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College Planning Q&A: Distribution Definitions

Also, gift taxes and beneficiary changes, and what to do with leftover funds.

Susan T. Bart, 05/23/2008

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

Question: Are distributions from a 529 plan that is owned by an irrevocable trust treated as "distributions" from the trust for fiduciary income tax purposes? If they are "distributions" to the beneficiaries, should they be part of the calculation allocating the distribution of current earnings (distributable net income or DNI) to the recipients of the distributions?

Susan: First, the caveat: There is no guidance on this issue. However, here's how I think it should be analyzed. For fiduciary income tax purposes the "separate share rule" applies, except in the case where the designated beneficiary is the sole beneficiary of the trust. The separate share rule applies "if different beneficiaries have substantially separate and independent shares." Treasury Regulation § 1.663(c) - 1(a). A separate share is created whenever a trust has more than one beneficiary (whether current, future or contingent) and a section 529 account is created for one of those beneficiaries, because so long as a section 529 account remains in existence it can only be distributed to the designated beneficiary. It can be revested by the trust, but that would terminate the separate share. 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 other shares. Treasury Regulation § 1.663(c) - 3(a).

As a consequence, distributable net income (DNI) for all section 529 accounts owned by a nongrantor trust for a particular designated beneficiary is determined separately from DNI for the remainder of the trust (and separately from DNI for section 529 accounts owned by the trust for other designated beneficiaries). Thus a distribution from the section 529 account to the designated beneficiary will not carry out DNI from non-section 529 account assets, regardless of whether the section 529 account distribution is qualified or nonqualified. Further, assuming the trust owns only one section 529 account for the designated beneficiary, a nonqualified distribution from a section 529 account to the designated beneficiary will only carry out income from the section 529 account, determined as provided under section 529.

Q: When is a change of owner and/or change of beneficiary a gift tax concern? The rules appear to be a moving target. At one point I understood that change of beneficiary was never an issue within the family tree. I thought only account owner changes were an issue. Tied into this is generation-skipping transfer tax. Does the GST tax apply to changes of owners or beneficiaries?

Susan: Currently changes of account owner do not have any gift tax consequences. However, don't get too creative with using changes of account owners followed by distributions to account owners to flaunt the gift tax rules. The Advance Notice of Proposed Rulemaking issued on Jan. 18, 2008 (the "Advance Notice") indicates that the IRS will promulgate a general anti-abuse rule to penalize, among other abuses, abusive changes of account owner. The anti-abuse rule will be retroactive. Further, arguably existing tax doctrines such as the step transaction doctrine could be used to catch such abuses.

With respect to changes of designated beneficiary, income tax consequences, but not necessarily gift or GST tax consequences, are avoided if the new beneficiary is a member of the family of the old beneficiary. The gift and GST tax consequences of a change of beneficiary are determined by comparing the generation of the new beneficiary with the generation of the old beneficiary. If the new beneficiary is in the same generation, there are no gift or GST tax consequences to the change of beneficiary. If the new beneficiary is one generation lower than the old beneficiary, it is a gift. If the new beneficiary is two or more generations lower than the old beneficiary, there are gift and GST tax consequences.

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