ARTICLES

The following article, written by Robert L. Struse, was presented before the Annual State Bar of Arizona Convention in June 2000.

THE COMPLETED GIFT THAT CAN BE REVOKED: QUALIFIED STATE TUITION PROGRAMS UNDER IRC SECTION 529

Definitions

As with most Internal Revenue Code sections, there are definitions which need to be considered. The major ones are:

1. Designated beneficiary. The term designated beneficiary means (a) the individual designated as a beneficiary of the account at the time the account is established; or (b) the individual who is designated as the new beneficiary if the beneficiaries are changed.
2. Member of the family. A member of the family is a fairly extensive term including brother, sister, parent, grandparent, son, daughter, uncle, aunt, niece, nephew, immediate in-law, spouse of any of these persons, and includes half-siblings, step-children and step-parents. The Affordable Education Act of 2000 which passed the Senate on March 2, 2000 would increase the class of member of the family to include first cousins as well.
3. Qualified higher education expense. This includes tuition, fees, books, supplies, or equipment required for enrollment or attendance of a designated beneficiary at an eligible education institution. It also includes room and board if the student's enrollment qualifies as at least half-time. The levels for room and board are generally the school's posted room and board charge for students living in student housing, or $2,500 per year for students living off campus and not at home, or $1,500 for students with no dependents living at home with a parent.
4. Distributee. The designated beneficiary or account owner who receives, or is treated as receiving, a distribution.
5. Account owner. The person who is entitled to select or change the designated beneficiary account to designate any person other than the designated beneficiary to whom funds may be paid from the account, or receive distributions from the account, if no other such person is designated. This means the account owner can retake possession of the money placed in the account.
   

General Requirements

With the definitions in mind, Section 529 dictates general requirements for a state plan to become a Qualified State Tuition Program (QSTP). The general qualifications are:

1. The program must be maintained by a state or agency or instrumentality of a state;
2. The program allows a person to purchase tuition credits or certificates on behalf of a designated beneficiary or make contributions to an account which is established for the purpose of meeting qualified higher education expenses of the designated beneficiary;
3. The program must require that all contributions be made in cash;
4. The program must impose a penalty on any distribution of earnings from the account which is not used for qualified higher education expenses of a designated beneficiary or made on account of the death or disability of the designated beneficiary. The proposed regulations provide a safe harbor if the penalty is equal to or greater than ten percent (10%) of the earnings;
5. Each designated beneficiary must receive a separate accounting of the assets held for him or her;
6. The program must not allow the contributor or any designated beneficiary to manage the investment of the contributions, directly or indirectly, of the program or any earnings thereon;
7. The account may not be used as security for a loan; and
8. The program must provide adequate safeguards to prevent contributions in excess of those necessary to provide for the qualified higher education expenses of the beneficiary.

Income Tax

Assuming the state run program meets all of the requirements imposed by Section 529, the income from the program is not taxable within the program. Thus, the earnings on the contributions can roll over tax free so long as they are maintained within the program. Once a distribution is made, the distribution is includible in gross income of the distributee in the same manner as provided in Section 72 of the Internal Revenue Code. This means that the increase in the plan value is taxed upon distribution at ordinary income tax rates. Distributions are divided between income and return of principal prorated based on account value. Example 2 under proposed Regs. Section 1.529-3 provides generally that in 1998, an individual, B, opens a college savings account with a qualified state tuition program (QSTP) on behalf of a designated beneficiary. B contributes $18,000 to the account. On December 31, 2011, the total balance in the account is $30,000. In 2011, the designated beneficiary enrolls in a four-year university and the QSTP makes distributions to the university for expenses in the amount of $7,500. The calculations for 2011would be as follows:

• Investment in the account $18,000
• Total balance in the account as of 12/31/11 30,000
• Earnings as of 12/31/11 12,000
• Distributions in 2011 7,500
• Earnings ratio for 2011 ($12,000 / 30,000) 40%
• Earnings portion of distribution 2011 ($7,500 x 40%) 3,000
• Return of investment portion 4,500
  

The Affordable Education Act of 2000 provides that the earnings from a 529 Plan would not be taxable to the distributee if the payments were made to a designated beneficiary for qualified education expenses. Should this be ultimately enacted, this obviously would have even greater effect on the usability of Section 529 Plans. For a distribution made which is subject to the penalty as a non-qualified distribution, the amount of the penalty is not included in the gross income of the distributee nor is it deductible by the distributee.

The owner of the account may change the designated beneficiary of an interest in a QSTP and this will not be considered a distribution if the new beneficiary is a member of the family of the old beneficiary. Additionally, it is not considered a distribution if, within 60 days of the payment, the payment is transferred to the credit of another designated beneficiary under a QSTP who is a member of the family of the designated beneficiary.

Gift, Estate and Generation-Skipping Tax

The income tax effects make Section 529 a good program for use in saving for the college education of the designated beneficiary. However the estate, gift and generation-skipping tax provisions are also interesting and create additional benefits. Initially, a contribution to a qualified tuition program on behalf of any designated beneficiary is considered a completed gift which is not a future interest under gift and generation-skipping tax provisions. It is not a qualified transfer under Section 2503(e). In addition, should transfers be made in excess of the limitation set forth in Section 2503(b), the aggregate amount, at the election of the donor, shall be taken into account ratably over the five-year period beginning with that calendar year. This means that someone could contribute $30,000 to a QSTP in year one and elect to treat it as having been made at the rate of $6,000 per year over the five-year period. Any amount over the 2503(b) amount ratably assessed over five years is a gift in the year given. In addition, the proposed regulations provide that these gifts may be split between spouses under Section 2513. Thus, a person could contribute $100,000 for the benefit of a grandchild and split the gift with his or her spouse and not be subject to any gift or generation-skipping tax. This provides good benefits in a particular year in that larger amounts can be given and the earnings accrue tax free. The distribution to a designated beneficiary is not a taxable gift.

Should the account owner change the designated beneficiary, it is not treated as a gift if the transfer is to a member of the family and of same generational level. If the new designated beneficiary is one generational level below the original designated beneficiary, and is a member of the family, it is considered a gift. If the new designated beneficiary is two or more generational levels lower than the original designated beneficiary, it is treated as a gift and a generation skipping transfer as well. Interestingly, the person considered to having made the gift is not the account owner who made the change in designated beneficiary but the original designated beneficiary. However, the five year average and gift splitting devices would be available for the original designated beneficiary.

In the estate tax area, the amount held in a QSTP is not includible in the gross estate of the donor. The donor could be subject to estate tax if the donor has elected the five-year averaging and dies within that time period. In that case, the portion of the contributions properly allocable to the periods after the death of the donor are includible in his or her estate. Revenue Ruling 54-246 provides that no portion of a split gift is includible in the estate of the spouse having joined in on the gift splitting. However, that Revenue Ruling specifically applies to Section 811 of the 1939 Code which translates to Sections 2031-2044 of the 1986 Code. Potentially, this ruling may not apply to split gifts includible under Section 529. Section 529 provides any amounts properly paid on account of the death of the designated beneficiary would be includible in the estate of a designated beneficiary. However, the proposed regulations say that the value of the gross estate of the designated beneficiary includes the value of any interest in the QSTP. If the plan does not allow the assets in the plan to be paid to the estate of the deceased designated beneficiary or to dispose of it by will, perhaps it has no value in the designated beneficiary's estate.

As an example, any elderly person with substantial assets, including separate property, may wish to divest him or herself of a substantial portion of wealth. If that person had 20 grandchildren and great-grandchildren, in one year he could allocate $100,000 to a QSTP for each of the 20 descendants using a split gift with his wife. It would not be a gift for gift tax or generation-skipping tax purposes. Should he die within the five years, only that portion of his share of the gift would be brought back into the estate, therefore, a relatively small inclusion. If his wife dies within the five-year period, potentially no part of her gift would be pulled back into the estate. Should these contributions be made into accounts set up by his children, they could continue to control the accounts. They could change beneficiaries should a child not go to college, or in fact even remove the money for their own purposes after paying the 10% penalty.

State Plans

For information about various states QSTP, you can look at the internet at Saving for College and College Savings. Arizona has adopted a QSTP and has two different investment managers. The first is conducted by College Savings Banks. In this program, contributions would be placed in a certificate of deposit. The rate of return is adjusted with national index of college costs with a minimum guarantee of 4%. The second provider is Securities Management and Research Inc., a subsidiary of American National Insurance. This group allows you to select among six SM&R mutual funds. They range in risk from a growth fund to a more conservative bond fund. In addition, you can elect prior to making contributions a specific time period in which the mutual funds will change. As a result, the donor can elect a more aggressive equity portfolio in a designated beneficiary's early life and change at some point then to a more conservative portfolio for safety and liquidity during the payout years.

Arizona allows the account to be used to pay all higher education expenses allowed under Section 529 and exempts the earnings from Arizona state income taxes. Arizona allows the maximum amount to be held for any designated beneficiary as seven times the College Board Independent 500 College Index rounded down to the nearest $1,000 multiple. For the 1999-2000 college year, that indexed amount is $22,991. This would translate to a maximum amount of $160,000 this year. The Plan will not accept contributions in excess of that amount, and should the plan grow through investment to an amount beyond that barrier, the excess will be distributed.

Maine has another interesting plan. Merrill Lynch, Pearce, Fenner & Smith, Inc., serves as their program manager. In addition to more traditional mutual funds, they provide portfolios which they call active allocation portfolios. The asset allocation of each of these active allocation portfolios is periodically adjusted based on the age of the designated beneficiary in that portfolio. For example, if the designated beneficiary were ten years old, he or she would fit within a portfolio of children approximately his or her same age. As the class of designated beneficiaries mature toward college age, the asset allocation would slowly change from more aggressive growth to a more conservative portfolio for payment of the distribution amounts. This is actively managed by the manager.

Finally, the U.S. Department of Education has issued rules concerning student financial aid and 529 Plans. Whenever the account owner is the student or student's parent, it is considered an asset of the student or parent for student financial aid purposes. However, if the plan is held by a grandparent or someone else, it will not be considered at all as an asset in computing the expected family contribution.

*This article is not meant to be relied upon for any purpose, and the law concerning 529 Plans has changed since the article was initially published.