Also, prorating contributions and year-end investment changes.
College-savings expert Susan Bart answers advisors' questions on 529 plans and other education-planning matters. E-mail your questions to email@example.com.
Question: A grandchild is potential beneficiary of multi-generation trust. The grandchild is also a college student. Discretionary distributions of income to pay tuition would be taxable to student and subject to the Kiddie Tax. What about having a trust invest in a 529 plan and use distributions from the plan to pay the tuition bills with appropriate documentation? Can this get us around the Kiddie Tax to the grandchild with the trust income either taxed at the trust level or to other distributees?
Susan: Yes, this potentially works to avoid any income tax consequences to the student-beneficiary when the trust-owned 529 account is used to pay tuition bills for the student-beneficiary. The trust would establish a 529 account with the trust as the account owner and the student-beneficiary as the 529 account designated beneficiary. When a distribution is made from the 529 account to pay tuition, there would be no federal income tax consequences from the 529 account to the trust or the student-beneficiary.
Ordinarily, however, if the trust had ordinary income from other trust assets, a portion of that income would be carried out to each trust beneficiary who received a distribution from the trust during the year, regardless of which trust assets were used to make the distribution. Thus a distribution from a trust-owned 529 account could potentially carry out income from other trust assets to the beneficiary. There is an exception if the separate share rules apply.
The separate share rule applies "if different beneficiaries have substantially separate and independent shares." Treas. Reg. § 1.663(c)-1(a). The separate share rule may apply even though separate and independent accounts are not maintained and are not required to be maintained for each share on the books of account for the trust and even though no physical segregation of assets is made or required. Treas. Reg. § 1.663(c)-1(c). Thus in a typical case a trust such as you describe (a "spray trust") under which the trustee can make discretionary distributions among a group of beneficiaries (e.g. the grantor's descendants) does not have separate shares.
I would argue, however, that when a spray trust establishes a trust-owned 529 account, because the 529 account must have only one of the trust beneficiaries as the 529 designated beneficiary, a separate share is created because so long as the 529 account remains in existence, it can only be distributed to the designated beneficiary (unlike the remainder of the trust assets, which can be sprayed). Treas. Reg. 1.663(c)-3(a) says that a separate share may exist even if the share might not ultimately be received by the beneficiary or if in the future it may be recombined with the other shares. Thus the fact that the trustee may later liquidate the 529 account and combine the proceeds with the rest of the trust assets does not prevent separate share treatment while the 529 account is in existence.
So if a spray trust established a 529 account and the separate share rule applies, a distribution from the 529 account share only carries out income from the 529 account share. If the 529 account distribution is a qualified distribution to the student-beneficiary, there are no federal income tax consequences and therefore there is no federal income to be carried out to the student-beneficiary. If a nonqualified distribution is made to the student beneficiary from the trust-owned 529 account, the distribution only carries out the income on the 529 share to the student-beneficiary, and none of the income from the 529 account share would be carried out to any other trust beneficiary who received trust distributions during the year. The separate share rule can prevent a messy tax result.
Note that separate share treatment would not be available if the trust were only for one beneficiary. If a trust for one beneficiary made a qualified distribution from a trust-owned 529 account to the beneficiary, even though the 529 account distribution would not result in any federal income tax, the distribution to the beneficiary could carry out income from other trust investments, resulting in the beneficiary having income tax liability. In most cases the trust could make additional distributions from the other trust assets to the beneficiary to provide the beneficiary with funds with which to pay the beneficiary's income tax liability.