September 12, 2008
The IRS and Treasury recently issued an advance notice of proposed rulemaking in response to reports of abusive transactions involving Section 529 qualified tuition programaccounts. The notice announced that forthcoming proposed regulations would include both a general anti-abuse rule and specific rules to address perceived inconsistencies between Section 529 and certain income and transfer tax provisions.
The IRS and Treasury are taking comments on the issues described by the notice, the information a QTP would need to collect for enforcement purposes, and suggestions for minimizing burdens on QTPs. Ballard Spahr’s Tax and Investment Management Groups are well-positioned to assist QTPs that want to submit comments and, once rules are finalized, to counsel QTPs on implementing the changes.
Background
Section 529 governs the tax treatment of accounts and contracts established under QTPs. Under a QTP, contributions may be made to provide for the waiver or payment of the qualified higher education expenses of a designated beneficiary. A contributor may not deduct contributions, and they are not includible in the income of the DB or the account owner. Earnings accumulate tax-free until a distribution is made, and a distribution for QHEE is not subject to income tax. If a distribution is not used for a DB’s QHEE, the earnings portion of the distribution is subject to federal income tax and a 10 percent additional tax.
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For gift and generation skipping transfer tax purposes, a contribution to a Section 529 account is treated as a completed gift from the contributor to the DB. Contributions qualify for a gift tax exclusion for each donee ($12,000 for 2008), and also are exempt from GST tax to the extent of such exclusions. If a gift exceeds the exclusion, a contribution totaling up to five times the exclusion amount may be spread ratably over the five-year period beginning with the calendar year of the contribution if a timely election is made.
Proposed Section 529 regulations issued in 1998 (1998 Proposed Regulations) did not contain anti-abuse rules. However, the Pension Protection Act of 2006 granted the IRS broad regulatory authority to deal with abusive transactions.
General Anti-Abuse Rule
The general anti-abuse rule envisioned by the Notice would deny favorable transfer tax treatment under Section 529 if contributions were intended or used for purposes other than a DB’s QHEE. Three perceived abuses are targeted:
- Cases where a contributor establishes multiple accounts with different DBs, elects to spread a gift over five years, claims the transfer tax exclusion, subsequently changes the multiple DBs to a single DB, and then causes the entire amount to be distributed to the sole DB without additional transfer tax consequences;
- Cases where a contributor seeks to use a Section 529 account as a retirement account without subjecting it to the restrictions applicable to income tax-qualified retirement accounts; and
- Cases where grandparents contribute $120,0001 to each of their grandchildren in separate Section 529 accounts, name a grandchild as the AO and allow that grandchild to withdraw funds for expenses other than QHEE. Although the AO grandchild would pay the income tax and 10 percent additional tax on the account earnings, the distributions would not be included in the grandparents’ gross estates for estate tax purposes if they survived for five years from the contribution date.
The IRS and Treasury anticipate that the new regulations will help determine whether the overall transaction in such cases has been designed to avoid the transfer tax by focusing on the actual source of the funds for the contribution, on the person who actually contributes the cash to the Section 529 account, and on the person who ultimately receives any distribution from it.
Specific Rules
Changes of DB by AO. Because a contribution to a Section 529 account is treated as a completed gift, a DB change is generally treated under the 1998 proposed regulations as a taxable transfer, from the former to the new DB. That result occurs even though the income tax portion of the 1998 Proposed Regulations treats a DB change that is directed by the AO as a taxable distribution to the AO. The notice indicates that the forthcoming proposed regulations would treat a DB change that results in an income tax being imposed as a distribution to the AO, followed by a new gift. As a result, an AO that retains the power to designate a new DB would be liable for any gift or GST tax imposed on the DB change. The future regulations might also include special rules to cover cases in which the AO is a trust or bank, rather than an individual.
Distributions to AO. The IRS and Treasury also expect to develop rules to address transfer tax abuses in situations where an AO transfers control to a new AO, or names himself (or his spouse) as DB. In such cases, the contributor transfers amounts under the QTP not exceeding the annual gift tax exclusion to several Section 529 accounts with different DBs but the same AO. When the AO subsequently distributes the accounts to himself (and not for QHEE payment), the AO pays income tax, plus the 10 percent additional tax, on the earnings. However, the contributor takes the position that he owes no transfer tax, even though all of the contributed amounts have been received by the AO. Similar issues arise when an AO transfers his control of a Section 529 account to another AO. The new regulations would combat the perceived abuses by restricting QTP benefits to AOs that are individuals, and by making an AO liable for income tax on the entire amount of funds distributed for his benefit, except to the extent that the AO can substantiate that he personally made contributions to the Section 529 account.
Contributors Other Than Natural Persons. While Section 529 contemplates gift contributions by individuals, the forthcoming rules would clarify that, in addition to an individual, a corporation, partnership, estate, trust or other entity could contribute to a Section 529 account. In that circumstance, the gift tax provisions would be applied by treating the individual beneficiaries or equity owners of the entity as the contributors to the extent of their allocable share of the entity’s contribution. Moreover, the rules would add further procedures and reporting requirements to ensure the assessment and collection of all appropriate income, employment and transfer taxes related to a contribution that is in the nature of disguised wages paid by a contributor-employer for the benefit of an employee’s child.
Contributions for the Benefit of the Contributor. Although Section 529 appears to contemplate only contributions that are gifts to people other than the contributor, the IRS and Treasury recognize that an individual may want to save for his own education (or a Uniform Gift/Transfer to Minor Account may want to save for its beneficiary) through contributions to a Section 529 account. The 1998 Proposed Regulations did not address whether an individual could do so. The rules anticipated by the Notice would permit such contributions. Moreover, where the contributor is the DB, the rules would treat a change to a new DB as a distribution to the contributor, followed by a contribution to a new Section 529 account for the new DB. The distribution and new contribution would be treated as a rollover and not be subject to income tax or the 10 percent additional tax if the new DB is a family member of the former DB. However, the new contribution may be subject to gift and GST tax, after taking into account the annual gift exclusion and the election of a five-year spread of the amount contributed.
Distributions upon the Death of the DB. Generally, amounts distributed from a Section 529 account upon a DB’s death are subject to estate tax. However, the notice acknowledges that when a deceased DB did not have an interest or control over the property in the account, it may be inappropriate to include its value in his gross estate. The future regulations would provide bright-line tests for determining when inclusion would be appropriate. These tests would focus on the ultimate distribution of the funds held in the Section 529 account as of the DB’s death and, in some cases, would impose income tax liability on the AO, in lieu of including amounts in the DB’s gross estate.
Compliance Measures. The forthcoming regulations would provide procedural and administrative guidance on spreading a contribution over five years, on reporting losses recognized in Section 529 accounts, and on the timing of distributions in relation to the incurrence of QHEE. The proposed rules also may contain recordkeeping requirements designed to facilitate their implementation. QTPs may be required to collect, retain and report to the IRS additional information. Their program documents, administrative procedures, and promotional and required literature for AOs and DBs may need revisions. A grace period of no less than 15 months would be provided for implementing changes.
Our firm will be pleased to assist QTPs that wish to submit comments to the IRS on the Notice of proposed rulemaking or on the forthcoming proposed regulations before the IRS and Treasury issue final rules. We are also available to counsel QTPs on the implementation of any new administrative and reporting procedures that may be required by the new regulations, and on the updating of program documents and promotional literature. For additional information and assistance on QTP issues, please contact Thomas H. Duncan, Paul W. Scott or Wayne R. Strasbaugh.
1 $60,000 to each grandchild by each grandparent using the current $12,000 gift tax exclusion and the five-year spread election.
Copyright 2008 Ballard Spahr Andrews & Ingersoll, LLP. Used by permission.