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By Rodney C. Koenig
Perhaps as recently as a century ago, the way to transfer wealth was to transfer the family farm or the family business to the next generation. The farm or the business was capable of sustaining the livelihood of generations to come. Today, the best way to transfer wealth is perhaps to transfer knowledge through the education process. Often this knowledge transfer involves a massive wealth transfer transaction, as anyone who has educated children through secondary school, university and professional schools is aware. It has been said that to feed a person for a day, one should give the person a fish, but to feed someone for a lifetime, one should teach that person to fish. This article discusses several methods by which families can start the process of setting aside funds to teach someone to fish.
Qualified State Tuition Programs
Arguably, the hottest and most interesting area affecting college costs is the relatively new Code § 529 qualified state tuition program, which was passed by Congress in its current form in 1996. See Small Business Job Protection Act of 1996, Pub. L. No. 104-188, 110 Stat. 1755 (1996). Substantial gifts can be made that remove funds from the donor's taxable estate, yet the donor can reacquire the same funds with only a modest penalty. These concepts seem contrary to basic tax law but are allowed by Code § 529 and Prop. Treas. Reg. §§ 1.529-0-1.529-6. Generally, these rules provide that the earnings generated by funds in a qualified state tuition program are exempt from income tax before withdrawal.
A qualified state tuition program is a program established and maintained by a state or agency or instrumentality of a state under which, subject to additional requirements:
a person (i) may 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, or (ii) may make contributions to an account which is established for the purpose of meeting the qualified higher education expenses of the designated beneficiary of the account.
Code § 529(b)(1)(A). These programs are divided substantially into two types: one is a prepaid tuition plan and the other is a savings plan.
A state tuition plan must satisfy certain standards to qualify for Code § 529 treatment. First, the program must restrict contributions and purchases to those made in cash. Second, the program must impose a penalty on any refund of earnings, and this penalty must be more than de minimis. If the earnings are used for the qualified higher education expense of a designated beneficiary, are made on account of the death or disability of a designated beneficiary or are made on account of a scholarship received by the designated beneficiary in certain circumstances, then the penalty will be waived. Third, a program must provide separate accountings for each designated beneficiary. Fourth, contributors and designated beneficiaries may not directly or indirectly direct the investment of any contributions to the program or any earnings on it. Fifth, a program cannot permit any interest in the program or any portion of it to be used as security for a loan. Sixth, a program must provide adequate safeguards to prevent contributions exceeding those necessary to provide for the beneficiaries' qualified higher education expenses.
Under Code § 529, each individual U.S. state may create a program within the parameters discussed above. The amount of the penalty for withdrawal is a function that each state controls, so long as the penalty is not de minimis. Likewise, a state can determine the amount of contributions, but the state must use some logic in determining the total amount of permitted contributions. For example, the New Hampshire Plan initially set its contribution limit based on the averages of tuition and other educational costs at Dartmouth College and the University of New Hampshire. States comply with the prohibition against allowing investment direction by the individual donors by requiring certain universal rules for investing. Many of these plans invest somewhat more aggressively when a child is young and then level off more to a conservative investment, such as bonds and fixed income products, as the child approaches college age. Some states have handled the investment of the funds brought into these plans directly, as has Texas in its Texas Tomorrow Fund. Other states, such as Massachusetts, Delaware and New Hampshire, have obtained outside program managers and investment advice.
Tax Treatment of Designated Beneficiaries and Contributors
Code § 529 addresses both transfer tax and income tax consequences. First, Code § 529 characterizes a contribution to a qualified state tuition plan as a completed gift; it treats that contribution as a present interest gift, thereby qualifying the contribution for the annual exclusion. Second, Code § 529 defers taxation on the income generated by these contributions until that income is distributed. At that time, distributions are to be included in the distributee's gross income. In 1999, the omnibus budget bill included provisions making the earnings generated within a Code § 529 plan completely exempt. Although the President vetoed the bill, Congress will likely reintroduce the favorable Code § 529 items.
Gifts Exceeding $10,000
Code § 529 modifies traditional gift tax rules on amounts contributed to a qualified state tuition program in excess of the annual exclusion. If the total contribution exceeds the annual exclusion amount under Code § 2503(b) (which is currently $10,000 per donee) per donor, the aggregate amount shall, at the donor's election, be ratably extended for gift tax purposes over a five year period, with the appropriate election being made on the gift tax return. Code §§ 529 (c)(2)(B), 2503(b). For example, $50,000 could be given in one year, assuming no other gifts to the donee in those five years, with the gifts being ratably spread over the current year and the next four years thereafter, without any adverse gift tax consequences. Thus, if the particular qualified state tuition program allows, a husband and wife could donate as much as $100,000 collectively at one time for the benefit of one child, grandchild or other person. If one contemplates creating a Code § 529 gift near year end, it would be strategic to donate $10,000 near year end and then donate $50,000 early in the next year, using the five year spread. In this way, a couple could donate as much as $60,000 each, totaling $120,000. Of course, in that case, gift tax returns reflecting the action would be filed the following April 15.
Estate Tax and Income Tax
Code § 529 prescribes special estate tax treatment of certain contributions at the donor's death. As discussed above, Code § 529 recognizes two types of contributions. It provides for transfer tax treatment of contributions falling within the Code § 2503 annual exclusion amount, namely $10,000, as well as contributions exceeding this amount. The amounts contributed within the annual exclusion amount will not be included in the gross estate of the individual who contributed the amount. Conversely, should more than $10,000 be contributed in any one year, the excess amounts will be included in the donor's gross estate for those remaining years of the five year period that have not elapsed as of the donor's death. For example, two grandparents with 10 grandchildren could give $100,000 ($50,000 from each grandparent) to a Code § 529 plan for each of their 10 grandchildren or a total of $1 million, collectively. If they both live for the full five years after making the gift, none of the $1 million gift will be included in their taxable estates.
If they are willing to accept being taxed on the accumulated income and are willing to pay the penalty, however, the grandparents can withdraw the funds from the Code § 529 plan at will. This feature of most Code § 529 plans makes this an excellent method of giving for individuals who are concerned that they may need the donated funds later. Furthermore, most states will provide deferral from state income taxes as well. Hence, counsel should review the state income tax rules in this regard before a client enrolls in any state's plan.
A donor to a qualified state tuition plan must designate a beneficiary, but then later may change the beneficiary to a member of the initial beneficiary's family. The term "member of family" is defined in Code § 529(e)(2) to include the beneficiary's spouse, a descendant, stepchild, brother, sister, stepbrother or stepsister, parents and in-laws, as well as an ancestor of a parent, a stepfather or stepmother of a beneficiary, a son or daughter of a brother or sister of a beneficiary or a brother or sister of the father or mother of the beneficiary. Code § 152(a). As a practical matter, this flexibility allows a parent to designate child A. If child A either does not complete school or elects not to go to school, the parent can immediately change the designation to child B as the beneficiary without any adverse tax consequences.
Changing a beneficiary is not quite as simple for a grandchild. A grandparent who contributes can designate grandchild A-1 but then can change the designation only to grandchild A-2 if A-2 is a descendant of the same parent. In effect, grandparents can change designations to grandchildren who are siblings but cannot change designations to grandchildren who are cousins. There are no gift or generation-skipping tax consequences if a new designated beneficiary is in the same generation as the old beneficiary. If the donor dies before the funds are completely used, control of the account and the ability to change beneficiaries will be passed on by the donor's will or by intestacy, if no will disposes of that right.
Qualified Higher Education Expenses
Funds distributed from a Code § 529 plan must be used for qualified higher education expenses. Qualified higher education expenses include tuition, fees, books, supplies and equipment required for the enrollment or attendance of a designated beneficiary at an eligible educational institution. These expenses also include room and board for students who are at least half-time students. Code § 529 savings plans allow payments for room and board, whereas Code § 529 prepaid tuition plans do not allow payments for room and board. An eligible educational institution is defined as an institution described in Section 481 of the Higher Education Act of 1965 and one that is eligible to participate under Title 4 of the Higher Education Act, which essentially covers all accredited colleges and universities.
Withdrawal Ability and Total Contributions
If the donor withdraws funds from the qualified state tuition program, then a penalty, which cannot be de minimis, is imposed, the income is taxed and the funds will be included in the donor's estate. Notwithstanding the donor's ability to withdraw and notwithstanding Code § 2036, however, if the donor does not withdraw such amounts, then the amount is not included in the donor's gross estate at his or her death.
The total amount that can be contributed for a given child or grandchild to a Code § 529 plan is a function of the amount allowed by a given state. A state usually evaluates actual costs at a public university and a private university in an area to arrive at this amount. For example, Maine's Code § 529 plan currently has a maximum contribution per designated beneficiary of $138,000, which is based on the average highest cost of attending private colleges for five years of undergraduate enrollment in New England, as published by the College Board. Other states have different plan limits, such as Massachusetts, which currently has a maximum contribution of over $150,000, and New York, which currently has a maximum of $100,000.
Many state plans allow residents of other states to participate in their plans, but some allow only in-state residents to participate. The state income tax consequences may vary for in-state resident participants, who may receive additional benefits. Many of the Code § 529 savings plans allow nonresidents to participate, while many of the prepaid tuition plans are limited to in-state residents. Obviously, when choosing a Code § 529 plan, one must consider the state income tax consequences.
Major Players in § 529 Programs
As indicated earlier, the qualified state tuition programs are exactly what they purport to be, programs adopted by the various states. Certain states run these programs completely on their own, while a number of other states are using major financial institutions as agents. The following list includes some, but not all, of the current major players in this market:
As previously noted, many states allow nonresidents to participate in their programs. Certain other states, such as Texas, do not allow nonresidents to apply. The chart accompanying this article reflects a number of Web sites that may be helpful in locating and reviewing Code § 529 plans.
Education IRAs-Code § 530
Another technique that might be used for college expenses is the education IRA under Code § 530. The most serious drawback of education IRA plans is the limitation on contributions. Contributions must be in cash, must be paid before the beneficiary attains age 18 and are limited to $500 per year, except in the case of rollovers. An interesting aspect of the education IRA allows monies previously placed in the education IRA to be contributed toward a Code § 529 plan.
A further limitation on education IRAs reduces and then eliminates their use for contributors with modified adjusted gross income over $95,000 for a single taxpayer and $150,000 in the case of a joint return. Complete phase-out occurs at $110,000 for an individual return and at $160,000 in the case of a joint return.
It should be noted that no contributions can be made to an education IRA on behalf of a child if any amount is contributed during the tax year to a qualified state tuition program on behalf of the same child. As in the qualified state tuition program, rollovers can occur to a new education IRA for the same beneficiary or for a member of that beneficiary's family.
An interesting and quite effective way to prepay tuition directly to an educational institution was highlighted in the recent PLR 199941013. It should be noted that Code § 2503(e) allows direct payment of tuition, which is not deemed a taxable gift. In PLR 199941013, a grandmother paid over $180,000 in tuition payments, including a significant amount for future tuition, directly to a private elementary/high school for certain of her grandchildren. The future tuition payments were not refundable. The grandmother and the children's father agreed that they would pay for any differential if the school increased tuition. The payments would be forfeited to the school if a child did not attend for any reason. Because the payments were made directly to an educational organization to be used exclusively for specific tuition for designated individuals, Code § 2503(e)(2) applied and such payments were not subject to gift tax.
The process of educating the next generation requires a massive transfer of wealth, considering the cost of a four to five year college program to obtain an undergraduate degree, as well as the cost of a possible advanced or professional degree. Various avenues are available to provide funds for this process. If a child cannot win an academic or athletic scholarship, then Code § 529 plans are a favorable option for parents and grandparents.
Rodney C. Koenig is a partner with Fulbright & Jaworski, L.L.P. in Houston, Texas.
Helpful Web Sites for Locating Qualified State Tuition Plans