On Jan. 17, 2008, the Internal Revenue Service issued an Advance Notice of Proposed Rulemaking (Advance Notice), in which the IRS requests help writing regulations to Internal Revenue Code Section 529 to deter abuse.1 The threat is that if the IRS does not receive better suggestions, it will impose these proposed rules — which will eliminate many of the advantages of 529 savings accounts. The Service is about to throw the baby out with the bathwater.
Congress enacted Section 529 in 1996 to provide taxpayers with a tax-advantaged, flexible vehicle for saving for qualified higher education expenses. The IRS issued proposed regulations in 1998. Section 529 provides great flexibility, but in doing so contravenes many of the venerable rules of gift, generation-skipping transfer (GST) and estate taxation. Congress' disregard of these rules produced many theoretical tax loopholes. So Congress became concerned about abuses. But, rather than solving perceived problems with statutory amendments, the lawmakers directed the IRS to prescribe regulations to prevent the perceived abuse.2
I feel a bit of sympathy for the IRS' struggle with the Gordian knot that Congress created. On the other hand, I wonder how much abuse there actually is (let alone documented), and why existing anti-abuse doctrines such as the step-transaction doctrine, combined with the new preparer penalty rules and bolstered by the Section 529's 10 percent penalty for nonqualified distributions, do not give the Service sufficient ammunition against abuses.
Here's what the IRS proposes to do with 529s and why some of these changes are misguided. I call on my fellow practitioners to acquaint themselves with the specifics and speak up — before it's too late. March 18, 2008, is the deadline for comments. The more voices raising reasonable objections and offering reasonable alternatives, the better our hopes for preserving the flexibility of 529 savings accounts.
Change of beneficiary — Section 529 permits the beneficiary of an account to be changed without income tax consequences if the new beneficiary is a “member of the family” of the old beneficiary. However, the gift tax will apply to a change of beneficiary if the new beneficiary is in a lower generation than the old beneficiary. The GST tax will apply if the new beneficiary is two or more generations below the old beneficiary. The proposed regulations impose the gift and GST tax consequences on the old beneficiary, notwithstanding that the old beneficiary had no control over the account. The Advance Notice proposes to assign the tax liability to the account owner by treating a change of beneficiary that is subject to gift tax “as a deemed distribution to the [Account Owner] followed by a new gift.” The Advance Notice does not make clear whether the IRS will attempt to treat this “deemed distribution” to the account owner as a nonqualified distribution subject to income tax. The statute itself appears to prohibit the imposition of income tax in such a situation.3
On the gift tax side, the Advance Notice does not indicate whether the GST tax consequences of the new gift will be determined by assuming that the transferor is in the generation assigned to the account owner or the generation assigned to the old beneficiary. Unfairness will result unless the GST tax consequences of the new gift are determined by allowing the account owner to “borrow” the generation assignment of the old beneficiary, because the original contributor already incurred the transfer tax consequences of getting the 529 assets down to the old beneficiary's generation.
Although assigning the transfer tax liability to the account owner solves the problem of thrusting liability on the beneficiary who does not control the account, it does not permit the use of the old beneficiary's gift and GST tax annual exclusions. Because Section 529 treated the original contribution as a completed gift to the old beneficiary, the old beneficiary's annual exclusions should apply to the imputed transfer to the new beneficiary if the old beneficiary consents. A fairer solution would be to impose the transfer tax consequences on the account owner only when the old beneficiary does not file a timely gift tax return reporting the imputed gift, and to permit a parent or guardian to file a gift tax return on behalf of an old beneficiary who is a minor, at least to use the old beneficiary's gift and GST tax annual exclusions and make the five-year election.
Distributions to account owners — The Advance Notice states that the IRS intends to develop rules “making the [Account Owner] liable for income tax on the entire amount of the funds distributed for the [Account Owner's] benefit except to the extent that the [Account Owner] can substantiate that the [Account Owner] made contributions to the section 529 account.”
This rule would mean that once the original account owner ceases to act, whether by choice, disability or death, the entire account (not just the earnings) would be subject to income tax if distributed to the new account owner. Not all refunds to a noncontributing account owner are abusive. Further, this rule would seem to be easily avoided in the case of a nonqualified distribution if the new account owner changed the beneficiary to a member of the family of the old beneficiary, possibly even the account owner's spouse, and then made the distribution to the new beneficiary. The theoretical abuses can be addressed by the proposed anti-abuse rule.
Anti-abuse rule — The Advance Notice presages an anti-abuse rule, which may be applied on a retroactive basis. The rule “will generally follow the steps in the overall transaction by focusing on the actual source of the funds for the contribution, the person who actually contributes the cash to the section 529 account, and the person who ultimately receives any distribution from the account.” The favorable tax treatment granted by Section 529 will be denied if “it is determined that the transaction, in whole or in part, is inconsistent with the intent of section 529.” We can look forward to examples “that provide clear guidance to taxpayers about the types of transactions considered abusive.”
It is certainly fair to prohibit abusive step transactions, and kind of the IRS to provide examples for those who do not recognize a step transaction when they see one. But the IRS goes further with this threat: “If concerns regarding abuse continue, the IRS and the Treasury Department will consider adopting broader rules including, for example, rules limiting the circumstances under which a [Qualified Tuition Program] may permit [Account Owners] to withdraw funds from accounts; limiting the circumstances under which there may be a change in [Designated Beneficiary]; and limiting the circumstances under which the [Account Owner] may name a different [Account Owner].”
Trusts (and other entities) as account owners — Section 529 states that “persons” may contribute to 529 savings accounts. Section 529 does not refer to “account owners,” so it does not state who may be an account owner. IRC Section 7701(a)(1) defines “person” to include generally an individual, a trust, estate, partnership, association, company or corporation.
The Advance Notice in Section II, B states that the IRS expects to develop rules that limit account owners to individuals. Section II, C of the Advance Notice calls for comments on whether contributors to 529 accounts should be limited to individuals.4
Both limitations are unnecessary restrictions on the ability of trusts and estates to be account owners of 529 savings accounts. First, trusts permitting distributions for the qualified higher education expenses of a beneficiary should be able to use the same tax-favored investment vehicle as individuals. Second, a trust limits the potential for abuse, because if the trust makes a nonqualified distribution to itself, the funds are refunded to the trust and not to the transferee or grantor personally. Third, it is feasible to draft workable tax rules for when a trust is the account owner.
Self-owned accounts and Uniform Transfers to Minors Act (UTMA) accounts — The Advance Notice states that “it is anticipated that the notice of proposed rulemaking will allow contributions to section 529 accounts by individuals for their own benefit and by Uniform Gifts to Minors Act (UGMA) and UTMA accounts for the benefit of their minor beneficiaries.” Although the Advance Notice makes this sound like a concession by the IRS, there is no policy reason why the income tax advantages of 529 should not be available to individuals saving for their own higher education or to UTMA accounts when the custodian expects to make distributions for the beneficiary's higher education. Section 529 savings accounts should be both a gift vehicle and an investment choice for saving for higher education.
The Advance Notice correctly notes that because no gift occurs in such situations, a subsequent change of designated beneficiary should be subject to transfer tax as if it were an original 529 contribution by the old account owner/beneficiary to the new beneficiary.
Inclusion in beneficiary's estate — The Advance Notice proposes sensible rules for when a 529 savings account should be included in the estate of the beneficiary. Section 529 cryptically says that amounts distributed on account of the death of a beneficiary are subject to estate tax, without defining what is meant by “distributed.” The legislative history and the proposed regulations suggest that the value of any interest in a 529 account will be includible in the estate of a deceased beneficiary. This position does not make sense because the beneficiary does not have any control over the account and the beneficiary's estate will not necessarily receive the account funds. The Advance Notice proposes five rules:
Rule 1 — If the account owner distributes the 529 account to the deceased beneficiary's estate within six months of death, the account will be included in the deceased beneficiary's estate.
Rules 2 and 3 — If the 529 account contract, the 529 program, or the account owner names a successor beneficiary who is a member of the family of the deceased beneficiary and in the same or a higher generation than the old beneficiary, the account will not be included in the deceased beneficiary's estate.
Rule 4 — If the account owner withdraws the account, the account owner will be liable for income tax and the account will not be included in the deceased beneficiary's estate.
Rule 5 — If, by the due date for filing the deceased beneficiary's estate tax return, the account owner has allowed funds to remain in the 529 account without naming a new designated beneficiary, the account will be deemed distributed to the account owner, making the account owner liable for income tax, and the account will not be included in the deceased beneficiary's estate.
There seems to be no rule for what happens if a new beneficiary is designated who is a member of the family of the deceased beneficiary, but is in a lower generation than the old beneficiary. If the IRS follows this rule for taxable changes of beneficiaries, the account owner would be treated as making a taxable gift to the new beneficiary. However, in many cases, deemed inclusion in the old beneficiary's estate would not result in any estate tax because of the estate tax exclusion.
A compromise would be to treat the account as included in the beneficiary's estate and to not subject the account owner to transfer tax when the deceased beneficiary's estate includes the 529 account in the estate on a timely filed estate tax return, or when the value of the deceased beneficiary's estate — including the value of the 529 account — would not require the deceased beneficiary's estate to file an estate tax return.
Five-year election — A contributor to a 529 account may elect to have a contribution in an amount up to five times the annual exclusion amount treated as if it were made pro rata over five years. The Advance Notice does not change prior guidance, except to provide that the election may be made, if a timely gift tax return is not filed, on the first gift tax return filed by the donor after the due date.
Timing of distributions and expenses — The Advance Notice proposes a rule that, 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. This is a reasonable rule to match distributions to expenses without the rigidity of a rule that requires the expenses to be paid within the same calendar year.
Written comments may be submitted to the IRS by March 18, 2008. The IRS then plans to issue a new notice of proposed rulemaking that will include the 1998 proposed regulations with modifications and rules addressing the issues discussed in the Advance Notice. The IRS anticipates that the new rules will generally apply only prospectively — except that the anti-abuse rule will apply retroactively.
- The text of the Advance Notice of Proposed Rulemaking on Internal Revenue Code Section 529 can be found online in the Trusts & Estates Bookstore and Library in the Supporting Documents section at www.trustsandestates.com.
- See Section 529(f), created by the Pension Protection Act of 2006.
- See IRC Section 529(c)(3)(C)(ii).
- The Advance Notice erroneously asserts that it can be argued that “person” should be limited to individuals. IRC Section 529(e)(1)(C) anticipates that governmental entities and charities, which are obviously not individuals, may contribute to 529 accounts.
Susan T. Bart is a partner in the Chicago office of Sidley Austin LLP