First Place Winner 2009


Adam Winger 
Georgia State University/New York University


I. Introduction


Section 529 of the Internal Revenue Code (“Code”) enables states to create Qualified Tuition Programs (“QTPs”).[1] QTPs offer tax advantages to “encourage saving for college costs.”[2] These programs come in two forms: the prepaid tuition plan, and the education savings plan.[3] The prepaid option permits an individual to “purchase tuition credits or certificates on behalf of a designated beneficiary which entitle the beneficiary to the waiver or payment of qualified higher education expenses of the beneficiary.”[4] These programs essentially “‘lock in’ tuition at today’s rate and avoid the risk that tuition increases will exceed the rate of earnings on the funds invested.”[5] Savings account programs allow contributors to make contributions to an account originated for a “designated beneficiary” (“DB”).[6]These plans permit participants “to select among different investment options or strategies” to best ensure sufficient funding to offset future tuition expenses.[7] 

Section 529 encourages college savings by extending to contributors income and transfer tax benefits.  All earnings realized within a § 529 savings account are exempt from income tax while inside the account.[8] These earnings avoid income taxes altogether so long as they are eventually used to pay “qualified higher education expenses” to an “eligible educational institution.”[9] Proceeds used for non-educational purposes are treated less favorably.  Not only are the earnings subject to income tax, but an additional 10% tax penalty is also imposed on those earnings not used for educational purposes.[10] 

In the transfer tax context, donor contributions to a § 529 plan are “treated as a completed gift to such beneficiary” and not future interests in property.[11] As such, funding a § 529 account qualifies for the federal gift tax annual exclusion underCode § 2503(b).[12] The excludible portion for gift tax “also satisfies the requirements of section 2642(c)(2) and, therefore, is also excludible for purposes of the generation skipping transfer tax imposed under section 2601.”[13] Rounding out the transfer tax treatment, the donated sum is generally not included in the donor’s gross estate.[14] Instead, because the contribution is treated as a completed gift to the beneficiary, the plan assets are included in that prospective student’s gross estate.[15] 

In addition to the various tax incentives, § 529 also offers the benefit of flexibility.  Under § 529, an “account owner” (“AO”) serves as fund manager and thus “retains control over the selection of the DB and has personal access to the funds.”[16]  The original contributor may personally assume this role or may appoint another to serve as AO.  While this flexibility is undoubtedly consistent with § 529’s core effort to encourage saving for college expenses, the expansive control afforded the AO creates a number of tax and non-tax complications.[17] 

It is inconsistent with general transfer tax concepts that a contributor enjoy the tax benefits of a completed gift while retaining sole control over the account assets.  Furthermore, the AO’s unbridled ability both to rename the beneficiary and withdraw funds frustrates § 529’s intent, placing the DB’s education at risk.  Even worse, AOs currently owe no fiduciary duties to DBs.  Thus, an AO may raid the § 529 account of a defenseless, and likely unknowing, DB without the threat of legal recourse.

This paper analyzes the potential for AO abuse under § 529, and proposes solutions to rectify the section’s shortcomings.  Part II chronicles the statute’s legislative history.  Part III exposes the historical events leading to the current abuse.  Part IV sets forth potential solutions to restore the focus of § 529 to the education of the DB.  Finally, part V concludes by calling the Treasury to action.


II. Legislative History

A. Small Business Job Protection Act of 1996
Section 529 was added to the Code by the Small Business Job Protection Act of 1996.[18] Under § 529, as originally enacted, contributions to a § 529 account were not treated as completed gifts.[19] Instead, the contributed funds remained a part of the donor’s estate until an actual distribution was made.[20] This approach comports with general transfer tax policy.

Under gift tax regulations, a gift is considered “complete” when “the donor has so parted with dominion and control as to leave in him no power to change its disposition, whether for his own benefit or for the benefit of another.”[21] Because the original § 529 contributor retained both the right to change the account DB and the ability to take personal distributions, she had not sufficiently “part[ed] with dominion and control.”[22] As a result, the gift was deemed “incomplete” and the donor was not able to utilize her annual § 2503(b)exclusion.[23] Thus, as originally drafted, the only tax benefit afforded the contributor was the prospect of the investment’s tax-free growth.[24]
B. Taxpayer Relief Act of 1997
Apparently, this enticement was not sufficient, for one year later, Congress found it necessary to sweeten the tax treatment of § 529 accounts with its passage of the Taxpayer Relief Act of 1997.[25] Notwithstanding the blatant inconsistencies involving the donor’s continuing control, in 1997, a contribution to a § 529 account became treated as a completed gift to the DB.[26] Estate tax consequences were also modified to reflect the new characterization.  Because the gift was complete, the donated proceeds became includable in the DB’s, not the contributor’s, gross estate.[27] While this amendment may have furthered the effort to attract additional contributions, its inconsistencies with transfer tax law created a number of residual problems.

One particular issue arose when the contributor elected to change the recipient DB.  Under the original version, neither the initial contribution nor a change in beneficiaries resulted in a taxable transfer because the account assets remained part of the donor’s estate.[28] When the contribution became a completed gift, however, it became necessary to determine whether the naming of a new DB also constituted a taxable transfer.

The 1997 amendments adopted the position that a change in DBs is not a taxable transaction so long as the new DB and old DB are “members of the same family.”[29] Should the DBs be unrelated, however, the amendment considers the transfer a taxable gift from the old DB to the new DB.[30] As a result, the old DB is responsible for filing a gift tax return and is liable for any resulting transfer taxes.[31] This result comports with general transfer tax policy.  Because the funds were “given” to the initial DB, any subsequent transfer made without “adequate and full consideration” must also be deemed a gift.[32]
C. 1998 Proposed Regulations
The next major § 529 modification came a year later in the Treasury’s issuance of the 1998 Proposed Regulations.[33]  In addition to providing a number of much-needed technical clarifications, the regulations represent the Treasury’s first recognition of the Account Owner.[34]  The regulations formally define the AO as the individual “entitled to select or change the designated beneficiary of an account, to designate any person other than the designated b­­eneficiary to whom funds may be paid from the account, or to receive distributions from the account if no such other person is designated.”[35]  Before 1998, the only figures involved in the federal § 529 conversation were the contributor and DB.[36]  The introduction of the AO represented the Treasury’s recognition and endorsement that a potentially non-contributing individual may “retain[] control over the selection of the DB and ha[ve] personal access to the funds in the account.”[37]
D. Pension Protection Act of 2006
Approximately eight years after the issuance of the Proposed Regulations, Congress made the next material alteration to § 529 with its passage of thePension Protection Act of 2006.[38]  In addition to extending many of the § 529 tax benefits, the Act added § 529(f) to the Code.[39]  Section 529(f) permits the Treasury Secretary to prescribe regulations “to carry out the purposes of this section and to prevent abuse of such purposes.”[40]

The Joint Committee on Taxation prepared the Technical Explanation to the Act.  In it, the committee described the current § 529 tax treatment as both “unclear and . . . inconsistent with generally applicable transfer tax provisions.”[41]  Accordingly, § 529(f) also confers upon the Secretary “broad regulatory authority to clarify the tax treatment of certain transfers.”[42]  The Technical Explanation also made public Congress’ knowledge that current § 529 practices created the risk of abuse.  In doing so, the committee called upon the Secretary “to ensure that qualified tuition program accounts are used for the intended purpose of saving for higher education expenses of the designated beneficiary.”[43]
E. 2008 Advanced Notice of Proposed Rulemaking
Armed with this authoritative firepower, on January 18, 2008, the Treasury took action, issuing its Advance Notice of Proposed Rulemaking (“Advanced Notice”).[44]  The Advanced Notice addressed a number of abusive scenarios, two of which have a direct impact on the DB. First the Treasury took issue with an AO’s taking a distribution from the § 529 assets for his or her own personal purposes,[45] and secondly, it questioned the tax treatment associated with an AO’s changing of account’s beneficiaries.[46]
1. Personal AO Withdrawals
The Advanced Notice recognizes the inherent unfairness in treating “contributions . . . as completed gifts to the DB even though the account owner may be able to withdraw the money at his or her own discretion.”[47]  It finds the situation particularly unjust when the contributing AO transfers his control to a new, potentially dishonest AO.[48]  Specifically, the Advanced Notice takes issue with the non-contributing AO’s “right to completely withdraw the entire account for the new AO’s benefit,” thus depriving the DB of any educational security.[49]  While the Advanced Notice declines to provide specific factual examples, abusive scenarios could easily arise in a variety of forms.[50]  

Suppose, for instance, a contributing AO passes away leaving his entire estate to his wife, the stepmother of the DB.  The stepmother takes over as AO, and because she is either dissatisfied with her inheritance or because she simply dislikes the stepchild, she raids the § 529 account leaving nothing for the child’s future education.  While more benign scenarios surely exist, the result of any non-contributing AO distribution is the same; assets securing at least a portion of the child’s education are appropriated for the personal benefit of another.

To guard against this result, the Advanced Notice proposes regulations to apply greater scrutiny to transactions where “the person who actually contributes the cash to the section 529 account, . . . [is not] the person who ultimately receives [the] distribution.”[51]  Should this heightened investigation expose the presence of AO impropriety, the Advanced Notice warns that “taxpayers will not be able to rely on the favorable tax treatment provided in § 529.”[52]  Specifically, the Treasury intends to hold the “AO liable for income tax on the entire amount . . . distributed except to the extent that the AO can substantiate that the AO made contributions to the section 529 account.”[53]  This tax would presumably be in addition to the standard 10% penalty already imposed on earnings distributed for non-education purposes.[54]  In conjunction with these negative tax consequences, the Treasury indicated its willingness to “consider adopting broader rules . . . limiting the circumstances under which a QTP may permit AOs to withdraw funds from accounts.”[55]
2. Taxable Change in DB
In accordance with both the 1997 amendments and the 1998 Proposed Regulations, when “the AO directs a rollover of credits or account balances from the account of one beneficiary to the account of another beneficiary [who is not in the same family] . . . , the change of DB by the AO is treated as a taxable gift by the former DB to the new DB.”[56]  The DB is held liable even though the “AO retains control over the selection of the DB,” and in many cases, the minor DB is not even “aware of the existence of the account.”[57]  Thus, in the hypothetical introduced above, if instead of taking the money for her own benefit, the stepmother renames the DB to an unrelated recipient, the old DB is still held responsible for the gift taxes.[58]  

The American College of Trust and Estate Counsel took issue with this treatment stating “the fact that the old DB had no control over the section 529 account may make it impractical, if not unconstitutional or otherwise legally impermissible, to require that the DB report the gift and incur any gift tax consequences.”[59]  The Treasury apparently agreed, and in the Advanced Notice a new two-step process was proposed to better “assign the tax liability to the party who has control over the account and is responsible for the change.”[60]

The new approach treats any taxable change in DBs, that is directed by the AO, as “a deemed distribution to the AO followed by a new gift” to the successor DB.[61]  This approach appropriately holds the controlling AO, not the DB, liable for resulting transfer taxes.  Furthermore, it avoids the improper use of the old DB’s lifetime gift exclusion for a transfer made without the DB’s consent or knowledge.

This approach, as well as the proposals set forth for limiting AO withdrawals, represents a much needed step in protecting the DB’s ability to pay higher education expenses.  Unfortunately, however, it appears more is necessary to realign § 529’s focus from extending tax benefits to providing the nation access to higher education.

III. Erosion of DB’s Access to Higher Education


As the Advanced Notice suggests, the mechanics of § 529 reflect a near complete indifference for the educational security of the prospective student.[62]  Two key events can be held accountable for this result: (1) the 1997 amendment treating contributions as completed gifts to the DB,[63] and (2) the Treasury’s endorsement of an AO’s access to the account assets in the 1998 Proposed Regulations.[64]

A. 1997 Amendments
The 1997 decision to treat § 529 contributions as completed gifts began the process of eroding the DB’s interest in the account assets.  As previously mentioned, general gift tax law provides that a “transfer will be recognized as a gift only if the transfer is complete and irrevocable.”[65]  Because the AO retains almost complete control, under ordinary circumstances a § 529 contribution would not be considered a completed gift.[66]  In addition to contradicting fundamental principles of transfer tax law, treating it as a completed gift creates other legal irregularities by disregarding the structural realities of the § 529 arrangement.
1. Trust Law Inconsistencies
The approach adopted in 1997 gives the donor all the transfer tax benefits of a contribution to an irrevocable trust, even though the arrangement’s structure more closely resembles one with rights of revocation.  However, the AO is in an even better position than the settlor of a revocable trust because while she retains complete control over the account she is assigned none of the accompanying legal duties.[67]
a. Revocable Trust
At the very least the creation of a trust involves a declaration by the settlor that “he holds the property in trust for himself and that upon his death the property is to be held for other beneficiaries.”[68]  Even after the declaration is made, the settlor of a revocable trust retains any “number of rights and powers, such as the right to receive the trust income, to amend or revoke the trust and the right to control trust investments.”[69]  Recognizing this retention of significant control, the I.R.S. holds the settlor liable for any income taxes owed on trust earnings.[70]  Similarly, for transfer tax purposes, the funding of the trust is not deemed to be a “completed gift” and “the trust assets will be included in his gross estate upon his death.”[71]

In addition to the ability to control and amend trust terms, settlor actions are not subject to fiduciary obligations.[72]  In fact, “the settlor or donee can properly, . . . with no need to justify or explain, eliminate the interest of any or all beneficiaries.”[73]  Nor can the settlor “be compelled to provide information or an accounting or report,” but he “is not subject to surcharge by other beneficiaries or a successor trustee for breach of trust.”[74]  Even though the settlor may not owe them any specific fiduciary duties, “[a] trust necessarily grants rights to the beneficiary that are enforceable in equity.”[75]  This recognition, while not amounting to property rights, vests in the beneficiary the ability to hold a non-settlor trustee accountable for actions that contradict the intent of the settlor.
b. Irrevocable Trust
In contrast to the broad powers retained by the settlor in the revocable trust context, when property is transferred to an irrevocable trust, the settlor relinquishes all authority “to revoke or amend.”[76]  This generally involves the divestment of both the “power to change beneficiaries” and the ability to compel distributions for the settlor’s own personal purposes.[77]  Furthermore, once trust assets are transferred, common law imposes fiduciary duties upon the named trustee.

Perhaps the most fundamental of these obligations is the requirement “to carry out the directions of the . . . settlor as expressed in the terms of the trust.”[78]  Courts typically impose the affirmative duty that “[t]he clearly expressed intention of the settlor should be zealously guarded.”[79]  Thus, only in rare circumstances may a trustee take “actions which conflict with the grantor’s stated intent.”[80]  Trust law also imposes a duty of disclosure upon the trustee.

The disclosure obligation requires trustees to make “beneficiaries of the trust reasonably informed about the administration of the trust and of the material facts necessary for them to protect their interests.”[81] To satisfy this requirement, the trustee is obligated to provide an accounting to the beneficiaries.[82]  An accounting essentially includes an explanation of the trust’s performance and a record documenting all actions taken by the trustee.[83]  Such disclosures enable the beneficiary to monitor trustee actions to prevent breaches of trust.[84]  For example, without the right to request an accounting, a trustee could loot the trust and the beneficiaries would have no way to detect it.

In addition to imposing fiduciary duties, the settlor’s divestment of control confers upon the beneficiaries an immediately recognizable property interest.[85]  This finding is in accord with the I.R.S.’s determination that a transfer to an irrevocable trust constitutes a completed gift for tax purposes.[86]  Despite the beneficiary’s lack of immediate access to the trust funds, the settlor has “parted with dominion and control,” and as a result, the gift is appropriately deemed complete.[87]  Consequently, the grantor is no longer responsible for any income tax generated by the property, and the contributed assets are then includible in the beneficiary’s estate.[88]
c. Trust Comparison to the § 529 Account.
The structure of the § 529 savings account is a hybrid of the revocable and irrevocable trusts.  Like both trusts, an initial § 529 contribution requires the donor to have the initial intent to pay future education costs of the DB.[89]  Aside from this, the only other structural resemblance to an irrevocable trust is that both require a legal transfer from the “Contributor” to the “Account Owner.”[90]  The § 529 savings account and the revocable trust have much more in common.

Like a revocable trust grantor’s ability to appoint herself as trustee, the § 529 donor may name himself or anyone else to the position of AO.[91]  Furthermore, the AO, like the revocable trust’s grantor-trustee, retains an unchecked ability to change beneficiaries and make personal withdrawals.  If the donor assumes the role of AO, as is typically done by the settlor in the revocable trust, there is clearly no “part[ing] with dominion and control.”[92]  Notwithstanding these extensive similarities, the I.R.S. treats a § 529 contribution as a completed gift just as if an irrevocable trust were funded. This treatment is clearly unwarranted, for unlike the irrevocable trust, and contrary to the “completed gift” terminology, no property rights are transferred to the DB.[93]

In fact, courts have found that “[a] designated beneficiary has no rights or legal interests in an account unless the designated beneficiary is also the account owner.”[94]  Conversely, “contributions to the accounts ‘made by persons other than the account owner become property of the account owner,’ not the beneficiary.”[95]  Denying the § 529 DB such rights moves the DB to an even lower position than the beneficiary of a revocable trust.  At least in the trust context, the equitable rights enable the beneficiary to assert her rights in the event of a breach of trust.  Despite the absence of anything even remotely resembling a legally defensible property interest, the 1997 amendments treat the DB as the recipient of a gift, and therefore the DB is held liable, as “owner,” for any resulting taxation.[96]  

Consistent with the lack of property rights, DBs are also denied the benefit of any type of fiduciary protections.  Commentators routinely recognize that “the account owner of a section 529 savings account has no fiduciary duties to the beneficiary.”[97]  Consequently, other than being conferred equivalent tax treatment, the § 529 account bears almost no resemblance to the irrevocable trust.  Where the irrevocable trust requires the trustee to act in accordance with the terms of the trust document, “the account owner could change the beneficiary or withdraw the funds . . . and the beneficiary would have no grounds for complaint.”[98]  This is true, “even if the account owner’s actions clearly violated the donor’s intent.”[99]  Thus, a newly-appointed AO may flagrantly disregard the contributor’s desire that the proceeds be used to provide an education to the DB, and instead extract all the funds for his own personal benefit.  

Because the AO owes no fiduciary duty to the DB, there is also no obligation to keep the DB informed.  Unlike the trustee of an irrevocable trust, no legal requirement compels an AO to furnish information to the DB.  In fact, “[i]n many cases, the DBs are minors who may not even be aware of the existence of the account for their benefit.”[100]  Because the AO has no reporting obligation, the DB is essentially defenseless to the selfish whims of the AO.

In sum, the structure of the § 529 account shares nearly all characteristics of the revocable trust.  Neither imposes fiduciary duties, neither confers legal rights to the trust/account assets to the beneficiaries, and in both the AO/settlor retains complete control over the direction and management of the account.  Notwithstanding these extensive similarities, the 1997 amendments confer transfer tax treatment akin to that of an irrevocable trust.  Applying such treatment not only mischaracterizes the relationship between the AO and DB, but it incorrectly implies that the DB has legal standing to protect the educational funds in court.  While extending the additional transfer tax benefits may encourage additional § 529 contributions, it does so unnecessarily at the expense of the DB.
B. Recognition of the AO
The second event leading to the potential deprivation of the DB’s education was the Treasury’s recognition of the AO in the Proposed Regulations of 1998.  By acknowledging a non-contributing AO’s right to withdraw § 529 assets, the Treasury did more than provide definitional clarification; it conferred supreme rights to a previously unrecognized figure.

The original 1996 Conference Report to § 529’s enactment explains that, “[e]arnings on an account may be refunded to a contributor orbeneficiary.”[101]  Noticeably missing from the list is the AO.  Furthermore, only rules pertinent to the “Tax Treatment of Designated Beneficiaries andContributors” are provided in § 529.[102]  In fact, at no point in either the original statutory language nor at any time in the evolution of § 529 is the term “Account Owner” ever mentioned.[103]  While this omission could be the result of sheer legislative oversight, the more logical conclusion is that the drafters never envisioned giving access to a non-contributing party.

The Treasury added credence to this conclusion in the Advanced Notice, stating that the definition of AO was added merely “to reflect practices used at that time to facilitate the establishment of accounts for minor beneficiaries.”[104]  States most likely found it necessary to add the AO to resolve conflicts relating to the many situations in which the contributor does not participate in the active management of the account.  For instance, the contributor could pass away, become incompetent, or simply contribute to an existing account already managed by an AO.[105]  Unfortunately, conforming § 529 to current state practices meant also giving unrestricted access to a potentially dishonest AO.  The extension of this unfettered authority creates a number of disastrous results.

Most importantly, permitting a withdrawal by a non-contributing AO may deprive the DB of resources necessary to secure a higher education.  Allowing non-educational distributions unavoidably decreases the likelihood that the DB will have sufficient funds to cover his or her education expenses.  Combine this with (1) the rising cost tuition, and (2) private lenders’ current reluctance to issue student loans, [106] and it becomes a legitimate possibility that the child will be unable to attain a higher education, much less attend the school of her preference.[107]

In a recent nationwide poll of prospective college students, 16% “said they are putting off college because they don’t think their families will be able to afford the costs,” while 57% reported “considering a less prestigious college because they are worried about affordability.”[108]  Though the flexibility of providing access to a non-contributing AO may well promote § 529 deposits, the risk of frustrating the primary purpose of increasing accessibility to college education seems of far greater importance.[109]  While there may be any number of compelling reasons to justify a non-donor AO withdrawal, the regulatory focus should remain on providing the utmost protection for § 529’s core purpose, education.  To do so, an AO’s access to § 529 account assets should be limited.

In addition to potentially depriving the student of her education, permitting access to a non-contributing AO also risks frustrating the donor’s original intent.  While the possibility of withdrawal may add to the account’s attractiveness, reporting states uniformly agree that DB’s education is the donor’s actual objective.[110]  A personal withdrawal by a non-contributing AO, for any reason, results in the frustration of that intent.[111]  While extenuating circumstances surely justify emergency distributions, to further the stated objective of § 529 and the original intent of the donor, all effort should be made to restrict non-education related withdrawals.[112]

Lastly, permitting a disbursement to a non-contributing AO produces the harmful result of contradicting the very text of § 529.  As previously mentioned, the term ’account owner’ does not appear in section 529.  This omission supports the conclusion that even though Congress envisioned providing the contributor the flexibility of a personal distribution, under no circumstances was granting a non-contributor access envisioned.  By extending contributor rights to a successor AO, the Proposed Regulations not only added a completely unimagined participant, but conferred the most precious of § 529 rights; access to plan assets.  In doing so, the regulations unreasonably expanded the terms of § 529 in direct contradiction to the language and intent of § 529.

IV. Potential Solutions.


Despite the significant setbacks introduced by Congress and the Treasury, viable remedies exist.  While none are without drawbacks, they all represent a step in the right direction.

A. Eliminate Non-Contributor Account Modifications & Withdrawals
Denying all access to non-contributing AOs removes many of the issues currently afflicting § 529 plans.[113]  Doing so would (1) prevent AO withdrawals, and (2) deny non-contributing AOs the right to perform a taxable change in DBs.
1. Prohibit Non-Contributing AO Withdrawals
An action permanently denying non-contributing AO’s the right to make personal distributions offers a logical and effective solution.
a. Language and Intent
Eliminating non-contributing AO access is consistent with both the language and intent of § 529.  Original Committee Reports demonstrate Congress’s willingness to allow “refund[s] to a contributor or beneficiary”.[114]  Not only is the AO not an eligible recipient of such a refund, but the word “refund” itself supports denying the payment.[115]  Because a non-contributing AO made no initial investment, it is illogical to conclude that she would be entitled to a “refund.”  Furthermore, the omission of the term “account owner” supports the conclusion that the drafters never intended to extend account access to such a figure.  Finally, eliminating the AO’s ability to withdraw funds can be achieved with relative legislative ease.  Because the Treasury now has the ability to monitor and prevent abuse under § 529(f), corrective regulations can be promulgated as opposed to a burdensome and untimely legislative procedure.
2. Reverse Harm Associated with AO Recognition
While the recognition of the AO was explained as an effort to “reflect practices used at that time,” doing so silently endorsed the theft of the DB’s academic future.[116]  The Treasury erred in giving credence to this state-initiated practice, and denying an AO’s access to the account represents an effort to reverse the harm.  It is argued, however, that abuses associated with AO withdrawals are only hypothetical in nature and “it is less clear empirically the extent” to which they are actually taking place.[117]  While historical figures may support this assertion, proactively denying non-contributing AO access is still the preferable approach.

First, a wait-and-see approach ignores the fact that a significant population of beneficiaries will be deprived of educational benefits while the negative results are compiled.  In keeping with § 529’s primary purpose, every effort should be made to preserve funds for the DB’s education.  Taking proactive steps achieves this result without unnecessarily subjecting the assets to abuse of the AO.

Secondly, today’s economic recession increases the likelihood that an AO will turn to a § 529 savings account for financial assistance.[118]  Although past evidence may suggest the absence of AO abuse, at no point in § 529’s history have AOs been under such financial pressure.  With unemployment figures climbing and retirement investments at 20-year lows, the personal use of previously reserved financing becomes a much more attractive alternative. 

Finally, current § 529 income tax treatment supports a proactive approach.  Under current law, should a § 529 savings account decrease in value, the distributee is entitled to a deduction for the loss “only when all amounts from that account have been distributed.”[119]  Thus, a non-contributing AO may recognize a loss on his income tax return, but he must first withdraw all account assets.[120]  Not only does this encourage hasty, non-qualifying withdrawals, but it does so at the worst possible time.  When paired with the struggling economy, the prospect of a tax deduction and immediate access to cash provides the perfect storm for a raid on § 529 assets.[121]  Furthermore, providing a deduction to the non-contributing distributee permits a theft of the tax basis “given” to the DB.  Because the initial contribution is treated as a gift to the DB, it is the DB, not the AO who should benefit from any corresponding loss.  This approach is consistent with current transfer tax policy which holds the DB liable for any gift taxes flowing from a change in DB.[122]

While it is argued that the 10% penalty provides an adequate deterrent for such abuse, the this penalty is only imposed on account earnings.  With year-over-year market values down close to 50%, it is unlikely any earnings will be recognized upon a sale of account assets.  Because none of the distributed assets will be subject to the penalty, this deterrent can only be described as illusory.  Even assuming the penalty is imposed, however, concluding that a 10% penalty will have its intended result is uncertain at best.  When faced with the decision of having nothing or 90% of the account assets, it is unlikely the penalty will dissuade a desperate or vengeful AO.  In sum, a proactive approach is appropriate because it takes into account the current economic climate while simultaneously respecting the original § 529 intent.
3. Amend Current Substantiation Process
To eliminate non-contributor withdrawals effectively, the I.R.S. should amend its current process used to review non-educational distributions.  Under present practices, a distribution is found to be made for “qualified higher education expenses,” thus not subject to the 10% penalty, if it “is made directly to an eligible institution” or if the disbursement is issued after the DB provides appropriate substantiation.[123]  In either situation the distribution is conditioned on the pre-receipt of the supporting documentation.  As such, QTPs are required to have a “process for reviewing the validity of the substantiation prior to the distribution.”[124]  If a distributee fails to provide this support, the QTP must “retain[] a sufficient balance in the account to pay the amount of penalty, withhold[] an amount equal to the penalty from a distribution, or collect[] the penalty on a State income tax return.”[125]  Thus, even without supporting documentation, the distribution is made, the penalty is simply withheld.

The Treasury should require the QTP to implement a strict pre-approval process before any distributions are permitted.[126]   Under this approach, the non-contributing AO would need to provide sufficient information for the state to adequately ascertain the AO’s motives.[127]  Doing so would provide a screening mechanism to filter abusive withdrawals.

To implement such a process, regulations would need to be promulgated to guide states in the development of standards to be used when performing the motive analysis.  In keeping with the donor’s original intent, the standards would require the AO to show that the funds will be used to at least provide an indirect benefit to the DB.[128]  For instance, in the example above involving the non-contributing stepmother attempting to withdraw funds from the DB’s § 529 account, the I.R.S. might demand that she demonstrate, to a reasonable degree of certainty, that not only will the funds be used for, but that they are necessary to ensure, the DB’s health, maintenance, education and support.

By essentially guaranteeing that account benefits inure at least partly to the DB, a step is taken to reconcile the inequities of treating the contribution as a gift to the DB.  While this still allows the § 529 funds to be used for non-educational purposes, ensuring a benefit to the DB offers some justification for the “completed gift” treatment.  This approach also removes much of the concern surrounding the trust law inconsistencies.  

While these measures do not substitute for legal fiduciary duties, compelling a review of the AO’s motives before a distribution has a similar protective effect.  This layer of governmental scrutiny compensates for the DB’s inability to personally protect the future of their education and similarly mitigates the burdens associated with lack of disclosure.  Because a third party oversees all account withdrawals, it no longer becomes imperative to provide such information to the DB.  Informed commentators argue that these fiduciary-like objectives can be more easily met by simply “placing a trust wrapper around the section 529 savings account.”[129] 

There, the “trustee would open the section 529 savings account with cash already in the trust, with the trust as the account owner and the trust beneficiary as the section 529 savings account designated beneficiary.”[130]  At that point, the trustee, acting on behalf of the AO, would make all relevant account decisions, and would do so under the fiduciary confines of applicable trust law.  While admittedly this approach may provide greater DB protection, it is less desirable for two reasons.

First, the average § 529 savings account balance is only $12,316.[131]  Consequently, it is extremely unlikely a contributor would be willing to pay the expensive legal fees required to create the type of complex trust needed to facilitate the protection.  Secondly, adding convoluted legal checkboxes to the contribution process has the potential to chill § 529 participation.  If the contributor sees the funding process as unduly burdensome, she will likely forego the opportunity regretfully denying the DB of beneficial academic security.  Thus, while the “trust wrapper” provides a potentially fail-proof mechanism to protect the account assets, the associated costs and added complexity render it unworkable.  

In sum, numerous benefits support the adoption of a plan restricting a non-contributing AO’s access.  Not only will doing so resolve many of the inconsistencies currently burdening § 529 taxation, but it will also provide protection for the DB’s education which is currently absent from the § 529 discussion.
a. Taxable Change in DBs
In addition to limiting personal withdrawals, a number of reasons support prohibiting a non-contributing AO from performing taxable changes in DBs.  First, doing so removes the need to assign transfer tax liability to an uninvolved DB for the independent actions of the AO.  Because transfers to an unrelated DB would no longer be possible, the burden of determining the ultimate bearer of gift tax is avoided entirely.  This approach also prevents the depletion of account assets involved in the transfer.  Because a taxable change in DBs requires the imposition of a 10% penalty on distributed earnings, the transaction results in fewer proceeds actually being transferred.  Denying all taxable changes avoids this depletion.
B. Challenges
Notwithstanding the attractive benefits associated with restricting personal AO and denying all taxable DB changes, both proposals face a number of obstacles.
1. Cost
Perhaps the greatest hurdle for both initiatives is the difficulty of justifying the additional costs. Requiring heightened scrutiny of every § 529 distribution certainly will create additional administrative expenses.  Unfortunately, these costs will likely be borne by the DBs in the form of increased management fees.[132] The benefit of protecting the academic future of all DBs, however, far outweighs this financial burden.  When the incremental cost is spread over all a state’s account-holders, the individual imposition would likely be minimal.  Furthermore, if AO abuse results in even 10 students being denied access to higher education, the loss in tax revenue from earnings produced by those educations should justify the added scrutiny by itself.
2. No Intent to Attend College
Another challenge to this approach arises when neither the DB, nor anyone in the DB’s family, intends to attend college.[133]  Because transfers and distributions by non-donor AOs would categorically be disallowed, a change in AOs would result in the currently named DB occupying that position indefinitely. To resolve this issue, Congress should merely look to the donor’s intent.  While providing for the DB’s education likely served as the contributor’s primary motivator, a broader analysis reveals an objective focused on providing a general life-benefit to the DB.  As such, it seems appropriate to make available an option to roll the account assets into a Roth IRA for the beneficiary.  Doing so not only maintains the current post-tax contribution treatment under § 529, but it also ensures that the funds are used to beneficially enhance the beneficiary’s life.  Finally, similar to a non-qualifying § 529 distribution, the Roth IRA imposes a 10% tax penalty on early withdrawals.  This provides some incentive to leaving the funds untouched in the event the DB is a spendthrift, or otherwise a generally unsuitable recipient.
3. Multiple Contributors to Single Accounts
Another challenge in adopting such an approach lies in the administrative burden of determining whether the current AO is, in fact, the contributor.  Because the current method permits contributors to add assets to existing accounts, it may be impossible to effectively determine which funds were actually contributed by the AO.  While perhaps the most preferable response is to require states “to track and allocate amounts . . . not just by AO, but also by contributor . . . , this would impose massive subaccounting burdens on QTP’s . . . result[ing] in higher fees.”[134]  This burden, however, must again, be weighed against the benefit of protecting the beneficiary’s education and furthering § 529’s core purpose.[135]  However, even if the tracking methodology were not employed, another option is to permanently adopt the substantiation approach set forth in the Advanced Notice.

There, the AO is found to be “liable for income tax on the entire amount of the funds distributed for the AO’s benefit except that the AO can substantiate that the AO made contributions.”[136]  This appropriately places the burden of proof on the AO, and provides a cost-effective alternative to the individual accounting approach.
4. Chill Contributions
Lastly, as previously indicated, it is quite possible that the burdens associated with additional rules to § 529 may ultimately chill contributions.  However, those forced to shoulder these burdens are the same individuals who receive the lucrative benefits of tax-free growth and favorable transfer tax treatment.  Furthermore, the approach may have the exact opposite effect.  The contributor deposited the funds under the impression that they would be used to assist the DB.  By providing a mechanism to ensure that this, in fact, will occur, contributions could be increased.



Section 529 seeks to encourage taxpayers to save for the costs of higher education.  It does so by conferring both income and transfer tax benefits upon the contributor of the account.  Unfortunately, however, current practices expose the beneficiary’s future education to an inordinate amount of risk.  Because non-contributing AOs have unfettered access to use account assets for personal purposes, both the general intent of § 529 and the donor’s wishes are undermined.  Thus, Congress or the Treasury should take action to refocus the section from conferring tax benefits to protecting and promoting the taxpayer education.  To do so, a non-contributing AO’s privileges must be limited.  Not only should the right to change DBs be confined, but only after the state is certain that the funds are to be used for the DB’s benefit should a distribution be authorized.  While it is true that these tasks will result in increased administrative costs, when balanced with the benefit of protecting DB’s education, the burdens seem both appropriately distributed and well-balanced.

[1] H.R. Rep. No. 111-16, at 1444. (Feb. 12, 2009) (Section 529 sets forth income and transfer tax rules for accounts and contracts originated under a QTP); Susan Bart, Section 529: Can You Master the Magic?, A.L.I. Estate Planning for the Family Business Owner 288 (2007).
[2] An Introduction to 529 Plans, visited Apr. 15, 2009)
[3] James Spallino, Jr., IRS Seeks to Educate Taxpayers on Abuses in Section 529 Plans, 18 Ohio Prob. L.J. 225, 225 (August 2008).  This paper deals almost exclusively with § 529 savings accounts.  Thus, unless specifically indicated, all references to § 529 accounts will refer to the savings account option.
[5] Bart, supra note 1, at 288.
[7] Id.; An Introduction to 529 Plans, visited Apr. 15, 2009).
[9] Id. at §§ (a), (c)(3).
[12] See I.R.C. § 2503(b) (2006) (excluding from the taxable gifts the first $13,000 given to each recipient). See also I.R.C. § 529(c)(2)(B) (2009) (allowing a donor to treat the contribution as if made ratably over five years if the current gift exceeds the annual exclusion). For example, in 2009 an individual donor may contribute $65,000 ($13,000*5), $130,000 for a married couple, without making a taxable gift.
[16] Advanced Notice of Proposed Rulemaking, 73. Fed. Reg. 3441, 3443 (Jan. 18, 2008).  The AO also provides the general investment direction of the account.
[17] See Advanced Notice of Proposed Rulemaking, 73 Fed. Reg. 3441, 3443 (Jan. 18, 2008) (recognizing the many potential abuses associated with this structure).
[27] Id. at 328.
[29] I.R.C. §§ 529(c)(3)(C)(i)-(iii) (1996).  See also I.R.C. § 529(e)(2) (1996)Prop. Treas. Reg. § 1.529-(1)(c), 63 Fed. Reg. 45019, 45026 (Aug. 24, 1998)(defining “Member of the family”).
[30] I.R.C. § 529(c)(3)(C)(i)-(iii) (1997).
[31] Id.  Note also that to avoid transfer taxation, the new DB must be in the same or a higher generation (as determined under I.R.C. § 2651) as the old DB.
[35] Id.
[36] Neither the original text nor the subsequent, 1997 amendment mentions the AO.
[39] Id., at § 1304(b).
[40] I.R.C. § 529(f) (2006).
[42] Id.
[43] Id.
[45] Id. at 3442.
[46] Id.
[47] Id.
[48] Bart, supra note 1, at 332.
[50] See id. (promising that the future “anti-abuse rule will include examples . . . that provide clear guidance to taxpayers about the types of transactions considered abusive.”)
[51] Id.
[52] Id.
[53] Id. at 3443 § II B.  Compare to I.R.C. § 529 (c)(3) (taxing only the earnings portion of a distribution).
[57] Id.
[58] See id. § II A (recognizing “the AO rather than the DB has the power to change a beneficiary.”)
[59] James V. Roberts et al., Comments of the American College of Trust and Estate Counsel in Response to the Advanced Notice of Proposed Rulemaking, at 7 (2008) available at
[61] Id.
[65] Ray D. Madoff et. al., Practical Guide to Estate Planning, at § 8.02[c] (2009).
[67] See Susan T. Bart, The Best of Both Worlds: Using a Trust to Make Your 529 Savings Accounts Rock, 34 J. of Amer. Col. of Trust & Estate Counsel 106, 106 (Winter 2008) (stating “the account owner of a 529 savings account has no fiduciary duties to the beneficiary of the account.”)
[68] George G. Bogert, et. al., Revocable Trustsin Bogert’s Trusts and Trustees, § 233 (2008).
[69] Id.
[71] Id.I.R.C. § 2036(a)(1) (2009)Sanford v. Comm’r, 308 U.S. 39, 55 (1959)(stating “a gift in trust with the reservation of a power in the donor to alter the disposition of the property . . . was held to be incomplete and not subject to the gift tax . . . so long as the donor retained that power” (citing Hesslein v. Hoey, 91 F.2d 954 (2d. Cir. 1937).
[72] Unif. Trust Code § 603(a) (2005) (stating that “[w]hile a trust is revocable . . . , rights of the beneficiaries are subject to the control of, and the duties of the trustee are owed exclusively to, the settlor.”).
[73] Bogert, supra note 68, at § 233.
[74] Restatement (Third) of Trusts § 74 (2007) ; see also Unif. Trust Code § 603(a) cmt (2005), (finding “the duty . . .  to inform and report to beneficiaries is owed to the settler of a revocable trust.”)
[75] See Jacob v. Davis, 738 A.2d 904, 913 (Md. Ct. Spec. App. 1999) (stating “[If] the settlor really intended to create a trust, it would seem that accountability . . . must inevitably follow . . . [or beneficiaries would] be in the dark as to whether there has been a breach of trust.”)
[76] See generally, Vincent J. Russo & Marvin Rachlin, Use of Revocable Living Trusts - Overviewin N.Y. Elder Law and Special Needs Practice, § 13:43 (implying that only when a tust is deemed “revocable” are alterations permitted).
[77] Bart, supra note 67, at 112.
[78] Bogert, supra note 68, at § 541.
[79] First Nat'l Bank & Trust Co. v. Brimmer, 504 P.2d 1367, 1371 (Wyo. 1973).
[80] Id.
[81] Unif. Trust Code § 813(a) (2005)See also Restatement (Third) of Trusts § 82 (2007) (requiring the trustee to inform “beneficiaries of the existence of the trust, of their status as beneficiaries and their right to obtain further information”).
[82] Unif. Trust Code § 813(c) (2005) (requiring the trustee to distribute, “at least annually . . . , a report of the trust property, liabilities, receipts, and disbursements, including the source and amount of the trustee’s compensation, [and[ a listing of the trust assets”).
[83] See 76 Am. Jur. 2d Trusts § 371 (2008).
[84] See John H. Langbein, Mandatory Rules in the Law of Trusts, 98 Nw. U. L. Rev. 1105, 1125 (2004) “a [trust] term that prevents the beneficiary from obtaining the information needed to enforce the trust entails the risk of making the trust unenforceable and hence illusory.”
[85] Bogert, supra note 68, at § 147 (stating “[t]here can be no trust without an equitable interest in the beneficiary.”)
[87] Id.
[88] See I.R.C. § 674(a) (because the grantor no longer controls the “beneficial enjoyment” he will not be responsible for the income tax.”
[89] Seee.g., (Advanced Notice of Proposed Rulemaking, 73. Fed. Reg. 344, at 3442 § I Jan. 18, 2008) (promising to deny favorable tax benefits if it is found that “contributions to those accounts are intended or used for purposes other than providing [qualified higher education expenses] of the DB.”)
[93] See Bart, supra note 67, at 130 (in the § 529 context that “unless the beneficiary is the account owner, the beneficiary has only a mere expectancy, and does not have any property interest.”).
[94] In. re McFarland, No. 04-01623, 2004 WL 4960367, *2 (Bankr. D. Idaho 2004) (citing Idaho Code § 35-5407(1)(a)).
[95] In re Addison, 540 F 3d 805, 819 (8th Cir. 2008) (citing Minn. Stat. Ann. § 136G.09(1)).
[96] Prop. Treas. Reg. § 1.529-5(b), 63 Fed. Reg. 45019, 45031 (Aug. 24, 1998)But see Prop. Treas. Reg. § 1.529-3(c)(1), 63 Fed. Reg. 45019, (Aug. 24, 1998) (treating, for  income tax purposes. a change in DBs to a new DB as a distribution to the AO so long as the AO has the authority to make the change).
[97] See e.g., Bart, supra note 67, at 106.
[98] Id.
[99] Id.
[102] I.R.C. § 529(c) (1996) (emphasis added).
[103] See I.R.C. § 529 (1996); I.R.C. § 529 (2009).
[105] See Advanced Notice of Proposed Rulemaking, 73. Fed. Reg. 3441, 3443 § II B (Jan. 18, 2008) (providing tax treatment for an AO withdrawal when not all contributions were made by the AO.) For instance, instead of creating a new account, a grandparent may chose to contribute to an existing account managed by the DB’s parent.
[106] Pope, Justin, Glimmer of Hope for Student Aid in a Bad Economy, USA Today, March, 18 2009, available at
[107] Ramirez, Eddy, Recession Forces Students to Shop Around, U.S. News & World Report, Dec. 26, 2008, available at
[108] Id.
[109] See generallyH.R. Rep. 105-148, at 323 (1997) (explaining that additional changes were made to further “encourage families and students to save for future education expenses.”)
[110]  See  e.g., Lynn Jenkins, Kansas State Treasurer, Comment on REG-127127-05 Advance Notice of Proposed Rulemaking Guidance on Qualified Tuition Programs under Section 529, at 1 (Mar. 17, 2008) (stating “[o]ur average account size of just over $17,000 suggests that the participants are using our program for its designed purpose – to save for the future costs of higher education.”) (emphasis added).
[111]  Susan Bart, Section 529 College Savings Accounts: More Than a Decade Without Final Rules, 42 Miami Inst. Est. Plan. 9, 918.8 (2008) (finding the donor loss of control permits, “the successor individual account owner may be able to frustrate the donor's intent.”)
[112]  See id.
[113]  Under this approach, contributing AO’s would retain all power given under § 529.
[114]  See  H.R. Rep. No. 104-737 at 281.
[115]  See Merrian Webster’s Dictionary, (defining “refund” as “to return (money) in restitution, repayment, or balancing of accounts.”).
[117]  Roberts, supra note 64, at 7 (2008).
[118]  See Brett Arends, A Little Known Tax Break for Bruised 529s, Wall St. J. Online, Nov. 12, 2008 (encouraging families to take distributions to avail themselves of deductions for § 529 losses) available at
[119]  IRS Publication 970 (2008), Tax Benefits for Education, at Ch. 8 pg. 56 (deduction is characterized as a miscellaneous itemized deduction and is thus subject to the 2% floor).
[120]  See id. (indicating these losses are deductible as itemized, miscellaneous deductions subject to the 2% floor.  They are not treated as capital losses).
[121]  See Brett Arends, A Little Known Tax Break for Bruised 529s, Wall St. J. Online, Nov. 12, 2008 (stating that “[f]amilies saving for education may be eligible to recoup some of the money lost in the market this year.”) available at
[122]  See Prop. Treas. Reg. 1-529-3(c), 63 Fed. Reg. 45019, 45030 (Aug. 24, 1998).  But see Advanced Notice of Proposed Rulemaking, 73. Fed. Reg. 3441, 3443 II A (Jan. 18, 2008). (indicating that the forthcoming regulations will hold “AO liable for any gift or GST tax imposed on the change to the DB”).
[124]  Id. at § 1.529-2(e)(4)(ii)(A)(3).
[125]  Id. at § 1.529-2(e)(4)(ii)(E).
[126]  If the distribution is requested by the donor, the existing practice should remain effective.
[127]  This is consistent with the I.R.S.’s recent effort to compare “the person who . . . contributes the cash to the section 529 account, and the person who ultimately receives any distribution.” Advanced Notice of Proposed Rulemaking, 73. Fed. Reg. 3441, 3442 (Jan. 18, 2008).
[128]  This approach is broader than that the one proposed in the Advance Notice which plans to deny “favorable treatment . . . if contributions to those accounts are intended or used for purposes other than providing for the QHEE’s of the DB.”  Advanced Notice of Proposed Rulemaking, 73. Fed. Reg. 3441, 3442  (Jan. 18, 2008).
[129]  Bart, supra note 67, at 107.
[130]  Id.
[131]  Tax Incentives for Post Secondary Education: Hearing Before the Subcomm. on Select Revenue Measures of the H. Comm. Of Ways and Means, 110th Cong. 80 (2008) (statement of Dan Ebersole, Chair, College Savings Plans Network).
[132]  Roberts, supra note 64, at 11 (2008).
[133]  Id. at 4 (finding it necessary to retain the option to revoke in the event “the DB receives a scholarship or does not attend college.”)
[134]  Roberts, supra note 64, at 7.
[135]  See H.R. Rep. 105-148, at 323 (1997).