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Beneficiary in the Dark on 529 Account

Plus questions about distributions when tuition is otherwise covered, when computer expenses qualify, and more.

Susan T. Bart, 07/29/2011

Question 1: My great grandparents set up an EdVest account for me to use to go to school, but since my great grandfather passed away, my grandfather has been given power of attorney and will not communicate to me about the account. I have already used some of the funds but have not been able to obtain an account history or any more information regarding this fund. Is there anything I can do to get this information? I am 21 years old and currently enrolled in college. I suspect that my grandfather is draining the account as he did with my mother's and aunt's, and when I called EdVest, the only information they would give me is that my social security number is linked to an account owned by my great grandmother.

Answer: If your great grandmother is the account owner, she controls the account and your grandfather should not have any power over the account unless she gave it to him. You should talk to your great grandmother and make sure she understands what she needs to do to make sure your education expenses continue to be paid.
If she gave your grandfather power over the account and she is still competent, she can take away that power and put someone else in place who will make certain the funds are used for your education. She should also designate a successor account owner in the event of her death who will make certain the funds are used for their intended purpose.

Question 2: I have a new and rather wealthy client who set up 529 plans a few years ago for his children, who are now in college. I told him he should pay the college tuition to the school from his own funds to reduce his estate, and we could consider starting to pay the funds in the 529 plans out to his children now, as they are in low tax brackets, or else keep them in place as "retirement" plans for the children (to avoid paying the 10% penalty any earlier than we have to).

I had always assumed that if the parents paid the school directly, any distributions made to the children from the 529 plan could not be income-tax free. However, the IRS Publication 970 on page 55 indicates that the parents' "gifts" to a child will be ignored and, in fact, the 529 distributions could remain tax free, at least in part. The Publication involves what looks like a cash gift from the parents to the child, and not the parents' direct payment of schooling costs, which is a non-gift, but it is not clear that that distinction is meaningful.

So perhaps the 529 plans can distribute funds each year to each child equal to such child's college expenses (but which the child would keep, as the parents already paid the bills) and have the earnings be tax and penalty free?

Answer: Fascinating question. Code section 529 does not actually trace the use of the funds distributed from the 529 account but rather merely compares adjusted qualified education expenses with the amount withdrawn. Publication 970 states:

To determine if total distributions for the year are more or less than the amount of qualified education expenses, you must compare the total of all QTP distributions for the tax year to the adjusted qualified education expenses.

Adjusted qualified education expenses. This amount is the total qualified education expenses reduced by any tax-free educational assistance. Tax-free educational assistance includes:

  • The tax-free part of scholarships and fellowships (see chapter 1),
  • Veterans' educational assistance (see chapter 1),
  • Pell grants (see chapter 1),
  • Employer-provided educational assistance (see chapter 11), and
  • Any other nontaxable (tax-free) payments (other than gifts or inheritances) received as educational assistance.

Gifts are not adjustments to adjusted qualified education expenses. While the direct payment of tuition under Code section 2503(e) is not treated as a gift for purposes of the gift tax chapter of the Internal Revenue Code, it is a gift for other purposes. Therefore, I agree with you that the parents can pay the tuition directly and still take tax-free withdrawals from the 529 account.

Question 3: IRC § 529(e)(3)(A)(i) includes in qualified higher education expenses, "tuition, fees, books, supplies, and equipment required for the enrollment or attendance of a designated beneficiary at an eligible educational institution." IRC § 529(e)(3)(A)(iii) added this to the definition of qualified expenses: "expenses paid or incurred in 2009 or 2010 for the purchase of any computer technology or equipment (as defined in section 170(e)(6)(F)(i)) or Internet access and related services, if such technology, equipment, or services are to be used by the beneficiary and the beneficiary's family during any of the years the beneficiary is enrolled at an eligible educational institution."

If a student purchases a computer in 2011 and his or her school "requires" a computer for enrollment or attendance, does that fit within the "supplies and equipment" allowed under the general rule for qualified expenses that can be paid from a 529 plan account?

Answer: If the school requires the computer for enrollment or attendance it should fit within the category of supplies and equipment required for enrollment or attendance.

Question 4. Grantors set up 529 plans for step great nephews. Their niece got divorced and the grantors want to shift some of the money from the 529s of the former step nephews to their niece who intends to go back and do some graduate studies. Two of the step nephews are already college age; one is in the military and the other did not go to college, so they think that, at a minimum, they have overfunded these plans. Do you think they can accomplish their objective? As you know, the definition of "family member" is broad but since it is defined in the context of the beneficiary's "family member," not the grantor's, I wasn't positive what the impact of the divorce would be. Would a former stepmother count as a "family member"?

Answer: To be clear, the grantor's niece married H, and H had sons (who were not children of niece). Niece and H divorce. A change of beneficiary is not treated as a nonqualified distribution if it is to a member of the family of the old beneficiary. Code section 529(e)(2) defines "member of the family" as:

(2) MEMBER OF FAMILY. - The term "member of the family" means, with respect to any designated beneficiary -
(A) the spouse of such beneficiary;
(B) an individual who bears a relationship to such beneficiary which is described in subparagraphs (A) through (G) of section 152(d)(2);
(C) the spouse of any individual described in subparagraph (B); and
(D) any first cousin of such beneficiary.

Code section 152 deals with the dependency exemption. Code section 152(d)(2)(A) through (G) includes:
(A) A child or a descendant of a child.
(B) A brother, sister, stepbrother, or stepsister.
(C) The father or mother, or an ancestor of either.
(D) A stepfather or stepmother.
(E) A son or daughter of a brother or sister of the taxpayer.
(F) A brother or sister of the father or mother of the taxpayer.
(G) A son-in-law, daughter-in-law, father-in-law, mother-in-law, brother-in-law, or sister-in-law.

The regulations to Code section 152 provide: "The relationship of affinity once existing will not terminate by divorce or the death of a spouse. For example, a widower may continue to claim his deceased wife's father (his father-in-law) as a dependent provided he meets the other requirements of section 151." Treas. Reg. § 1.152-2(d). Thus it seems that the former stepmother would continue to count as a member of the family of her former stepchildren. PAGEBREAK

Question 5: We located one of your articles while researching the election under IRC Section 529(c)(2)(B) to take contributions to a QTP in excess of the gift tax annual exclusion into account ratably over a five-year period. Specifically, we are seeking guidance about the nature of the election insofar as it being revocable or irrevocable following the due date including extensions for the gift tax return, which includes the election. In your article in the "Late Returns" section, second to last paragraph, Rule 1, it is indicated the election is irrevocable following the due date. We are curious about the source(s) contributing to that conclusion.

This matter is of particular interest to us because the state of Vermont does not have a gift tax nor does it include a taxpayer's lifetime taxable gifts in his or her Vermont taxable estate. The state estate tax threshold is less than the federal with decedents dying in 2010 with estates of $2,000,000 or greater and $2,750,000 in 2011 being subject to Vermont estate tax. In cases where a federal Form 706 filing is not required, a pro forma 706 is prepared for Vermont purposes in determining the size of the Vermont taxable estate. Consequently, if the election were revocable, there would be an opportunity for state estate tax savings for a Vermont taxpayer who (1) made a five-year election under IRC Section 529(c)(2)(B) dies prior to the expiration of the five years, and (2) who is not required to pay federal estate taxes.

In addition to your article, we have found other interesting research (also attached). Unfortunately, none is conclusive:

  • RIA Checkpoint Federal Tax Coordinator 2d Q-1910.1A - footnote 7.6 indicates election is irrevocable.
  • IRS tax law question email reply to telephone inquiry - again, inconclusive (excerpt): "There is not any guidance in the IRS code 529 or Regulations 1.529 - 1 through 1.529 - 6 that addresses that situation. Also in the same context, there is not anything in the codes that indicates once an election is made it is not revocable."

Answer: There is no binding guidance yet on whether the election is revocable, but there are a number of authorities (and strong policy reasons) that indicate it will be treated as irrevocable. The 2008 Notice of Proposed Rulemaking on Code section 529 proposes that the final regulations will provide that the five-year election is irrevocable (except under very limited circumstances). The Notice provides:

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.

If the election were made, was revocable and was then revoked, the taxpayer would have to go back and amend the gift tax return reporting the gift to report the amount of the contribution in excess of the annual exclusion amount as a taxable gift for the year. This taxable gift would reduce the taxpayer's lifetime exclusion or, if the taxpayer had exhausted his or her lifetime exclusion, would result in gift tax. (Remember, back when your client made that 529 contribution, your client did not have a $5,000,000 lifetime exclusion, which only went into effect in 2011.) All subsequent gift tax returns filed by the taxpayer would also have to be amended as the gift tax is calculated on a cumulative basis. If, however, the statute of limitations for the gift tax return had passed (generally three years), the taxpayer might argue that he or she did not have to file the amended return and bear the tax consequences. Therein lies the policy reason why the IRS will not allow the election to be revocable; it could permit a taxpayer to make a gift that avoids tax without either using up annual exclusions over the five-year period or using up part of the lifetime exclusion.

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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    Susan T. Bart is a partner in the Private Clients, Trusts & Estates Group at Sidley Austin LLP in its Chicago office, where her practice includes estate planning, estate and trust administration, and fiduciary counsel. She has written two books, including Education Planning and Gifts to Minors published by Illinois Institute for Continuing Legal Education (iicle.com), which extensively discusses 529 plans.

    She is the author of Education Planning and Gifts to Minors 2004 Edition. She is a frequent speaker on trust and estate topics in general and Section 529 college savings plans in particular.

    The author is not an employee of Morningstar, Inc. The views expressed in this article are the author's. They do not necessarily reflect the views of Morningstar. The author is a freelance contributor to MorningstarAdvisor.com. The views expressed in this article may or may not reflect the views of Morningstar.

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