Sec. 529 provides the rules for qualified tuition programs (QTPs). Sec. 529(f), added by the Pension Protection Act of 2006, P.L. 109-280 (PPA ’06), states, “Notwithstanding any other provision of this section, the Secretary shall prescribe such regulations as may be necessary or appropriate to carry out the purposes of this section and to prevent abuse of such purposes. . . .” The Joint Committee on Taxation (JCT) noted in its explanation of the provision that abuse may arise because of the ability to change designated beneficiaries (DBs) in certain circumstances without triggering transfer tax and because taxpayers may be able to use Sec. 529 accounts as retirement accounts, thus gaining the tax benefits of qualified retirement accounts while avoiding their restrictions (JCT, Technical Explanation of H.R. 4, the “Pension Protection Act of 2006” (JCX-38-06), March 3, 2006, p. 369).
The Service has observed other situations in which the current law makes the abuse of Sec. 529 accounts possible. For example, the gift tax may be improperly avoided if a person contributes a large sum to a Sec. 529 account for himself or herself and then changes the DB to a member of his or her family who is in the same or a higher generation as the contributor. The potential for abuse also exists because contributions to accounts are treated as completed gifts to the DB even though the account owner (AO) may be able to withdraw the money at his or her discretion.
The IRS has announced that because of the potential for the abuse of Sec. 529 accounts, it intends to issue proposed regulations and is requesting written comments from tax practitioners on the rules it is contemplating.
The proposed regulations will include a general anti-abuse rule that will apply when Sec. 529 accounts are established or used for purposes of avoiding or evading transfer tax or for other purposes inconsistent with Sec. 529. In addition, the proposed regulations will provide specific rules relating to the tax treatment of contributions to and participants in QTPs, including rules addressing the inconsistency between Sec. 529 and the generally applicable income and transfer tax provisions of the Code.
General Anti-abuse Rule
The general anti-abuse rule will deny the favorable transfer tax treatment under Sec. 529 if contributions to those accounts are intended or used for purposes other than providing for the DB’s qualified higher education expenses (except to the extent otherwise allowable under Sec. 529 or the corresponding regulations). It is anticipated that the anti-abuse 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 Sec. 529 account, and the person who ultimately receives any distribution from the account. If it is determined that the transaction, in whole or in part, is inconsistent with the intent of Sec. 529 and the regulations, taxpayers will not be able to rely on the favorable tax treatment provided in Sec. 529.
Rules Relating to Contributions to and Participants in Sec. 529 Accounts
To address specific problems that have been identified, the Service plans that the proposed regulations will include rules:
- Treating a change of DB that results in the imposition of any tax as a deemed distribution to the AO followed by a new gift. The AO will therefore be liable for any gift or generation-skipping transfer (GST) tax imposed on the change of the DB, and the AO must file gift and GST tax returns if required.
- Limiting AOs to individuals and making the AO liable for income tax on the entire amount of the funds distributed for the AO’s benefit except to the extent that the AO can substantiate that the AO made contributions to the Sec. 529 account and therefore has an investment in the account within the meaning of Sec. 72.
- Providing that the definition of “person” as used in Sec. 529(b)(1) will have the same meaning as under Sec. 7701(a)(1) (i.e., individuals, trusts, estates, partnerships, associations, companies, or corporations).
- When contributors set up Sec. 529 accounts naming themselves as DB (or when Uniform Gifts to Minors Act and Uniform Transfers to Minors Act accounts set up such accounts for their minor beneficiaries) and subsequently change the DB, deeming the change of DB from the contributor to any other person to be a distribution to the contributor followed by a new contribution of the account balance by the contributor to a new Sec. 529 account for the new DB.
The proposed regulations will also include the following rules regarding the tax consequences arising from the death of a DB:
1. The value of the account will be included in the deceased DB’s gross estate for federal estate tax purposes if the AO distributes the entire Sec. 529 account to the deceased DB’s estate within six months of the DB’s death.
2. The value of the account will not be included in the deceased DB’s gross estate for federal estate tax purposes if:
- A successor DB is named in the Sec. 529 account contract or program and the successor DB is a member of the deceased DB’s family and is in the same or a higher generation as the deceased DB;
- No successor DB is named in the Sec. 529 account contract or program, but the AO names a successor DB who is a member of the de-ceased DB’s family and is in the same or a higher generation as the deceased DB;
- No successor DB is named in the Sec. 529 account contract or program, and the AO does not name a new DB but instead withdraws all or part of the value of the account; or
- By the due date for filing the de-ceased DB’s estate tax return, the AO has allowed funds to remain in the Sec. 529 account without naming a new DB.
In the last two instances, the regulations will also provide that the AO will be liable for the income tax on the distribution.
To some extent, the IRS’s proposed anti-abuse rules seem like a solution in search of a problem, as there is little evidence that taxpayers are actually taking advantage of the Sec. 529 loophole. For example, according to the College Savings Plan Network, as of March 31, 2007, the average Sec. 529 plan held only $11,709. However, the potential for abuse does exist, and as such it is the Service’s duty to close down the loophole as directed by Congress in the PPA ’06.
Announcement 2008-17, 2008-9 IRB 512 (2/28/08)