Also, possibilities for late elections on gift-tax returns..
Q. A few years ago my client funded 529 savings accounts for his children with $10,000 each. My client is now considering divorcing his wife. If he adds $60,000 to each 529 account prior to filing the divorce petition, will the money in the 529 accounts be protected from his wife's claims in a divorce? He lives in a state that provides creditor protection to 529 savings accounts.
Susan: Adding money to 529 accounts, or establishing such accounts, in anticipation of divorce will not protect the 529 funds from the claims of the other spouse. Even 529 savings accounts funded before divorce was contemplated may be subject to the orders of the divorce court.
First, the court might find that a transfer of funds to the 529 savings account is voidable as a fraudulent transfer. The Uniform Fraudulent Transfer Act, which has been adopted by forty-three states and the District of Columbia, provides that a transfer is fraudulent as to any present or future creditor if the transfer is made "with actual intent to hinder, delay, or defraud any creditor of the debtor." Thus a transfer made with the intent of frustrating a spouse's claims in divorce would be a fraudulent transfer. A transfer can also be fraudulent as to present creditors if the debtor is insolvent or becomes insolvent as a result of the transfer. A creditor is a person who has a claim, which is defined in the UFTA as "a right to payment, whether or not the right is reduced to judgment, liquidated, unliquidated, fixed, contingent, matured, unmatured, disputed, undisputed, legal, equitable, secured, or unsecured." A spouse almost certainly becomes a creditor when the spouses separate or a divorce petition is filed. A spouse may even become a creditor before a petition is filed, if divorce proceedings are expected or imminent. See Yacobian v. Yacobian, 24 Mass. App. Ct. 946, 508 N.E.2d 1389 (1987).
Dissipation of Assets
Second, the court may find that such a transfer to 529 savings accounts is a dissipation of assets and that the transferred assets should be charged against the client's share of property in the divorce. Dissipation has been defined as the use of marital property for the sole benefit of one of the spouses for a purpose unrelated to the marriage at a time when the marriage is undergoing an irreconcilable breakdown. Dissipation of assets in a sense is really a special subcategory of fraudulent transfers. Charging the 529 assets against the client's share of property would be consistent with the fact that the client, as the account owner, could refund the 529 funds to himself. See Head v. Head, 168 Ill. App. 3d 697, 523 N.E.2d 17 (1st Dist. 1988) (dissipation found when husband established a trust to pay income to children for a number of years with the corpus then payable to husband); Baker v. Baker, 201 Neb. 409, 267 N.W.2d 756 (1978), appeal after remand, In re Marriage of Head, 273 Ill. App. 3d 404, 652 N.E.2d 1246 (1st Dist. 1995) (after filing divorce petition, husband made a gift of bonds to children; court did not set aside gift, but ordered husband to pay to wife one-half the value of the bonds).
Third, in a state that classifies property earned during marriage as marital property subject to equal or equitable division in a divorce, if the client's contributions to the 529 accounts were made with marital property, and if the client were the account owner, the court could order the client to reacquire the property so the court could order its division. A similar theory could operate in a community property state if the contribution had been made from community property without the other spouse's consent. The client might argue that under section 529, the contributions to the 529 accounts are considered completed gifts for gift tax purposes. However, a court might well respond that although the transfer was a completed gift for gift tax purposes, it was not a completed gift for property law purposes because of the rights retained by the account owner over the funds. The bankruptcy court made this argument in Lance v. Addison, 368 B.R. 761 (2007):
But § 529 merely gives favorable tax treatment to such accounts; it does not determine who is the owner of the account for any other purpose. In reality, the purported "gift" to the beneficiary is revocable. As the Debtor concedes, § 529 funds can be re-vested in the settlor of the account, albeit with a tax penalty, similar to a § 401K retirement plan. In addition, the settlor retains control over the account and may even change the designated beneficiary of the account without a penalty. Hence, for all purposes other than tax treatment, the creation of a § 529 account is not a completed transfer to the beneficiary, and the settlor remains the owner of the funds.
Limits of Creditor Protection Statutes
Even in the unlikely event that a divorce court found that none of the foregoing theories applied (which would be more likely in the case of funds transferred to the account before even an inkling of divorce entered either spouse's mind), the creditor protection statute might not protect the 529 assets from a spouse's claims. The applicable creditor protection statute would need to be carefully reviewed to see if there were some reason that it might not apply. For example, Illinois's statute incorporates a fraudulent transfer rule by providing that the statute does not apply to "any contribution to such account by the debtor as participant or donor that is made with the actual intent to hinder, delay, or defraud any creditor of the debtor." Idaho's statute explicitly permits the court to provide in a qualified domestic relations order that the 529 account be payable only to the beneficiary, and not to the account owner. Rhode Island's exemption does not apply to a judgment of divorce or order of the court concerning child support. Nevada's statute states expressly denies creditor protection to the extent the money will not be used by any beneficiary to attend a college or university.
Restrictions on Accounts
Even if the divorce court did not find a fraudulent transfer or dissipation of assets, and the divorce court recognized the transfers to the 529 savings accounts as valid gifts (as it might with respect to transfers made to the accounts prior to contemplation of divorce), the divorce court could exercise its equitable powers to ensure that the accounts are used for the children's education, and are not withdrawn by the client for other purposes. For example, in Oliver A. v. Christina A., 9 Misc. 3d 1104A, 806 N.Y.S.2d 446 (Sup. Ct. 2005), the court ordered that the 529 savings account be transferred to the custodial spouse and be held for the child's education. In Griggs v. Griggs, 234 N.Y.L.J. 70 (Sup. Ct. 2005), the court ordered that the parties be named co-owners and that the 529 accounts be solely used for the children's educations.
Using 529 Accounts in Divorce
Divorcing spouses might even find 529 savings accounts a useful tool in designing a divorce settlement. If Spouse 1 has greater earning power (and/or greater assets) and will be required to pay for college for the children, Spouse 2 could request that Spouse 1 fund a 529 savings account with $60,000 for each child, subject to the agreement that the funds will be used only for the children's education. These 529 savings accounts could go a long way towards securing Spouse 1's obligation to pay for college.
In a state in which the divorce settlement agreement does not contain a final resolution of the spouses' obligations to pay education costs and court retains jurisdiction after the divorce to order payment of a child's education expenses, the parties may wish to provide in the settlement agreement that any post-divorce contributions made by one of them to a 529 savings account (or to a trust for the child) will be applied to satisfy that spouse's obligations under any subsequent order regarding the payment of education expenses. In the absence of such an agreement, in some states a court might order that any 529 savings accounts be viewed as the child's assets and be applied to education costs first, and that the parties share the obligation to pay any expenses in excess of the 529 savings account funds.
Q. I just discovered that in 2005 my client transferred $60,000 to a 529 account for his granddaughter, but failed to make the five-year election on a timely filed gift tax return. Can the client make a late election?
Susan: If your client already filed a gift tax return for 2005 and failed to make the election, it appears your client may not make a late election. In Private Letter Ruling 200743001 the IRS deemed the donor to have made "a valid and timely election under section 529(c)(2)(B)" where the donor reported the gift on a timely filed gift tax return, stated in an attachment to the return an intent to prorate the contribution over a five-year period, but failed to check the box on Line B of Schedule A to actually make the election. The IRS found that the donor had made the election because the information on the return was sufficient to indicated that taxpayer's intent to make the election and therefore was considered to be substantial compliance with the requirements for making the election. However, one can infer that the IRS might not have allowed a late election if the gift tax return did not indicate an intent to make the election. If your client has not filed a gift tax return for 2005, your client may be able to file a late return and make the election, in the same manner that a split gift election may be made on a late return under some circumstances. However, there is not yet any authority on whether the IRS will accept a late election where a gift tax return for the year has not yet been filed.
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.