73] The College does not believe that Congress intended to undermine the integrity of the gift tax system by enacting Code § 529. Moreover, from a taxpayer's standpoint, the desirability of establishing and making gifts to 529 Plan accounts would be reduced if abuses cause the Service to adopt draconian regulations. Ultimately, whether a situation is abusive may have to be judged on the particular facts and circumstances of each case. Nevertheless, guidance would be useful to taxpayers and their advisors to know if there are specific uses of 529 Plans that will be considered abusive by the Service.

[74] One possible approach to minimizing the potential for abuse of 529 Plans is to consider requiring taxpayers to report on a gift tax return all transfers to 529 Plans where the designated beneficiary is not a member of the donor's family. This would provide the Service with initial information to determine whether an abuse might exist.

[75] Another is for the Service to require specific disclosures on an individual income tax return concerning distributions from 529 Plans. A schedule or form could be developed that requires disclosure of whatever information would best allow the Service to identify abusive situations.

[76] Moreover, the Service could exercise its power under Code § 529(d) to require sponsors to provide such information as the Service in its judgment deems necessary or desirable to discover abusive situations.

[77] Finally, the Service can consider issuing an announcement of the sort used in connection with accelerated charitable remainder trusts to put potential abusers on notice that the Service considers certain uses of 529 Plans as abusive.

[78] These comments were prepared by Robert J. Rosepink, Esq., of Rosepink & Estes, P.L.L.C., Scottsdale, Arizona, Susan T. Bart, Esq., of Sidley Austin Brown & Wood, Chicago, Illinois, Mervin M. Wilf, Esq., of Mervin M. Wilf, Ltd., Philadelphia, Pennsylvania, and Linda B. Hirschson, Esq., of Greenberg Traurig, New York, New York.

[79] We appreciate the opportunity to submit these written comments and would welcome the opportunity to offer any additional assistance that might be desired.

Sincerely,

 

 

Carlyn S. McCaffrey

 

The American College of Trust and

 

Estate Counsel

 

Los Angeles, CA
DOCUMENT ATTRIBUTES
  • Authors
    McCaffrey, Carlyn S.
  • Institutional Authors
    American College of Trust and Estate Counsel
  • Cross-Reference
    For a summary of Notice 2001-55, see Tax Notes, Sep. 17, 2001,

    p. 1539, Doc 2001-23435 (3 original pages) [PDF], 2001 TNT 175-

    10 Database 'Tax Notes Today 2001', View '(Number', or H&D, Sep. 10, 2001, p. 2295. For a summary of

    Notice 2001-81, see Tax Notes, Dec. 17, 2001, p. 1563; for the

    full text, see Doc 2001-30416 (7 original pages) [PDF], 2001 TNT

    237-8 Database 'Tax Notes Today 2001', View '(Number', or H&D, Dec. 10, 2001, p. 2493. For the full text

    of the EGTRRA, see Doc 2001-15198 (158 original pages) [PDF], or

    2001 TNT 104-6 Database 'Tax Notes Today 2001', View '(Number'.
  • Code Sections
  • Subject Area/Tax Topics
  • Jurisdictions
  • Language
    English
  • Tax Analysts Document Number
    Doc 2003-10312 (22 original pages)
  • Tax Analysts Electronic Citation
    2003 TNT 84-32
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