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Matching 529 Distributions with Expenses

Plus, a case study on the key considerations when using 529 accounts in an irrevocable trust.

Susan T. Bart, 07/26/2012

1. I paid my son's spring tuition for 2012 with a check dated 12/23/11. I don't remember when I mailed the check, but it did not clear until 1/9/12. I am just now getting around in May to doing the 529 distribution for reimbursement. It seems that if this counts as a 2011 expense, I am outside the supposed grace period until March 2012 to do the distribution. If it counts as a 2012 expense, I'm obviously fine. Any thoughts as to whether it counts as a 2012 expense since the check only cleared in 2012?

There's very little guidance on when qualified expenses must be paid in order to make a 529 distribution a qualified distribution. Clearly if the distribution and the payment are in the same year, there shouldn't be problem. The Advance Notice of Proposed Rulemaking on Section 529 (published in the Federal Register, Jan. 18, 2008) proposes a rule that, in order for earnings to be excluded from income, any distribution from a section 529 account during a calendar year must be used to pay qualified higher education expenses in the same calendar year or by March 31 of the following year. The rule proposed in the Advance Notice, however, does not apply in your case if the expense was paid in 2011 because you would be applying a distribution to an expense paid in a prior year.

It would be helpful if the proposed regulations would also exclude from income any distribution from a section 529 account during a calendar year that is used in reimbursement of qualified higher education expenses paid during the last three months of the prior year. While we are waiting for further guidance, this may be a reasonable position that the IRS would accept.

If in your case the educational expense was actually paid in 2012, then you do not have an issue as the distribution and the expense would be in the same year. When an expense is paid by check, for tax purposes the payment generally is considered as having been made when the check is delivered or mailed (unless the check is postdated or remains under the control of the taxpayer). Thus if you mailed the check in 2012, you should have no issue.

2. We have an irrevocable trust that was established by Husband and Wife for the child of the Wife by her first marriage (Wife's Child), the children of Husband and Wife (Joint Child 1 and Joint Child 2), and their respective descendants. Husband and Wife subsequently divorced and Husband remarried and had an additional child (Husband's Child). By court order the trust was modified to include Husband's Child and such Child's future descendants. The trust is primarily for the college education of all of the descendants.

Wife's Child has completed her education and has two minor children (Wife's Grandchild 1 and Wife's Grandchild 2). Joint Child 1 has completed his education and has one minor child (Joint Grandchild). Joint Child 2 has completed her education and currently has no children. Husband's Child is a minor and has no children.

The Trustee would like to use the trust assets to establish six equal shares, one for each of the three living grandchildren, one for Husband's Child, who has not completed her education, one for the future children of Joint Child 2, and one for the future children of Husband's Child. Can 529 accounts be used for all six shares?

Here's a family tree to help us keep things straight:

Permissible Trust Investments. One consideration is whether 529 accounts are permissible trust investments. If the trust has normal investment provisions most likely they are.

Trusts as Account Owners. Second, you should consider whether a trust can be an account owner of a 529 account. Most, though not all, 529 programs permit trusts to be account owners. The Advance Notice of Proposed Rulemaking on Section 529 (published in the Federal Register, Jan. 18, 2008), however, indicates that the IRS is considering prohibiting trusts from owning 529 accounts. The Advance Notice is not binding, and any such rule would not be effective until incorporated into 529 regulations or at least a published IRS Notice. Further, the Advance Notice promises to give 529 programs at least 15 months to make any changes the IRS may require in the future. If the IRS did in the future prohibit trusts as account owners, it might grandfather trust accounts already in existence or permit trusts to terminate their 529 accounts without adverse tax consequences. It is conceivable that the IRS could force trusts to terminate their 529 accounts and subject the earnings to income tax, but this seems to me an unfairly harsh result. In any event, the Trustee should be aware that the IRS could change the rules with respect to trust-owned 529 accounts in the future.

GST Tax Rules. Next, the generation-skipping transfer ("GST") tax considerations of establishing 529 accounts for grandchildren and of making distributions from such 529 accounts to grandchildren should be considered. The IRS has not provided guidance on the tax consequences of trusts investing in and making distributions from trust-owned 529 accounts. If, however, the trust is either grandfathered from GST tax or has a zero inclusion ratio for GST tax purposes because GST exemption was assigned to the trust, there should be no GST tax issues.

Exercise of Trustee's Discretion. Fourth, the Trustee should consider whether dividing the assets in this manner is a reasonable exercise of the Trustee's discretion that appropriately balances the interests of the beneficiaries, including unborn children and grandchildren. This depends upon the terms of the trust, the law governing the trust, and the circumstances of the beneficiaries. It is important to note, however, that just because the Trustee divides the assets into six shares for purposes of establishing the 529 accounts, the Trustee will not be obligated to distribute all of a beneficiary's account to such beneficiary. The Trustee would retain the right to change the beneficiary of each account (subject to the income and gift tax rules discussed below) or to withdraw the account (subject to the income tax rules) and reinvest the account proceeds as trust assets. Thus the Trustee would still have the ability to modify the proposed education funding plan to take into account after-born beneficiaries or to make distributions for purposes other than education if permitted by the terms of the trust.

Accounts for Living Beneficiaries. For the living grandchildren and Husband's Child, who has not completed her education, the trust can establish a separate 529 account for each beneficiary with the trust as the account owner and the beneficiary as the designated beneficiary. The Trustee should consider what will happen with any 529 account that is not used by the particular beneficiary for his or her qualified higher education expenses. The Trustee should also consider what flexibility the Trustee will have to change the beneficiary of a particular account to provide for after-born beneficiaries.

A beneficiary can be changed without tax consequences if the new beneficiary is in the same generation as the old beneficiary and is a "member of the family" of the old beneficiary. If the new beneficiary is not a "member of the family" of the old beneficiary, the change of beneficiary will be treated as a nonqualified distribution, and income tax and a penalty will be imposed on the earnings. So, for example, who is a "member of the family" of Wife's Grandchild 1, to whom the beneficiary on the account for Wife's Grandchild 1 could be changed? Let's take a romp through the tax code.

"Member of the family" is defined in Code section 529(e)(2) with respect to the old beneficiary as:

(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.

Isn't it fun when one section of the tax code refers to another? Code section 152(d)(2) includes the following individuals:

(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.
 
So the beneficiary of the 529 account for Wife's Grandchild 1 could be changed to (1) Wife's Grandchild 2 or another child Wife's Child might have in the future (who would be a sibling of Wife's Grandchild; see 152(d)(2)(B)); or (2) to Wife's Child, for example if she went back to school (who would be a mother of Wife's Grandchild; see 152(d)(2)(C)).

Could the beneficiary of the 529 account for Wife's Grandchild 1 be changed to Husband's Child? While a sister of the mother of the taxpayer (an aunt) would be a member of the family, Wife's Child and Husband's Child are not related by blood and therefore are not considered to be siblings.

Could the beneficiary of the 529 account for Wife's Grandchild 1 be changed to Joint Child 1 or Joint Child 2? Yes. Code section 152(f)(4) provides that the terms "brother" and "sister" include a brother or sister by the half blood. A Joint Child would fall under 152(d)(2)(F) as a brother or sister of the father or mother of Wife's Grandchild 1.

Could the beneficiary of the 529 account for Wife's Grandchild 1 be changed to Joint Grandchild? Probably, but it is not clear. Code section 529(e)(2)(D) including first cousins as members of the family was not in the initial version of section 529 but was later added. Most of the members of the family are defined by reference to Code section 152, which specifically contains a provision including brothers and sisters of the half blood. Section 529, however, does not define "first cousin" or contain any provision including cousins by the half blood. Black's Law dictionary defines "first cousin" as the children of the brother or sister of one's father or mother. If one imports the rule in Code section 152 that brothers and sisters of the half blood are included, then Wife's Grandchild 1 and Joint Grandchild are first cousins and therefore Joint Grandchild is a "member of the family" of Wife's Grandchild 1. Although this seems a reasonable construction of the term "first cousin," there's no guarantee that the IRS will see things similarly.

Let's now consider a different beneficiary. If the Trustee later wants to change the beneficiary of the account for Joint Grandchild, who are "members of the family" of Joint Grandchild? Members of the family of Joint Grandchild include any future child of Joint Child 1 (who would be a sibling of Joint Grandchild; see 152(d)(2)(B)), Joint Child 1 (who would be a parent of Joint Grandchild; see 152(d)(2)(C)), Joint Child 2 (who would be a sibling of a parent of Joint Grandchild; see 152(d)(2)(F)), any future child of Joint Child 2 (who would be a first cousin of Joint Grandchild; see 529(e)(2)(D)), Wife's Child (who would be a sibling by half blood of a parent of Joint Grandchild; see 152(d)(2)(F)), and maybe Wife's Grandchild 1 (who would be a first cousin by half blood of Joint Grandchild).

If the Trustee later wants to change the beneficiary of the account for Husband's Child, who are members of the family of Husband's Child? Members of the family of Husband's Child include any future child of Husband (who would be a sibling or half sibling of Husband's Child; see 152(d)(2)(B)), Joint Child 1 or Joint Child 2 (who would be half siblings of Husband's Child; see 152(d)(2)(B)), any child of Husband's Child (but this moves the beneficiary down a generation), and maybe any child of Joint Child 1 or Joint Child 2 (Joint Child 1 and Joint Child 2 would be first cousins by half blood of Husband's Child, and a child of either of them would be a niece or nephew by half blood). Wife's Child and Wife's Grandchildren would not be members of the family of Husband's Child.

If the beneficiary of the account for Husband's Child is changed to a future child of Husband's Child, the new beneficiary would be a member of the family of the old beneficiary, but the new beneficiary would be in a lower generation than the old beneficiary. Code section 529(c)(5) provides that the gift tax and GST tax apply to any change of beneficiary if the new beneficiary is in a lower generation. However, the gift tax rules do not apply to trusts. Therefore there should be no gift tax consequence of changing the beneficiary to a lower generation in this case. Further, there should be no GST tax consequence of changing the beneficiary to a lower generation; any GST tax consequences should occur, if at all, only when a distribution is made to a beneficiary who is a grandchild or when the last beneficiary in the children's generation dies. Further, if the trust is exempt from GST tax (for example, because GST exemption was allocated to the trust) there should be no GST tax when a distribution is later made to the new beneficiary. Note that the IRS has not yet formulated gift and GST tax rules for trust-owned 529 accounts, so these conclusions are merely my speculation on how the rules should work.

Accounts for Beneficiaries to Be Born in the Future. If you are not yet exhausted by the analysis, let us consider what to do about the 529 accounts that the Trustee wants to establish for the unborn children of Joint Child 2 and the unborn children of Husband's Child. Each 529 account needs a living beneficiary. For the unborn children of Joint Child 2, there are two options. One is to establish a second account for Joint Grandchild, and when a child of Joint Child 2 is born, change the beneficiary to the newborn. Because the newborn would be a cousin of Joint Grandchild, and therefore a member of the family, and in the same generation, there should be no adverse tax consequences to the change of beneficiary. The Trustee would need to make certain that the combined balances of the accounts for Joint Grandchild would not exceed the contribution limit established by the 529 plan.

The alternative option is to establish an account with Joint Child 2 as the beneficiary and when Joint Child 2 has a child, change the beneficiary to the newborn. While Joint Child 2's child would certainly be a member of the family, the beneficiary would be moving down a generation. As noted above, the IRS has not formulated rules for a change of beneficiary of a trust-owned 529 account that moves the beneficiary down a generation. While I think that there should be no tax consequences to a change of beneficiary to a member of the family in a lower generation by a trust-owned account, that is merely my best analysis. Because of this uncertainty, my preference would be to use the first option, which seems to have less uncertainty.

For the unborn children of Husband's Child, who is still a minor, there are also two options. One is to open a second account for Joint Grandchild and change the beneficiary to Husband's Child's child when born. As discussed above, it is not absolutely clear that a first cousin by half blood is a member of the family. If the IRS decided that half blood cousins were not members of the family, then such a change of beneficiary would be considered a nonqualified distribution and subject to income tax and a penalty on the earnings. Further, given the likely age difference between Joint Grandchild and any future child of Husband's Child, Joint Grandchild could be fairly old before the beneficiary is changed. While most 529 plans do not currently impose age restrictions on beneficiaries, age restrictions could become more common in the future if the IRS finds that significant amounts of 529 funds are in accounts with relatively old beneficiaries who are unlikely to use such funds for their own education.

The second option is to put more funds in Husband's Child's account and then when Husband's Child has a child, change the beneficiary. This involves moving the beneficiary down a generation, with the risks described above, but it may be the better option given the family situation. Again, the Trustee would need to make certain that the combined balances of the accounts for Husband's Child would not exceed the contribution limit established by the 529 plan.

This question provides a great example of the complexities of using 529 accounts inside trusts.

* * * * * * * *
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.

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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