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529 Contributions and the Five-Year Election

Questions on allocating 529 contributions and gift tax liabilities over the five-year period.

Susan T. Bart, 09/23/2011

1. RIA's 706/709 Deskbook contains the following observation:

The proposed regulations state that a donor may take certain contributions to a QTP into account ratably over five years only with respect to contributions not in excess of five times the annual exclusion amount [Prop. Reg. 1.529-5(b)(2)]. The authors believe that this provision would permit the following, although guidance is not clear.

Example 25D-5: Excess QTP contribution-election of amount less than $65,000.

Taxpayer contributes $33,000 to a QTP in Year 1 and elects to treat $25,000 as a prorated contribution over five years. (Assume a $13,000 annual exclusion for all five years.) Thus, in Year 1, taxpayer utilizes the annual exclusion amount with an $8,000 (non-prorated) contribution and $5,000 from the amount subject to the election to prorate. In Years 2 through 5, the taxpayer is electing to treat as a prorated contribution $5,000 per year.

I believe that the statute specifically requires that the entire $33,000 contribution in RIA's example be allocated over the five-year period. Have you focused on this issue?

The statement quoted above is in RIA's PPC Federal Tax Compliance Library, the 706/709 Deskbook, Chapter 25, Key Issue 25D.

First, why does the taxpayer in the above example want to make the election over only $25,000 and not $33,000? Because the taxpayer wants to use fully his or her annual exclusion for Year 1, and by doing so reduces the amount of annual exclusion deemed to be used for Years 2 through 5 from $6,600 per year ($33,000 ÷ 5) to $5,000 ($25,000 ÷ 5). Thus the taxpayer can make greater additional annual exclusion gifts in Years 2 through 5.

I read the statute as requiring the entire contribution to the 529 account to be subject to the five-year election, if such election is made. I read the proposed regulations as trying to modify this rule only to provide that if the aggregate contributions exceed five times the annual exclusion amount, the excess must be treated as a taxable gift all in Year 1 and cannot be spread out over five years.

The relevant provision of IRC 529 provides as follows:

(2) Gift tax treatment of contributions. - For purposes of chapters 12 and 13 -

(A) In general. - Any contribution to a qualified tuition program on behalf of any designated beneficiary:(i) shall be treated as a completed gift to such beneficiary which is not a future interest in property, and
(ii) shall not be treated as a qualified transfer under section 2503(e).

(B) Treatment of excess contributions. - If the aggregate amount of contributions described in subparagraph (A) during the calendar year by a donor exceeds the limitation for such year under section 2503(b), such aggregate amount shall, at the election of the donor, be taken into account for purposes of such section ratably over the 5-year period beginning with such calendar year.

(Emphasis added.)

The statute appears to provide one and only one option for the five-year election; you can treat the aggregate amount of contributions as if they were made ratably over five years.

The proposed regulations state:

Under section 529(c)(2)(B) a donor may elect to take certain contributions to a QSTP into account ratably over a five-year period in determining the amount of gifts made during the calendar year. The provision is applicable only with respect to contributions not in excess of five times the section 2503(b) exclusion amount available in the calendar year of the contribution. Any excess may not be taken into account ratably and is treated as a taxable gift in the calendar year of contribution.

Prop. Reg. § 1.529-5(b)(2)(i) (emphasis added).

The proposed regulation has one purpose: to make sure that any taxable gift is taken into account in Year 1 and immediately uses up unified credit, or if no unified credit is left, results in gift tax in Year 1. The proposed regulations do not want to permit taxable gift tax consequences to be spread over five years. The proposed regulations do not say you can make an election of less than the amount contributed where it does not exceed five times the annual exclusion amount. The election is still permitted over only "certain contributions" as defined in section 529(c)(2)(B). Section 529(c)(2)(B) permits the election only over the aggregate contributions for the year, if they exceed the gift tax annual exclusion amount.

The Advance Notice of Proposed Regulations (Federal Register January 18, 2008) is more explicit than the proposed regulations in that it firmly states: "Section 529(c)(2)(B) provides that, if the aggregate amount of contributions to a section 529 account during a calendar year by a donor exceeds the gift tax exclusion amount for such year under section 2503(b), the donor may elect to have the aggregate amount taken into account, for purposes of section 2503(b), over the 5-year period beginning in such calendar year." The Advance Notice then goes on to provide the following Rule:

Rule 2. The election applies to contributions to a section 529 account on behalf of a DB during a calendar year that exceed the gift tax exclusion amount for that year but are not in excess of five times the exclusion amount for the year. Any excess may not be taken into account ratably and is treated as a taxable gift in the calendar year of the contribution.

Oddly, the instructions to the gift tax return (Form 709) read as if you could make the election for a portion of the aggregate contribution:

If in 2010, you contributed more than $13,000 to a QTP on behalf of any one person, you may elect to treat up to $65,000 of the contribution for that person as if you had made it ratably over a 5-year period. The election allows you to apply the annual exclusion to a portion of the contribution in each of the 5 years, beginning in 2010. You can make this election for as many separate people as you made QTP contributions.

You can only apply the election to a maximum of $65,000. You must report all of your 2010 QTP contributions for any single person that exceed $65,000 (in addition to any other gifts you made to that person).

For each of the 5 years, you report in Part 1 of Schedule A one-fifth (20%) of the amount for which you made the election. In column E of Part 1 (Schedule A) list the date of the gift as the calendar year for which you are deemed to have made the gift (that is, the year of the current Form 709 you are filing). Do not list the actual year of contribution for subsequent years.
(Emphasis added.)

It's clear why the IRS cares about having the taxable portion of the gift taxed entirely in Year 1. It's not so clear why the IRS would care about letting the taxpayer make the election over only a portion of the contribution in order to fully use the taxpayer's annual exclusion in Year 1. Nonetheless, the language of the statute seems clear that the election must be over the aggregate contributions for the year.

2. If a contribution to a 529 account exceeds five times the annual exclusion amount, doesn't the statute permit me to take the taxable portion into account pro rata over five years? Thus if I owe gift tax on the excess, shouldn't I get to pay it over five years?

I agree. That is what the statute says. The IRS, admittedly for good policy reasons, is attempting to construe the statute as if it said "such aggregate amount, to the extent it does not exceed five times the limitation for such year under section 2503(b), shall, at the election of the donor, be taken into account for purposes of such section ratably over the 5-year period beginning with such calendar year." (Italicized language added to the statutory language.) If this goes to court, it is unclear whether the IRS would prevail.

3. In January 2011, I put $10,000 in a Uniform Transfers to Minors Act account for my child. In July 2011, forgetting that I made the contribution to the UTMA account, I put $10,000 for the same child in a 529 account. Can I make the five-year election over the 529 contribution so that my total gifts to the child for 2011 are only $12,000 and do not exceed the $13,000 gift tax annual exclusion?

The statute permits the five-year election only if the gifts to the 529 account exceed the annual exclusion amount. (Arguably, the statute should have permitted the election if the aggregate gifts to the donee (including non-529 gifts) exceeded the annual exclusion.) The Advance Notice and the instructions to the gift tax return appear to enforce this rule. Thus you cannot make the five-year election unless you contribute at least $3,001 more to the 529 account before year end. If you don't make any additional contributions, you will have total gifts to your child of $20,000, $7,000 of which will be taxable and will use up unified credit, or, if you have exhausted your unified credit, result in gift tax. If you contribute an additional $3,001 to the 529 account, you can make the five-year election, which would attribute a gift of $2,600 to each year. Thus your total 2011 gifts to your child would be $12,600, less than the annual exclusion amount.

4. I intend to give $39,000 this year to a 529 account for my niece. Can I elect to have this treated as $13,000 gifts for Years 1 through 3, so that in Years 4 and 5, when my financial circumstances might be better, I could make additional annual exclusion gifts to my niece?

Unfortunately, you cannot. If you make the election, your contribution will be treated as if you made it pro rata over five years. Your only options are 1) not to make an election and have the contribution treated as made entirely in Year 1; or 2) to make the election and have the contribution treated as if made in installments of $7,800 over five years. The statute requires pro rata treatment over five years and this is confirmed by the following example in the Advance Notice:

Example A. Assume the contributor makes contributions to a section 529 account on behalf of DB in 2007, when the gift tax annual exclusion amount under section 2503(b) is $12,000. If the contributor's aggregate contributions on behalf of DB in 2007 are $30,000, contributor may elect to account for the gift as 5 annual gifts of $6,000 to DB, beginning in 2007. Assuming the gift tax annual exclusion amount remains at $12,000 over the 5-year period covered by the election, the contributor could make additional gifts described in section 2503(b) of up to $6,000 in each of the 5 years to the same beneficiary without the imposition of any gift tax.

Alternatively, you might simply contribute $13,000 per year for three years.

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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