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Gifts and 529s

Here's a quick review of the gift-tax reporting rules.

Susan T. Bart, 04/23/2010

College-savings expert Susan Bart answers advisors' questions on 529 plans and other education-planning matters. E-mail your questions to advisorquest@morningstar.com.

This an appropriate time to review the gift tax reporting rules for gifts to 529 college savings accounts.

Gifts Under Gift Tax Annual Exclusion
If a taxpayer's gifts to a particular individual during the calendar year, including any contributions to 529 accounts with such individual as the designated beneficiary, all qualify for the gift tax annual exclusion (and, in the case of a donee who is two or more generations below the donor, the generation-skipping transfer tax annual exclusion) and do not exceed the $13,000 gift tax annual exclusion, no gift tax reporting is required. Outright gifts to individuals, gifts to Uniform Transfers to Minors Act accounts and gifts to 529 accounts all qualify for the gift tax annual exclusion. Gifts to trusts may or may not qualify for the gift tax annual exclusion depending upon whether the trust gives the beneficiary a "present interest."

In the case of gifts to grandchildren or more remote descendants (or to certain nonfamily members who are more than 37 ½ years younger than the taxpayer), the taxpayer's gifts to the individual during the calendar year must also qualify for the GST annual exclusion to avoid reporting requirements. Outright gifts to individuals, gifts to Uniform Transfers to Minors Act accounts and gifts to 529 accounts all qualify for the GST annual exclusion. Gifts to trusts may or may not qualify for the GST tax annual exclusion; however, the rules for qualifying for the GST annual exclusion are more stringent than the rules for the gift tax annual exclusion. Therefore, a gift to a trust could qualify for the gift tax annual exclusion but not the GST annual exclusion.

Gifts Under Gift Tax Annual Exclusion After Split Gift Election
If a married taxpayer's gifts to a particular individual during the calendar year, including any contributions to 529 accounts with such individual as the designated beneficiary, all qualify for the gift tax annual exclusion and, if applicable, the GST annual exclusion, but exceed the $13,000 gift tax annual exclusion, if the combined gifts of the taxpayer and the taxpayer's spouse do not exceed twice the annual exclusion amount ($26,000 for 2009 and 2010) and all qualify for the gift tax annual exclusion and, if applicable, the GST annual exclusion, then a taxable gift can be avoided if the spouses make a split gift election under which they each agree to be treated as if they had made one-half of the gifts made by the other spouse. The taxpayer, however, must file a gift tax return and the spouse must sign the gift tax return to make the split gift election even though, after the election, there will be a taxable gift. Under some circumstances the spouse also will be required to file a gift tax return.

Gifts Over Gift Tax Annual Exclusion
If a taxpayer's gifts to a particular individual during the calendar year, including any contributions to 529 accounts with such individual as the designated beneficiary and after applying the split gift election if such an election is made, exceed the $13,000 gift tax annual exclusion, the taxpayer is required to file a gift tax return. Ordinarily the gifts to such individual in excess of the gift tax annual exclusion will be treated as taxable gifts. (But see the discussion below of the five-year election.) The amount of the taxable gifts will either decrease the amount of the taxpayer's $1,000,000 lifetime exclusion, or if such lifetime exclusion is exhausted, will be subject to gift tax.

In the case of gifts to an individual two or more generations below the taxpayer (e.g. a grandchild), the gifts to such individual in excess of the $13,000 GST annual exclusion will be GST transfers. The taxpayer may apply a portion of the taxpayer's $3,500,000 (in 2009) GST exemption to the gift to avoid gift tax (or in some cases the tax rules automatically allocate GST exemption to the gift unless the taxpayer elects out of automatic allocation). If the taxpayer (or the tax rules) does not allocate GST exemption to the GST transfer, the taxpayer will owe GST tax on the gift, in addition to any gift tax due on the gift.

The Five-Year Election
With respect to any gifts to a 529 account, if the taxpayer's contribution to the account (after applying any split gift election) exceeds the amount of the gift tax annual exclusion, the taxpayer may elect to treat the gift as if it were made pro rate over the five-year period beginning with the year of the gift. The election cannot be made if the contribution to the 529 account is less than the gift tax annual exclusion, even if the taxpayer's aggregate gifts to the beneficiary during the year exceed the gift tax annual exclusion. The taxpayer does not have the option to prorate the gift over a lesser number of years or to allocate different amounts of the gift to different years. For example, if the taxpayer contributes $25,000 in 2009 and makes the election, the taxpayer will be treated as making a $5,000 annual exclusion gift in each of years 2009-2013. The donor cannot elect to treat the gift as if it were a gift of $13,000 in 2009 and a gift of $12,000 in 2010.

If the gift exceeds five times the annual exclusion, the Proposed Regulations, the instructions to Form 709 (2009) and the Advance Notice of Proposed Rulemaking on Section 529 issued on January 18, 2008 (the "Advance Notice"), require that the excess be reported as a taxable gift in the first year. Prop. Treas. Reg. § 1.529-5(b)(2). Section 529(e)(2)(B), however, appears to permit the entire gift, including any excess over five times the annual exclusion, be reported ratably over the five-year period.

The taxpayer can make the election for some beneficiaries but not others. If gift-splitting is elected, the spouses separately make the five-year election on their respective returns. One spouse could make the five-year election with respect to her share of the gift while the other spouse fails to make the five-year election with respect to his share of the gift.

Reporting 529 Account Gifts on Form 709
Gifts to 529 accounts for children (or other persons who are not deemed to be two or more generations below the taxpayer for GST tax purposes) are reported on Schedule A, Part 1. Gifts to 529 accounts for grandchildren (or other persons who are deemed to be two or more generations below the taxpayer for GST tax purposes) are reported on Schedule A, Part 2, and Schedule C (Computation of Generation-Skipping Transfer Tax) needs to be completed with respect to such gifts.

To make the five-year election, check the box under Schedule A, line B, which states: "Check here if you elect under section 529(c)(2)(B) to treat any transfers made this year to a qualified tuition program as made ratably over a 5-year period beginning this year. See instructions. Attach explanation." The attached explanation must include the following:

* The total amount contributed per individual beneficiary
* The amount for which the election is being made, and
* The name of the individual for whom the contribution was made

A sample Explanation for gifts to 529 accounts for grandchildren is at the end of this column.

Late Returns
Clients commonly make two mistakes with respect to gifts to 529 accounts. One common mistake married couples make is for one spouse to make a gift of twice the annual exclusion amount for a beneficiary, but to then fail to file a gift tax return to make the split gift election. If the split gift election is not made, then the spouse making the gift will be treated as having made a taxable gift of the amount in excess of the gift tax annual exclusion ($13,000 for 2009), and this taxable gift will reduce the donor's lifetime exclusion, or if the lifetime exclusion has already been exhausted, result in gift tax. Further, if the gift is to a grandchild or more remote descendant (or someone deemed to be two or more generations below the donor for GST tax purposes), the amount in excess of the donor's GST annual exclusion ($13,000 for 2009) will be treated as a GST transfer and will either use up a portion of the donor's GST exemption or if the GST exemption has already been exhausted, result in GST tax.

If you discover that a client failed to file a gift tax return making a split gift election, the client may file a late return to make such election provided that neither spouse has previously filed a gift tax return for such year and provided that neither spouse has received a notice of deficiency for gift taxes for such year.

The second common mistake is to make a gift to a 529 account in excess of the gift tax annual exclusion and to fail to file a gift tax return making the five-year election. The Advance Notice permits a late election if no prior gift tax return has been filed for the year.

Rule 1. The election must be made on the last United States Gift (and Generation-Skipping Transfer) Tax Return (Form 709) filed on or before the due date of the return, including extensions actually granted, or, if a timely return is not filed, on the first gift tax return filed by the donor after the due date. The election, once made, will be irrevocable, except that it may be revoked or modified on a subsequent return that is filed on or before the due date, including extensions actually granted.

What if a gift tax return was filed for the year, but the client inadvertently failed to make the five-year election on the return? Given that at this point the Advance Notice is only notice of proposed rules that are not actually in effect, it may still be worth filing an amended gift tax return and making the five-year election.

Reporting in Future Years if Five-Year Election Was Made
If the taxpayer makes a gift to a 529 account and makes the five-year election, the taxpayer needs to keep in mind the portion of the annual exclusion that has been used by such gift for the following four years. If a gift tax return is filed in any of the following four years it should list as a gift the one-fifth portion of the original 529 account gift that is allocated to such year. The instructions to Form 709 state that the date of the gift should be listed as the calendar year for which the taxpayer is deemed to have made the gift (that is, the year of the current Form 709 that is being filed), and not the actual year of the contribution. However, if in any of the four years following the election the taxpayer is not otherwise required to file Form 709, the taxpayer does not need to file Form 709 to report the prorated portion of the gift attributable to that year.

Attached to and made a part of United States Gift (& Generation-Skipping Transfer) 2009 Tax Return (Form 709)

GRANDPA GREEN
SSN: 000-00-0000
QUALIFIED STATE TUITION PROGRAM CONTRIBUTION ELECTION for Calendar Year 2009

Gifts to qualified state tuition program on behalf of:

Granddaughter Green Schedule A, Part 2, Item 1
Total amount of gift $65,000
Amount for which election is being made $65,000

Grandson Green Schedule A, Part 2, Item 2
Total amount of gift $65,000
Amount for which election is being made $65,000

Granddaughter Blue Schedule A, Part 2, Item 3
Total amount of gift $65,000
Amount for which election is being made $65,000

Grandson Red Schedule A, Part 2, Item 4
Total amount of gift $65,000
Amount for which election is being made $65,000

The taxpayer hereby elects under section 529(c)(2)(B) to treat the entire amount of the each gift listed above to qualified state tuition programs as having been made ratably over a 5-year period beginning in 2009. The taxpayer has reported only 20% of his total contribution to each program on this return.

To comply with certain Treasury regulations, we state that (i) this article is written to support the promotion and marketing of the transactions or matters addressed herein, (ii) this article is not intended or written to be used, and cannot be used, by any person for the purpose of avoiding U.S. federal tax penalties that may be imposed on such person and (iii) each taxpayer should seek advice based on the taxpayer's particular circumstances from an independent tax advisor.

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