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College Planning Q&A: Looking at Proposed 529 Revisions

To prevent tax abuses of section 529, the government has proposed some changes and additions.

Susan T. Bart, 02/22/2008

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

On Jan. 17, 2008, the IRS issued an Advance Notice of Proposed Rulemaking with respect to Internal Revenue Code section 529, which permits states to establish Qualified Tuition Programs (QTPs), including college savings account programs. The Advance Notice requests comments on proposed revisions and additions to the proposed regulations in anticipation of reissuing comprehensive proposed regulations.

The proposals in the Advance Notice are intended to prevent tax abuses of section 529 by clarifying the tax consequences of changes of beneficiaries and refunds to the account owner, and creating a general anti-abuse rule. In addition, the Advance Notice announces an intention to permit only individuals to be account owners and to possibly limit the ability of entities to contribute to 529 savings accounts. The Advance Notice also proposes guidance on self-owned 529 accounts, accounts owned by UTMA custodians, the inclusion of a 529 account in a deceased beneficiary's estate, the five-year election and the matching of 529 distributions and qualified higher education expenses.

Congress enacted section 529 in 1996 to provide taxpayers with a tax-advantaged, flexible vehicle for saving for qualified higher education expenses. The IRS issued proposed regulations in 1998. Subsequently, Notice 2001-55 provided guidance regarding the statutory restriction against investment direction as applied to investment changes and rollovers, and Notice 2001-81 provided guidance on recordkeeping, reporting and other requirements applicable to QTPs. Section 529 provides great flexibility, but in doing so contravenes many of the venerable rules of gift, generation-skipping transfer (GST) and estate taxation. Congress' disregard of these rules produced many theoretical tax loopholes.

Congress became concerned about abuses and in the Pension Protection Act of 2006 added subsection 529(f), which directed the IRS to prescribe such regulations as may be necessary or appropriate to carry out the purposes of section 529 and to prevent abuse. I feel a bit of sympathy for the IRS' struggle with the Gordian knot created by Congress. However, I wonder how much abuse actually occurs.

The heart of the Advance Notice comprises three sections: (1) Anti-Abuse Rule; (2) Rules Relating to the Tax Treatment of Contributions to and Participants in Section 529 Accounts; and (3) Rules Governing the Function and Operation of QTPs and Section 529 Accounts.

I. Anti-Abuse Rule. The Advance Notice presages an anti-abuse rule, which may be applied on a retroactive basis, that "will generally follow the steps in the overall transaction by focusing on the actual source of the funds for the contribution, the person who actually contributes the cash to the section 529 account, and the person who ultimately receives any distribution from the account." The favorable tax treatment granted by section 529 will be denied if "it is determined that the transaction, in whole or in part, is inconsistent with the intent of section 529." We can look forward to examples "that provide clear guidance to taxpayers about the types of transactions considered abusive." The Advance Notice makes reference to the two examples of potential abuse found in the Technical Explanation accompanying section 529(f). The Technical Explanation identified as a potential abuse that taxpayers may seek to avoid gift and GST taxes by making contributions to multiple 529 accounts with different designated beneficiaries, potentially using the five-year election, with the intention of subsequently changing the designated beneficiaries of such accounts to a single, common beneficiary and distributing the entire amount to such beneficiary without further tax consequences. The Advance Notice contains a specific example of this abusive technique:

For example, assume that in 2007, when the gift tax annual exclusion amount under section 2503(b) is $12,000, Grandparents wish to give more than $1 million to Child, free of transfer taxes. Grandparents open section 529 accounts for each of their 10 grandchildren, naming Child the [Account Owner] of each account. Grandparents use the five-year spread rule of section 529(c)(2)(B) to contribute $120,000 ($60,000 from each Grandparent) to each grandchild's account without triggering any gift or generation-skipping transfer (GST) tax liability. The earnings then accumulate on a tax-deferred basis in the accounts and Child may withdraw the balance at any time. If Grandparents survive for five years, the account balances will not be included in their gross estates at death. In effect, Grandparents have transferred $1.2 million to Child while claiming no transfer taxes are due and claiming to use none of their applicable credit amount (formerly the unified credit).

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