In the “General Objectives and Premises” section below, we first set forth what we see as the general objectives of the Advance Notice and these comments, along with some general premises that we believe should be taken into consideration in evaluating any proposed rules regarding QTPs and section 529 accounts.
Section I of these comments suggests that existing approaches, such as the step-transaction and sham-transaction doctrines, are sufficient to address most abuse involving section 529 accounts and that a general anti-abuse rule specific to section 529 is unnecessary. If instead Treasury and the IRS maintain that such a general rule is necessary, any such rule should focus on the intended use of section 529 accounts, be general and simple, and include de minimis exceptions. Also, any discussion of abuse (with or without a new general rule) should include numerous examples distinguishing abusive and nonabusive situations.
Section II, A of these comments proposes that any deemed transfer resulting from a taxable change of DB should be treated as a transfer by the old DB. However, because of the old DB’s lack of control over the section 529 account, the DB should incur liability for the transfer only to the extent the DB consents. To the extent the DB does not consent, liability should be imposed on the AO, who has possession of the assets that are the subject of the deemed transfer.
Section II, B of these comments discusses the tax liability proposed in the Advance Notice on any withdrawal by the AO for the AO’s own benefit, to whatever extent the AO did not make all contributions to the section 529 account. The rule proposed in the Advance Notice would apply to many nonabusive situations, and is unnecessary because potential abuse could be addressed by general rules discussed in Section I. The proposed rule also entails significant practical problems. Section II, B also suggests that the forthcoming guidance should explicitly permit joint ownership of section 529 accounts and specify the transfer tax consequences of distributions from section 529 accounts to persons other than the AO or DB.
Section II, C of these comments recommends that any person, as defined under section 7701(a)(1), including a trust or an estate, should be permitted to be an AO or a contributor to a section 529 account. These comments recommend that revocable trusts be treated as the tax alter ego of their grantors. These comments recommend that when an irrevocable trust contributes to a section 529 account it should be treated as a trust investment with no transfer tax consequences. However, a distribution from a trust-owned section 529 account would be subject to income taxation under section 529 and, when made to a beneficiary, would be treated as a trust distribution to which the GST tax rules would apply for transfer tax purposes. Further, the separate share rules would apply where applicable for income tax purposes.
Section II, D of these comments agrees with the proposal in the Advance Notice that when the AO is the same as the DB, and the DB is then changed, the change of DB should be treated as a new contribution for transfer tax purposes and, for income tax purposes, as a distribution to the AO and a new contribution by the AO, which may qualify as a rollover.
Section II, E of these comments is in general agreement with the proposal in the Advance Notice that events occurring within a specified period of administration after a DB’s death should be taken into account, as if they occurred prior to the DB’s death, in determining whether the section 529 account should be included in the DB’s estate. These events may include a change of DB or a distribution to the AO. These comments suggest some refinements of the rules proposed in the Advance Notice.
Section III, A of these comments discusses three areas related to the use of five-year elections for contributions to section 529 accounts. One area concerns the use of multiple five-year elections and provides numerous examples highlighting specific issues where uncertainty exists and guidance is needed. Other areas concern the transfer tax and GST tax treatment of any amounts included in a donor’s estate following a five-year election, such as whether the deemed transferee would be the AO or DB (especially for marital deduction and GST tax purposes) and whether or not a direct skip would be deemed to occur for GST tax purposes.
Section III, B of these comments proposes extending the period proposed in the Advance Notice in which QHEEs may be paid in order to qualify a section 529 account distribution for tax-free treatment, both before and after the year of the distribution.
Section IV of these comments suggests some additional rules to carry out the purposes of section 529 in an administratively feasible manner. Part A suggests that any aggregation rule for investment changes should apply, at most, to accounts within the same QTP with the same AO and DB, and preferably should permit a state to treat each savings program separately when a state offers more than one savings program.
Part B recommends that the aggregation rule for rollovers apply only to section 529 accounts with the same AO and DB.
Part C recommends clarification that contributions to a section 529 account qualify for the GST tax annual exclusion as well as the gift tax annual exclusion and that the five-year election operates for purposes of both GST tax and gift tax.
General Objectives and Premises
1. Objectives. The Advance Notice makes it clear that one concern of Treasury and the IRS is to prevent the abuse of section 529 accounts for tax purposes wholly unrelated to the purposes of section 529: namely, promoting college savings and, in turn, higher education. In addition, the Advance Notice specifies that the forthcoming guidance will attempt to achieve other objectives as well. These objectives include (i) resolving certain inconsistencies between section 529 and general income tax and transfer tax principles, (ii) reducing uncertainty as to the proper tax treatment and reporting of certain transactions involving QTPs and section 529 accounts, and (iii) reducing uncertainty as to the proper administration of QTPs and section 529 accounts. The foregoing is consistent with section 529(f), added by the Pension Protection Act of 2006, which directs Treasury to propose such regulations as may be necessary or appropriate to carry out the purposes of section 529 and to prevent abuse of such purposes.
Our comments below do address the potential abuse of section 529 accounts and the best means to prevent such abuse. However, these comments do not focus solely on abuse, and in various places, the greater emphasis is on resolving inconsistencies or reducing uncertainty. This helps to promote the purposes of section 529 and is consistent with the other objectives set forth in the Advance Notice and in section 529(f), as described above. Resolving inconsistencies and reducing uncertainty generally reduces the potential for abuse and can make it clearer whether a particular transaction or reporting position is abusive or not.
2. Premises. Below are five general premises, which do not pertain solely to any one aspect of the Advance Notice but should be taken into consideration in evaluating any proposed rules for QTPs and section 529 accounts.
(1) The ability to withdraw funds is a primary virtue of section 529 accounts for parents and others wishing to save for a DB’s college education, and where the AO funds a section 529 account for a DB but later withdraws the funds, even for AO’s own benefit, sufficient deterrents to abuse already exist under current law. The AO’s ability to withdraw funds is a primary virtue of section 529 accounts because parents and others often wish to save for college without the funds passing irrevocably to the DB if they are not needed for college (e.g., because the DB receives a scholarship or does not attend college). Further, many grandparents wish to save for their grandchildren’s education but wish to retain the ability to reclaim the funds if they need such funds for unanticipated health care or other support costs. This virtue is consistent with the purposes of section 529, including encouraging saving for higher education while providing flexibility if circumstances change, and should be maintained. Meanwhile, where the AO funds the section 529 account, the primary existing deterrent to potential abuse (e.g., using the section 529 account for tax deferral alone, with no education-related intentions) is that the earnings portion of any nonqualified withdrawal is subject to ordinary income tax and the 10% additional tax. Another deterrent is that the AO cannot recapture any transfer tax annual exclusion or exemption allocated, or transfer tax paid, on account of a contribution that is later withdrawn by the AO . and where the amount involved is too low for the absence of recapture to be meaningful, then so too is the potential for abuse.
(2) Permitting contributions from non-AOs is also a virtue of section 529 accounts that is consistent with the purposes of section 529 and should be maintained. For example, grandparents or other relatives may wish to make contributions for a DB’s college education to a section 529 account already established by the DB’s parent as AO, without needing to open separate section 529 accounts with themselves as AOs. Similarly, a section 529 account with a deceased person’s child as DB and the child’s surviving parent or guardian as AO can provide relatives, friends, and co-workers with a meaningful, convenient, and tax-efficient way to honor the deceased and assist the surviving family members. In many cases involving non-AO contributors, the contributions are relatively small (often less than $100) and infrequent (perhaps once per year or even one time only); consequently, the inconvenience and cost of opening and maintaining separate section 529 accounts for these contributions (both for the donor and for the QTP) would not be justified.
(3) The ability to name a successor AO for a section 529 account at the existing AO’s death is indispensable and should continue to be permitted at the account/QTP level (that is, without requiring section 529 account assets to pass through probate or intestacy proceedings). When an AO dies a successor AO is required, and the original AO, rather than the probate process, is best positioned to determine who would be an appropriate successor AO. Moreover, because most consider death undesirable and the timing of one's death is typically unknown, taxpayers are unlikely to plan abusive transactions that are dependent upon the death of the current AO.
(4) As a general matter, the ability to name a successor AO for a section 529 account during the existing AO’s lifetime offers flexibility but is less crucial. However, it should remain possible to change the AO of a section 529 account during lifetime, without tax consequences, in certain circumstances (especially, in particular, to a spouse at any time or to a former spouse pursuant to divorce or separation).
(5) To ensure accuracy and integrity in tax reporting and substantiation with respect to section 529 accounts, AOs and DBs should, with very limited exceptions, be able to use and rely on the information provided to them by QTPs on Form 1099-Q, without further adjustment. If information reported to an AO or DB by a QTP on a Form 1099-Q is inaccurate, incomplete, or subject to further adjustment, depending on specific circumstances and special rules that may or may not be applicable, it becomes increasingly likely that the AO’s or DB’s reporting will be erroneous, notwithstanding the AO’s or DB’s best efforts.
I. Anti-Abuse Rule
The Advance Notice proposes to create a general anti-abuse rule to address misuse of section 529. We suggest that the new general anti-abuse rule might simply be an announcement that Treasury and the IRS will be using the full arsenal of existing approaches available to combat abuses, including the “step-transaction” and “sham transaction” doctrines and the rules regarding “reciprocal gifts” and the use of intermediaries or strawmen, combined with numerous examples. (The application of these existing approaches is illustrated in the Appendix to these comments, describing various potentially abusive scenarios.) In addition to these existing, more general approaches, section 529(c)(6) already provides one specific weapon against abuse of section 529 accounts: namely, the 10% additional tax that may be imposed when distributions are not used for educational purposes.
We believe that, when combined, the approaches above can be sufficient, and as discussed below, guidance detailing how they would be applied to specific abuses would have the necessary deterrent effect. We also note that the efficacy of these approaches (or any others) will be enhanced if Treasury and the IRS place greater emphasis on accurate and useful reporting with respect to section 529 accounts, including the matching of Form 1099-Q with individual returns.
Should Treasury and the IRS feel that, notwithstanding the foregoing, some sort of anti-abuse rule specific to section 529 accounts is appropriate, we would urge a general rule focusing on whether the contributions to the section 529 account are intended to be used for educational purposes when made. We urge that any such rule should recognize that the mere fact that the expected educational use does not occur does not mean that the educational intent was not present. There are legitimate reasons (such as financial hardship, health care needs, or other unanticipated circumstances) why section 529 account funds may not ultimately be used for educational purposes.
We also recommend that any anti-abuse rule specific to section 529 should be kept as simple and general as possible. Rules and limitations that are too specific or technical in nature would add undue complexity, and, in the process, discourage the use of section 529 accounts. This consideration is particularly important to the extent that section 529 is intended to encourage college savings by families whose circumstances and levels of potential savings would make them less willing or able to navigate complex rules themselves or to hire a tax advisor to navigate those rules for them; instead, those families would more likely simply decline to use section 529 accounts at all. [1]
In addition, because so many section 529 accounts and related transactions are small, we suggest that de minimis rules may be in order. Most de minimis transactions involving section 529 accounts are conducted not for improper tax-related reasons but for non-tax, non-abusive reasons that are quite consistent with the purposes and intentions underlying section 529.[2] De minimis transactions are unlikely to be abusive for transfer tax purposes because in most cases the transfer tax annual exclusions (or other exclusions) would prevent taxation of such transactions. De minimis transactions are unlikely to be abusive for income tax purposes because the taxation of earnings as ordinary income and the 10% additional tax are strong deterrents, not to mention that there would be little to gain with a de minimis transaction. Without de minimis rules, many potential, legitimate users of section 529 accounts could be intimidated and deterred by complex rules intended to apply to the larger transactions where abuse is most likely to occur.
Providing numerous examples of abusive situations—and how those situations would be addressed by existing approaches or by any new anti-abuse rule—will be important and helpful. For example, we illustrate some potentially abusive scenarios in these comments. See Appendix.
While one can come up with numerous potential abuses of section 529 accounts, it is less clear empirically the extent to which such potential abuses are in fact employed and not just hypothetical. Thus, we recommend that Treasury and the IRS further study and assess this matter, especially to ensure that any proposed anti-abuse rules do not complicate the use and administration of section 529 accounts, thus discouraging saving for college, in a manner disproportionate to the actual abuse otherwise occurring.
II. Rules Relating to the Tax Treatment of Contributions to and Participants in Section 529 Accounts
A. AO’s Liability for Any Gift and/or GST Tax Imposed on a Taxable Change of DB
Section 529(c)(2)(A) provides that a contribution to a section 529 account on behalf of a DB is treated as a completed gift to the DB that is not a future interest. (The forthcoming guidance should make clear that this rule applies only when an outright transfer from the contributor to the DB would be a gift. See Section II, D below.) Section 529(c)(3)(C)(ii) permits the DB of a section 529 account to be changed without income tax consequences if the new DB is a “member of the family” of the old DB. However, the gift tax and possibly GST tax will apply to a change of DB unless (1) the new DB is a member of the family of the old DB and (2) the new DB is in the same or a higher generation than the old DB. Only gift tax will apply if the new DB is one generation below the old DB, but both gift tax and the GST tax will apply if the new DB is two or more generations below the old DB.
The proposed regulations apply the gift and GST tax rules to a change of DB by treating it as a gift from the old DB to the new DB and imposing the gift tax liability on the old DB. This is the correct tax treatment under section 529. Because the original contribution to the account was treated as a completed gift to the DB (notwithstanding the AO’s power to withdraw the funds), any subsequent gift must be from the DB. However, 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. Even the use of the old DB’s annual exclusions without the old DB’s consent deprives the old DB of a property right, namely the opportunity to use such annual exclusions to offset other gifts.
The Advance Notice proposes to depart from the proposed regulations and instead to treat the AO as the transferor by treating a change of DB that is subject to gift tax “as a deemed distribution to the AO followed by a new gift.” Presumably, the deemed distribution would fall within the rollover rule exception of section 529(c)(3)(C)(i) and, therefore, would not be treated as a nonqualified distribution. See also section 529(c)(3)(C)(ii).
However, treating the AO as the transferor for gift and GST tax purposes is inconsistent with section 529, pursuant to which a completed gift was made to the old DB and, therefore, the old DB should be the transferor of any subsequent gift. Two examples may help to illustrate the problem.
Example 1. Assume Grandparent is the AO of a section 529 account for Child. Grandparent then changes the DB to child’s child, Grandchild. In the framework of section 529, the gift is from Child to Grandchild and should only be subject to gift tax, and Child should be permitted to use child’s exclusions against the gift. Under the theory of the Advance Notice, the gift is from Grandparent to Grandchild, which is inconsistent with the fact that Grandparent already incurred the gift tax consequences of passing the assets down one generation. Even if Grandparent’s initial gift was covered by gift tax annual exclusions, the Grandparent relinquished the opportunity to use such exclusions against other gifts the Grandparent may have made to Child, and Grandparent can never recover those exclusions. If Grandparent is treated as now making a gift to Grandchild, even if Grandparent’s gift and GST exclusions preclude the imposition of tax, Grandparent is deprived of the opportunity to use such exclusions to make other gifts to Grandchild using such exclusions.
Example 2. Assume Parent is the AO of a section 529 account for Child 1. Parent then changes the DB to Child 2. Section 529(c)(5)(B) mandates that the gift tax rules do not apply. However, the theory of the Advance Notice would require that the change of DB be treated as a deemed distribution to Parent and a gift by Parent to Child 2. The theory of section 529, under which a gift occurs only when the DB moves down one or more generations, does not permit a solely collateral change of DB (to a member of the family of the old DB) to be treated as a gift.
Therefore, consistent with the tax theory of section 529, the gift should be treated as if it were from the old DB. The forthcoming guidance should permit the old DB to agree to be treated as the transferor of the deemed gift and to file a gift tax return reporting such transfer if a gift tax return is required. The AO in such circumstances should only be required to report the deemed transfer on an informational gift tax return and attach a consent signed by the old DB under which the old DB agrees to be treated as the transferor of the deemed gift.
In the case of a minor DB, the forthcoming guidance should permit a parent or guardian to sign such a consent, to file the minor’s gift tax return if one is required and potentially to make the five-year election on behalf of the old DB. However, to avoid permitting a parent or guardian to use a minor’s lifetime gift tax exclusion or GST exemption, a parent or guardian should only be permitted to report such gifts to the extent they qualify for the gift tax annual exclusion (and when applicable, the GST tax annual exclusion), taking into account any five-year election. Where a parent or guardian files a gift tax return on behalf of a minor DB, to the extent the deemed transfer does not qualify for the annual exclusion, it should be reported on the AO’s gift tax return.
To the extent the DB does not consent to report the deemed transfer on the DB’s gift tax return, it is consistent with existing gift tax principles to impose the gift tax liability on the person in possession of the gifted property. Although ordinarily this would be the donee, under section 529 it is the AO who has actual access to the property. For administrative convenience, the forthcoming guidance could provide that to the extent the DB does not consent to being treated as the transferor of the deemed transfer, the AO must report the deemed transfer on the AO’s gift tax return. However, the AO should be deemed to be assigned to the same generation as the old DB. In a purely theoretical world, because the AO is only reporting and, if required, paying tax on a gift from the old DB, the old DB’s annual exclusions, lifetime gift tax exclusion and GST exemption could be applied against such gift. However, they cannot be so applied without the old DB’s consent. Therefore, to reach a result that approximates the theoretical result, the forthcoming guidance should permit the AO to apply the AO’s own exclusions and exemptions against the deemed transfer.
In Example 1 above, this means the Grandparent/AO would be deemed to be in the child’s generation and would be treated as making a transfer down one generation. Thus to the extent the Grandparent did not have annual exclusions available for the deemed gift to Grandchild, only gift tax, and not GST tax, would apply. Further, Grandparent may use Grandparent’s gift tax annual exclusions and lifetime gift tax exclusion.
The forthcoming guidance should also state that neither (1) the DB’s consent (or failure to consent) to being treated as the transferor of the imputed gift, nor (2) the AO’s reporting of such gift and payment of resulting transfer taxes, if any, shall be treated as a transfer for gift or GST tax purposes.
B. AO’s Liability for Tax Imposed on Any Withdrawal by the AO from a Section 529 Account for the AO’s Own Benefit and on a Change in AO
Section II, B of the Advance Notice discusses potential AO liability for tax (i) on any withdrawal by the AO for the AO’s own benefit or (ii) on any change in AO. The primary impetus for proposing this potential liability is a concern about certain abusive scenarios. Section I of the Appendix illustrates four such scenarios (one of which is also illustrated in the Advance Notice).
1. Limiting AOs to Individuals. One proposal set forth in Section II, B of the Advance Notice would limit AOs to individuals; this proposal, which we strongly discourage, is discussed in more detail in Section II, C of these comments.
2. AO Liability for Income Tax. Another proposal set forth in Section II, B of the Advance Notice would make the AO liable for income tax on the entire amount of funds distributed for the AO’s benefit, except to whatever extent the AO can substantiate that the AO made contributions to the section 529 account and thus has an investment in the section 529 account within the meaning of section 72. Under this proposal, in each of the four potentially abusive scenarios illustrated in Section I of the Appendix, the entire amount withdrawn would be subject to both ordinary income tax and the 10% additional tax (presuming no contributions were made by the withdrawing AO). Perhaps this provides rough justice, serving as some sort of proxy for the transfer tax that would have been due if the funds had been initially transferred directly from the donor to the withdrawing AO, but it does not compensate the donor for the gift (and possibly GST) tax consequences incurred when the donor was treated as making a gift to the DB.
a. General Observations. In addition, following are some general observations about this proposed rule.
(1) The proposed rule would impose a tax on the withdrawing AO even in situations that are not abusive. For example, grandparents might contribute to a section 529 account for a grandchild as DB, with the grandchild’s parent as AO, fully intending to provide for the DB’s college education. Then, the DB does not go to college or does not need the funds for college, but is a spendthrift (or worse), so distributing the funds to the DB would be inadvisable. There is no sibling or other family member who would be suitable as a replacement DB, so the AO withdraws the funds. There is no abuse in this situation, but under the proposal at hand, the entire withdrawal (and not just the earnings portion) would be subject to ordinary income tax and the 10% additional tax. This seems inappropriate, in large part because the funds were intended to be used for higher education when the contribution was made. By contrast, as discussed above, the consequences under current law (with only the earnings portion of the withdrawal being subject to ordinary income tax and the 10% additional tax) seem to us more appropriate and still sufficient to deter the abuse of section 529 accounts using AO withdrawals and contributions by non.AOs.
(2) Even if the proposed rule successfully addressed and eliminated abusive scenarios involving AO withdrawals or changes (such as those illustrated in the Appendix), the intended abusive results could still be achieved by strategically designating and changing DBs, with tax-free distributions then being made to the DB, as illustrated in Section II of the Appendix (rather than withdrawn by the AO, as in the four scenarios in Section I of the Appendix). The proposed rule would not apply to distributions to DBs, and extending the proposed rule or creating a new parallel rule to address DB distributions would more likely contradict statutory provisions under section 529.
(3) Abusive scenarios involving AO withdrawals or changes, as well as abusive scenarios involving DB designations and changes, can be adequately addressed by the general anti-abuse rules discussed in Section I above. These would include existing approaches not specific to section 529 and any general anti-abuse rule that may be adopted specifically with respect to section 529.
b. Specific Problems. We also note more specific problems with the proposed rule, as we perceive how it would be implemented.[3]
(1) In its current formulation, Form 1099-Q sets forth the earnings portion of distributions from a section 529 account in a given year and is issued to the distributee, who is either the DB (for distributions made to the DB or to an educational institution for the DB) or else the AO (for all other distributions). If the investment in the account were to be reduced, and the earnings portion correspondingly increased, on account of contributions which the AO could not prove were made by the AO, the proper earnings portion to be reported by the AO would differ from the earnings portion shown on the Form 1099-Q. Per one of the premises set forth above, it is bad policy for the amounts properly reportable by AOs to differ from amounts reported on the Form 1099-Q or to require significant adjustments. Moreover, as a practical matter, it would be impracticable and in some cases impossible for the AO to make the necessary adjustments and compute the proper earnings portion accurately, even with best efforts and intentions; this problem would compound as numerous contributions and withdrawals were made over time.
(2) The problem above could theoretically be solved by requiring QTPs to track and allocate amounts in a section 529 account not just by AO but also by contributor. However, this would impose a massive subaccounting burden on QTPs . especially considering that, in most cases, those contributions by non-AO contributors would be relatively small and would not reasonably warrant an additional level of accounting for the life of the section 529 accounts. That burden would result in higher fees being charged to section 529 accounts, directly or indirectly, or more likely, in QTPs deciding to avoid that burden altogether by disallowing contributions by non-AOs (thus negating one important virtue of section 529 accounts discussed above).
(3) Even if the subaccounting by contributor were achieved, other questions would then arise in turn. For example, where contributions have been made by the AO and by any non-AO and certain withdrawals are then made by the AO, the practical effect of the proposed rule would be to convert some of the investment in the account (namely, that which is attributable to the non-AO contributions) into earnings, which creates issues including the following:
• Would that “converted” investment portion come out of the section 529 account on a pro rata basis with any still-intact investment portion, in proportion to the AO and non-AO contributions, or would there be some sort of worst-in, last-out principle, whereby the AO could at least avoid having any such “conversion” to the extent of the AO’s own contributions, at least with respect to nonqualified withdrawals?
• This potential “conversion” of investment to earnings would only occur for certain nonqualified withdrawals, depending on reporting and substantiation by the AO—which will not be known to the QTP. This in turn would increase the risk that the QTP’s subsequent accounting and reporting of investment and earnings portions (on statements and Form 1099-Q) will not be accurate, taking into account the AO's treatment of past withdrawals. Unless this risk is sufficiently addressed by any proposed rule, it would violate one of the premises above, regarding the importance of AOs and DBs being able to use and rely on the 1099-Q reporting by QTPs. (Moreover, that risk should be addressed without imposing even further tracking burdens on the QTPs; it was by all accounts a welcome change for 2001 legislation to eliminate the prior requirement that nonqualified withdrawals be monitored and penalized by the QTP, and we would in no way suggest reversing that.)
• Unless current reporting rules are changed, there would no way for the AO to avoid the “conversion” of investment to earnings with respect to a non-AO contribution. For example, imagine that a non-AO makes a contribution to a section 529 account (with the intention that it be used for the DB’s education), but the AO determines shortly thereafter that the funds attributable to the AO’s own contributions were already sufficient to cover the DB’s projected QHEEs. Under the proposed rule, the non-AO contribution would effectively and immediately be converted entirely to earnings, if withdrawn by the AO or even if distributed back to the non-AO contributor (insofar as the AO would be the deemed distributee of that distribution for reporting purposes). The only way to avoid that effective conversion would be to distribute the funds to the DB; and that may be inadvisable, undesired, and unintended by the non-AO, if the funds are not needed for QHEEs.
• There should be some mechanism by which non-AO contributions could be attributed to the AO if made (i) by a spouse of the AO, (ii) if the AO is a parent of the DB, by the other parent of the DB, or (iii) if the AO is a successor AO, by the previous AO (at least where the change of AO occurs as a result of the previous AO’s death). Here, too, one difficulty with any such mechanism is that, if any such attribution is not known to the QTP, that would increase the risk that the plan’s subsequent accounting and reporting of investment and earnings portions (on statements and Form 1099-Q) will not be accurate—but it would be difficult to address that risk without imposing undue burdens on QTPs.
In summary, we believe that the proposed rule is simultaneously (i) too broad (ensnaring many non-abusive situations), (ii) too narrow (attacking potential abuses involving AO withdrawals and changes, but leaving the same abusive results available by strategic DB designations and changes), and (iii) ultimately redundant if general anti-abuse rules (including approaches already available), and better reporting and monitoring, are effectively implemented. Thus, we would recommend that Treasury and the IRS abandon this proposed rule and rely on the general approaches discussed in Section I above to combat perceived abuses involving AO withdrawals or changes.
3. Additional AO Issues. Because they are tangentially related to the issues addressed in Section II, B of the Advance Notice, we would like to suggest here that the forthcoming guidance concerning section 529 should address the following issues:
a. Joint Ownership. There has been some uncertainty among QTPs and practitioners as to whether a QTP may allow two people to be joint AOs of a section 529 account. However, (i) joint ownership is not prohibited, explicitly or implicitly, by section 529 itself (which is silent as to account ownership) or by the proposed regulations, (ii) in at least one private letter ruling for a QTP that offered joint ownership, and in informal conversations with at least one of us, Treasury and the IRS have found no inherent problem with joint ownership, (iii) joint ownership is not inconsistent with the purposes of section 529 or inherently abusive, and (iv) the flexibility offered by joint ownership would be helpful or preferable in some circumstances—for non-abusive reasons entirely consistent with the purposes of section 529—and would further encourage the use of QTPs as a college savings vehicle. The primary reason that most QTPs do not offer joint ownership seems to be the uncertainty about whether it is permissible. Thus, we request that the forthcoming guidance eliminate that uncertainty and explicitly provide that QTPs may offer joint ownership.
b. Directed Distribution to Third Party. With some QTPs, the AO may direct a distribution to a third-party recipient who is not the AO, the DB, or an educational institution for the DB. When such a distribution is made, it is clear from prior guidance that the AO is considered the distributee for income tax purposes (and the distribution may qualify for tax-free treatment if made to cover QHEEs of the DB). However, the potential transfer tax consequences of such a distribution, when it is not for QHEEs of the DB, a liability of the DB, or a liability of the AO, are less clear. For example, is the distribution a deemed transfer directly from the DB to the recipient, a deemed transfer directly from the AO to the recipient, or a two-step transaction consisting of a deemed withdrawal by the AO and then a deemed transfer from the AO to the recipient? One advantage of the two-step approach is that the deemed withdrawal by the AO should not be subject to transfer tax, any more than an actual withdrawal by the AO would be, and one thus avoids the problem of ever subjecting the DB to transfer tax consequences beyond the DB’s control. Another advantage of the two-step approach is that it provides a consistent reference point for determining whether the second transfer, from the AO to the recipient, is or is not a gift for transfer tax purposes. We request that these transfer tax consequences be addressed in the forthcoming guidance to avoid continued uncertainty.
C. Application of Transfer Tax Where Permissible Contributors to Section 529 Accounts Include Persons Other Than Individuals
Section II, C of the Advance Notice addresses only the transfer tax and income tax issues related to contributions by non-individuals. However, because we believe that the proposal to limit AOs to individuals is unnecessary to prevent abuse, this section of our comments also Page 14 addresses how the transfer tax and income tax rules would apply when a non-individual, such as a trust, is the AO.
1. Should the definition of “person” be limited to individuals? We believe that the definition of “person” under section 529(b)(1)(A) should not be limited to individuals. Narrowing the definition of “person” from that set forth in section 7701(a)(1) would be based on flawed statutory analysis and would deny many non-individuals with perfectly legitimate reasons for doing so the opportunity to contribute to section 529 accounts. Further, as elaborated below, we believe that fair and consistent transfer and income tax rules can be drafted to apply when a contributor or AO is not an individual.
From the standpoint of statutory analysis, the Advance Notice itself points out that section 529(b)(1)(A) uses the word “person,” and “person” is defined in section 7701(a)(1) as generally construed to mean and include an individual, trust, estate, partnership, association, company, or corporation. Under that section of the Code, the only cases in which the statutory definition is not to apply are those in which the term is not “otherwise distinctly expressed or manifestly incompatible with the intent thereof.” Nowhere in section 529 is there a distinct expression that the word “person” should not have the general meaning ascribed by section 7701(a)(1). Therefore, only if the general meaning of “person” is “manifestly incompatible with the intent” of section 529 should the word have any different meaning.
The legislative history of section 529 reveals no indication that Congress intended to restrict contributors to section 529 accounts to individuals. We believe the decision of Treasury and the IRS in the Advance Notice, to follow the proposed regulations in providing that the definition of “person” as used in section 529(b)(1) will have the same (broad) meaning as under section 7701(a)(1), is sound.
Estates and trusts can and do make contributions to section 529 accounts. An estate may do so pursuant to a specific direction in the dispositive provisions of a decedent's will. An estate or a trust may do so pursuant to a facility of payment clause, so as to avoid distributing property outright to a minor. Permitting contributions to section 529 accounts by an estate or a trust furthers the purposes of section 529 by permitting a decedent or trustee to earmark certain funds for higher education.
We believe that it is appropriate that trusts be permitted not only to make contributions to section 529 accounts, but also to be AOs of section 529 accounts. First, trusts permitting distributions for QHEEs of a trust beneficiary should be able to take advantage of the same tax-favored investment vehicle as individuals when setting aside funds for higher education. Second, a trust limits any potential for abuse, because if the trust revests the section 529 account through a nonqualified distribution to the AO, the funds are received by the trust and not by the grantor or the trustee personally. Finally, it is feasible to draft workable tax rules governing section 529 accounts owned by a trust.
Section 529 accounts provide an investment opportunity for trusts with beneficiaries who have not completed their higher education. Pre-existing trusts that may make distributions for higher education may wish to invest some or all of their assets in section 529 accounts. In other instances, a donor may create a trust specifically for the purpose of owning one or more section 529 accounts.
Furthermore, we do not believe that contributions to section 529 accounts by partnerships, associations, companies, and corporations are widespread in practice or significant in amount. Therefore, absent specific evidence of abuse, Treasury and the IRS should not prohibit partnerships, associations, companies, and corporations from contributing to section 529 accounts.
2. What rules are necessary to ensure appropriate transfer tax consequences where a person other than an individual makes a contribution to a section 529 account? The Advance Notice seeks comments on what rules are necessary to ensure appropriate transfer tax consequences where a person other than an individual makes a contribution to a section 529 account. Treasury and the IRS are also interested in comments regarding whether the complexity of any special rules would outweigh the benefit of allowing non-individual contributors. For gift and GST tax purposes, section 529(c)(2)(A)(i) treats any contribution to a section 529 account as a completed gift of a present interest in property to the DB. Absent that unique statutory treatment, a gift to a section 529 account would not be considered either a completed gift or a gift of a present interest, at least as QTPs and section 529 accounts are typically structured. Therefore, any judgment as to “appropriate” transfer tax consequences can only be judged in the context of that special (anomalous) transfer tax treatment.
a. Irrevocable Trusts. There are two types of trusts that could make contributions to a section 529 account. For convenience we will refer to these types of trusts as revocable trusts and irrevocable trusts. By the term “revocable trust” we mean a trust that has terms such that a transfer to the trust by the grantor will not be treated as a completed gift for gift tax purposes.[4] By the term “irrevocable trust” we mean a trust that has terms such that a gift to the trust by the grantor will be treated as a completed gift for gift tax purposes.[5]
With irrevocable trusts, the analysis begins with two principles: (1) only an individual (not a trust) can make a gift, and (2) the GST tax rules apply to trusts to preserve the integrity of the transfer tax system. A corollary of the first principle is that when an irrevocable trust invests its own funds in a section 529 account it is making a trust investment, not a gift and not a trust distribution. A corollary of the second principle is that assets generally should be subject to one of the transfer taxes at each generation.
If an irrevocable trust invests funds already held in the trust in a section 529 account, no transfer tax consequences should result because the funds in the trust already passed through the transfer tax system when contributed to the trust and because a trust cannot make a gift. So long as the trustee remains the AO and no distribution is made to anyone other than the AO, no transfer tax consequences should result from any change in DB.[6] This should be the case even if the new DB is in a lower generation than the old DB or if the new DB is not a member of the family of the old DB.
Nor should there be any gift tax consequences to a distribution from a section 529 account as to which a trustee is the AO. Once again, a trust cannot make a gift.
However, the GST tax may apply to a distribution from a section 529 account of which an irrevocable trust is the AO if the DB is two or more generations below the generation of the transferor. In determining the generation assignment of the transferor, section 2653(a) provides that if there is a GST of any property and immediately after such transfer such property is held in trust, then for purposes of applying the GST tax rules, the trust will be treated as if the transferor of such property were assigned to the first generation above the highest generation of any person who has an interest in such trust immediately after the transfer. If the original transfer to the trust was not a GST, the transferor would have his or her natural generation assignment.
A distribution from a section 529 account to a DB who is two or more generations below the generation assignment of the transferor should be treated as either a taxable distribution or a taxable termination (as the case may be, depending on whether the distribution fully distributes the trust) for GST tax purposes, subject to the trust’s GST tax inclusion ratio. No GST tax would be due if the trust has a zero inclusion ratio or is grandfathered for GST tax purposes.
Example 1. P establishes an irrevocable trust for the education of his descendants. P has one child, C, and one grandchild, GC, when the trust is established. P makes a taxable gift of cash to the trust. The trust establishes a section 529 account with C as the DB. Distributions are made from the section 529 account to C for QHEEs. When C completes C’s education, funds remain in the section 529 account and the trust changes the DB to GC. Distributions are made from the section 529 account to GC for QHEEs. After GC completes GC’s education, the trust refunds the remaining section 529 account funds to the trust with a nonqualified distribution. P is treated as the transferor of the trust and is assigned to P’s natural generation, because the transfer to the trust was not a GST. There are no transfer tax consequences to the trust’s contribution to the section 529 account, because a trust cannot make a gift. When distributions are made to C, no GST tax or other transfer tax consequences result, because the transferor is assigned to the generation immediately above C’s generation. Nor do any transfer tax consequences result when the trust changes the DB from C to GC. When distributions are made from the section 529 account to GC, they are taxable distributions for GST tax purposes because GC is two generations below the generation assignment of P, the transferor.[7] There are no transfer tax consequences when the trust makes a nonqualified distribution to itself as AO.
If the trustee is required to make a principal distribution to a beneficiary, for example because the beneficiary attained a certain age, and the trust owns a section 529 account with such beneficiary as the DB, the trustee could effectuate the trust distribution by making the beneficiary the AO of the section 529 account. Alternatively, where a trust provides for discretionary distributions, the trustee could make such a distribution to the beneficiary by making the beneficiary the new AO of all or a portion of a trust-owned section 529 account with the beneficiary as the DB. If the beneficiary is a minor, many trusts would permit a distribution to a custodian under the UTMA for the minor beneficiary. Where a trust owns a section 529 account and wishes to distribute it to a minor DB, the trustee may wish to change the AO to a custodian under the UTMA for the DB. In all of these cases, where the new AO is the same as the DB for transfer tax and income tax purposes, no transfer tax consequences should result under section 529. However, the change of AO should be treated as a trust distribution that may result in a GST tax if the AO/DB is two or more generations below the transferor’s generation.
Example 2. Same as Example 1, except that when GC has completed his education P has a great grandchild, GGC, who is also a beneficiary of the trust. The trustee, pursuant to authority in the trust, changes the DB to GGC and then changes the AO to GC, as custodian for GGC under the UTMA. The change of AO is treated as a trust distribution to GGC. Because P is the transferor and GGC is more than two generations below the generation assignment of the transferor, the change of AO is a taxable distribution or termination for GST tax purposes.
It is possible that a trustee may make a distribution to a trust beneficiary by changing the AO of a trust-owned section 529 account to the beneficiary when the section 529 account has as its DB someone other than the new AO.[8] Any such change of AO should be treated as a trust distribution (but not as a section 529 distribution) to the new AO followed by a contribution of the funds by the new AO to the section 529 account for the DB. The distribution should be deemed to be made to the AO because for trust law purposes a distribution should transfer actual property rights to the trust beneficiary or to a fiduciary for the trust beneficiary, and merely being the DB of a section 529 account does not confer property rights. The change of AO would be subject to whatever GST tax consequences result from such trust distribution. The deemed contribution by the new AO would have the same transfer tax consequences as any other contribution by an individual to a section 529 account.[9]
Example 3. Same as Example 1, except that when GC has completed GC’s education the trustee changes the AO (of the section 529 account with GC as the DB) to C. The change of AO is treated as a distribution to C, followed by a contribution of funds by C to a section 529 account for GC. Because C is only one generation below the generation assignment of P, the transferor, no GST results. However, C is treated as making a gift to GC, but may make the five-year election.
b. Revocable Trusts. The analysis with respect to revocable trusts begins with two principles: (1) transfers by the grantor in the grantor’s individual capacity to a section 529 account would be treated as completed gifts for transfer tax purposes, and (2) a trust cannot make a gift, but while the trust is revocable the gift can be imputed to the grantor.
Contributions to a section 529 account by a revocable trust should be treated as a contribution by the grantor of the trust to the section 529 account. The transfer tax treatment of a contribution to a section 529 account should not change merely because the grantor uses the grantor’s revocable trust as the AO. Further, this approach is consistent with the treatment of a revocable trust as a grantor trust for federal income tax purposes under section 676. Therefore, there should be no transfer tax consequences to a revocable trust if such trust makes a contribution to a section 529 account. The transfer tax consequences of the contribution should be treated as belonging to the grantor. The contribution by a revocable trust to a section 529 account should be treated as a completed gift by the grantor to the DB for gift and GST tax purposes.
The transfer tax consequences of any subsequent change in DB by the AO while the trust is revocable should be governed by the general rules applicable to individual AOs. Thus if the DB is changed and the new DB is in a generation below the old DB, the old DB will be treated as having made a gift to the new DB. If the DB is changed and the new DB is two or more generations below the old DB, the gift will also be treated as a direct skip for GST tax purposes. Either the old DB or the grantor, as the imputed AO, would report this gift under the rules proposed in Section II, A above.
A revocable trust will typically become irrevocable at some point in time . usually upon the grantor’s death. The assets of a revocable trust are generally includible in a decedent’s gross estate for estate tax purposes. However, section 529(c)(4)(A) provides that no “amount shall be includible in the gross estate of any individual for purposes of chapter 11 by reason of an interest in a qualified tuition program.” Therefore, a grantor’s estate should not include for estate tax purposes any interest in a section 529 account, regardless of whether that interest was owned directly or through the grantor’s revocable trust and even if the section 529 account funds could be withdrawn and used to pay claims, debts, expenses, or taxes.
A revocable trust may become irrevocable during the grantor’s life if the trust is amended or powers are released such that it is no longer a revocable trust. Because the trust’s contribution to the section 529 account was treated as a completed gift from the grantor for gift and GST tax purposes, no transfer tax consequences should occur with respect to a trust-owned section 529 account if the formerly revocable trust becomes irrevocable during the grantor’s life.
After the trust becomes irrevocable, the transfer tax consequences of future contributions can no longer be attributed to the grantor as the imputed AO. Further, the transfer tax consequences set forth in section 529 cannot apply, because a trust cannot make a gift. However, the GST tax rules can be applied to maintain the integrity of the transfer tax system.
Because the initial transfer to the section 529 account is treated as a completed gift by section 529, even if the section 529 account is owned by a revocable trust the generation of the transferor for GST tax purposes should be determined as of the time of the initial transfer to the section 529 account. For GST tax purposes the contribution to the section 529 account creates a separate trust for GST purposes because the section 529 account portion of the trust is treated as a completed gift warranting the designation of a GST transferor, whereas no transfer has occurred with respect to the remainder of the trust, and therefore there is not yet any GST transferor for the remainder of the trust. For GST tax purposes a portion of a trust is treated as a separate trust if it has a different transferor or if it is a substantially separate and independent share of the trust because it has different beneficiaries. See section 2654(b). In this unique situation the section 529 account portion of the trust has a different transferor (because the remainder has no transferor) and is a substantially separate and independent share of the trust from the time of the creation of the section 529 account.
Having established that the section 529 account is treated as a separate trust for GST tax purposes, Section 2653(a) provides that if there is a GST of any property and immediately after such transfer such property is held in trust, for purposes of applying the GST tax rules, the trust will be treated as if the transferor of such property were assigned to the first generation above the highest generation of any person who has an interest in such trust immediately after the transfer. Because the only person who for transfer tax purposes has an interest in a section 529 account is the DB, when the DB is two or more generations below the grantor, section 2653(a) would treat the trust (with respect to the section 529 account) as if the transferor is in the generation above the DB. If the transfer to the section 529 account is not a GST (because the DB is not two or more generations below the grantor), the transferor would be assigned to the grantor’s natural generation.
After a revocable trust has become irrevocable, so long as the trustee remains the AO and no distribution is made to anyone other than the AO, no transfer tax consequences should result from any change in DB. This should be the case even if the new DB is in a lower generation than the old DB or if the new DB is not a member of the family of the old DB. Because the trust cannot make a gift, the section 529 rules applicable to changes of beneficiaries cannot apply.
However, the GST tax consequences of any distribution from the section 529 account should be determined by applying the appropriate GST tax rules. If the DB is two or more generations below the transferor’s generation, the distribution will be treated as a taxable distribution or a taxable termination for GST tax purposes. If the distributee is one generation below the transferor’s generation, or in the same generation as the transferor’s generation, there will be no transfer tax consequences to the distribution.
Example 1. G’srevocable trust establishes a section 529 account for G’sgrandchild GC1. During G’slife, the revocable trust becomes irrevocable. Consistent with the governing instrument, the trust then changes the DB of the section 529 account to G’sgrandchild GC2, and then directs a distribution to GC2. When G’srevocable trust establishes the section 529 account, G is treated as if G made a gift to the section 529 account directly. Under section 2653(a), because the transfer was a GST, the transferor is treated as being one generation above the generation of GC1. There are no transfer tax consequences with respect to the section 529 account when the trust becomes irrevocable or when the trust changes the DB. When the trust makes a distribution from the section 529 account to GC2, no GST tax consequences result, because GC2 is only one generation below the deemed generation assignment of the transferor.
Example 2. G’srevocable trust establishes a section 529 account for G’schild, C. During G’slife, the revocable trust become irrevocable. Consistent with the governing instrument, the trust then changes the DB of the section 529 account to G’sgrandchild, GC, and then directs a distribution to GC. When G’srevocable trust establishes the section 529 account, G is treated as if G made a gift to the section 529 account directly. G is treated as the transferor for GST tax purposes, and because the contribution to the section 529 account was not a GST, G is assigned G’snatural generation. There are no transfer tax consequences with respect to the section 529 account when the trust becomes irrevocable or when the trust changes the DB. When the trust makes a distribution from the section 529 account to GC, the distribution is treated as a taxable distribution or taxable termination for GST tax purposes, because GC is two generations below G’sgeneration assignment.
Example 3. G’srevocable trust establishes a section 529 account for G’sgrandchild, GC1. During G’slife, the revocable trust becomes irrevocable. Consistent with the governing instrument, the trust then changes the DB of the section 529 account to G’sgreat grandchild, GGC1, and then directs a distribution to GGC1. When G’srevocable trust establishes the section 529 account, G is treated as if G made a gift to the section 529 account directly. Under section 2653(a), because the contribution to the section 529 account was a GST, the transferor is treated as being one generation above the generation of GC1. There are no transfer tax consequences with respect to the section 529 account when the trust becomes irrevocable or when the trust changes the DB. When the trust makes a distribution from the section 529 account to GGC1, the distribution is treated as a taxable distribution or taxable termination for GST tax purposes, because GGC1 is two generations below the deemed generation assignment of the transferor.
Thus a trust could have a section 529 account with the transferor assigned to a different generation than the generation assignment for the non-section 529 account assets in the trust. This could occur if the section 529 account was created while the trust was revocable and the creation of the section 529 account was a GST, causing the generation assignment of the transferor with respect to the section 529 account to move down a generation. See section 2654(b). This may require some recordkeeping by the trustee AO and/or by the DB for future gift and GST tax purposes.
Example 4. G’srevocable trust, for the benefit of G’schild C and grandchildren GC1 and GC2, establishes a section 529 account for GC1. Under the rules proposed above, this would be a completed gift for gift and GST tax purposes by G at that time. Subsequently, during G’slife, the revocable trust becomes irrevocable. G, as the transferor of the non-section 529 assets of the trust, is assigned to G’snatural generation because the transfer to the trust is not a GST. However, because the transfer to the section 529 account for GC1 was a GST, the transferor is treated as being in C’s generation (one generation above GC1) with respect to the section 529 account (which is treated as a separate trust for GST tax purposes). If after the trust becomes irrevocable the trust establishes a second section 529 account for GC2, G will be treated as the transferor of the section 529 account for GC2 (which is not a separate trust for GST tax purposes) and will be assigned to G’snatural generation. Thus, when the trust makes a distribution from GC1’s section 529 account to GC1, no GST tax consequences result from the distribution because GC1 is only one generation below the deemed generation assignment of the transferor (C’s generation). However, when the trust makes a distribution from GC2’s section 529 account to GC2, the distribution is treated as a taxable distribution or taxable termination for GST tax purposes and will be subject to GST tax unless the trust has a zero inclusion ratio or is grandfathered. Similarly, if the trust makes a distribution to GC1 or GC2 from non-section 529 account assets, the distribution is treated as a taxable distribution and will be subject to GST tax unless the trust has a zero inclusion ratio or is grandfathered.
c. Contributions to Trust-Owned Section 529 Accounts. Yet another possibility exists with trust-owned section 529 accounts: someone else may contribute property to the trust-owned account. For example, a trustee of an existing irrevocable trust is the AO of a section 529 account with a minor trust beneficiary as the DB. A grandparent of DB wants to contribute toward DB’s higher education. For reasons important to grandparent (such as the trustee’s superior reliability and judgment), grandparent wants the trustee (rather than the DB’s parent) to control Grandparent’s contribution. Setting up another separate section 529 account for the same DB would not subject it to the terms of the trust and would cause extra administrative expense. So grandparent would like to contribute funds to the existing trust-owned section 529 account.
We believe that if a donor contributes cash to a section 529 account owned by an irrevocable trust, the donor should be treated as if the donor had made the contribution to the trust for transfer tax purposes and then the trust had contributed the funds to the section 529 account. Thus, the donor should be entitled to claim the gift tax annual exclusion if the contribution to the trust itself qualifies for that, as would be the result in the case of a contribution to a section 2503(b) or 2503(c) trust or a Crummey trust; and the donor should also be entitled to claim the GST tax annual exclusion if the contribution to the trust itself qualifies for that, as would be the result in the case of a contribution to a trust that qualifies under section 2642(c)(2).
In addition, when a contribution to the trust would qualify for the gift tax or GST tax annual exclusion (as the case may be) as described above, then for purposes of the particular tax, the donor should be permitted to make the five-year election under section 529(c)(2)(B) with respect to the contribution, but only for up to five times the lesser of (i) the annual exclusion amount in effect at the time of the contribution and (ii) whatever amount of the contribution qualifies for the annual exclusion at such time.[10] Any such election would also be subject to rules and limitations generally applicable to five-year elections. See Section III, A below. As in the case where the five-year election is made with respect to a contribution to a section 529 account with an individual AO, this permits the donor to accelerate the use of the annual exclusions but does not result in granting the donor additional annual exclusions.
Example 1. P establishes a trust for P’s child, C, that qualifies as a 2503(c) trust. P contributes cash to the trust, which the trust contributes to a section 529 account with C as the DB. GP, C’s grandparent, contributes $60,000 to the section 529 account. Because the trust is a 2503(c) trust, a contribution by GP to the trust would qualify for both the gift tax and GST tax annual exclusions, in its entirety. Therefore, GP may make the five-year election with respect to the contribution to the trust-owned section 529 account, both for gift tax and GST tax purposes.
Example 2. P establishes an irrevocable spray trust for P’s child, C, and P’s future grandchildren. The trust gives the beneficiaries Crummey rights of withdrawal over contributions to the trust, up to $10,000 per year per beneficiary. The trust establishes a section 529 account for C. P contributes $60,000 to the section 529 account. Because C can withdraw up to $10,000 per year, $10,000 of the contribution by P to the trust would qualify for the gift tax annual exclusion. Thus, P can make the five-year election with respect to five times that amount, $50,000, but the remaining $10,000 is an immediate taxable gift to the trust. If C’s grandparent, GP, also contributes $60,000 to the section 529 account, the same consequences would apply to GP for gift tax purposes. However, because GP’s contributions to the trust would not qualify for the GST tax annual exclusion, GP would not be able to make any five-year election for GST tax purposes.
We believe that if a third-party donor contributes cash to a section 529 account owned by a revocable trust, the donor should be treated as if the donor had made a contribution to a section 529 account for the DB with the trust grantor as the AO.
The transfer tax consequences of any subsequent change in DB by the AO while the trust is revocable should be governed by the general rules under section 529 applicable to individual AOs. After the trust becomes irrevocable, the GST tax rules would govern the transfer tax consequences. The transferor for GST tax purposes would be the third-party donor, who would be (1) assigned to such donor’s natural generation if the original contribution to the section 529 account was not a GST (i.e., the DB is not two or more generations below the donor), or (2) assigned to the generation immediately above the DB’s generation if the original contribution to the section 529 account was a GST (i.e., the DB is two or more generations below the donor). If the section 529 account had contributions from different transferors, the respective portions of the account would be treated as separate trusts for GST tax purposes. See section 2654(b)(1).
d. Estates. As noted above, generally only an individual can make a gift; an estate cannot. Thus, there should be no gift or GST tax consequences if a decedent’s estate makes a contribution to a section 529 account. Section 529 provides no federal estate tax deduction or credit for contributions by an estate to a section 529 account. Thus, an estate will obtain no estate tax benefit for a contribution to a section 529 account. If the devisee or heir for whose benefit the estate makes a contribution to a section 529 account is a skip person, GST tax will be imposed at the decedent’s death (subject to any applicable GST tax exemption), but the contribution of a skip person’s devise or inheritance to a section 529 account does not provide any GST tax advantage to the estate. Therefore, there should be no transfer tax consequences when an estate makes a contribution to a section 529 account.
If an estate becomes the AO of a section 529 account by reason of the original AO’s death, the section 529 account should not be included in the original AO’s estate. See section 529(c)(4)(A). Any post-death transfer tax consequences would occur under the GST tax rules only upon a future distribution from the section 529 account or upon a future distribution of the section 529 account to a new AO. If the estate changes the AO and the DB is the same as the new AO, the change of AO should be treated as an estate distribution to the AO/DB for GST tax purposes. If the estate changes the AO and the new AO is different than the DB, the change of AO should be treated as an estate distribution to the new AO for GST tax purposes followed by a contribution of the funds by the new AO to the section 529 account for the DB. See the discussion above with respect to irrevocable trusts changing the AO of section 529 accounts.
d. Other Entities. As noted above, we do not believe that contributions to section 529 accounts by partnerships, associations, companies, and corporations are widespread or significant in amount. As set forth in the Advance Notice, under section 25.2511-1(h)(1) of the Regulations, the IRS has the power to treat a transfer of property by an entity as a gift from the owners of the entity. Absent evidence of abuse, we encourage Treasury and the IRS to rely on that power and the anti-abuse rule, when necessary, and not attempt to promulgate specific regulations dealing with the transfer tax consequences of contributions to section 529 accounts by partnerships, associations, companies, and corporations. Nevertheless, if Treasury and the IRS believe that specific regulations are necessary at this time, de minimis rules should be included so that the complexity of any special rules do not outweigh the benefit.
3. What are the income tax consequences when a contribution to a section 529 account is made by a person other than an individual? The Advance Notice seeks comments on the income tax consequences when a contribution to a section 529 account is made by a person other than an individual. Treasury and the IRS are also interested in comments regarding whether the complexity of any special rules would outweigh the benefit of allowing non-individual donors. The narrow question posed by Treasury and the IRS seems to focus only on the income tax consequences of a contribution by a non-individual, not on income tax consequences of a distribution from a section 529 account owned by a non-individual. Yet, there is a follow-up question in the Advance Notice that asks: “For example, if a trust makes contri |
