529 Plans - a Square Peg That Fits Nicely in a Round Hole

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529 Plans - a Square Peg That Fits Nicely in a
Round Hole

• The Dale Law Firm

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Introduction

• One of the most difficult puzzles our office
  faces is how to assist an SSI or Medicaid
  recipient to receive gifts without interfering
  with the recipients benefits and still have the
  gift qualify under the annual gift tax exclusion
  under IRC 2503(b)(1).

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Introduction

• Any practitioner who has attempted to use
  Crummey1 provisions in a Special Needs Trust is
  faced with the still unresolved question of
  whether a lapsed gift to a Special Needs Trust
  makes the gift the asset of the disabled
  individual subjecting the trust to d(4)a
  provisions, or does the gift qualify as a valid
  gift to a 3rd party Special Needs Trust? 1
  Crummey v. Commissioner, 397 F.2d 82 (9th Cir.
  1968)

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What is a 529 plan?

• A 529 Plan is an investment plan authorized under
  federal law and operated by each state to allow
  contributions to be made for eligible
  students1
• 1 See IRC 25A(b)(3)

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What is a 529 plan?

• for qualified higher education expenses2
• 2 The term "qualified higher education
  expenses" means tuition, fees, books, supplies,
  and equipment required for the enrollment or
  attendance of a designated beneficiary at an
  eligible educational institution as well as room
  and board, as limited by 20 U.S.C. 1087II.

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What is a 529 plan?

• in an "eligible educational institution3".
• 3 An "eligible educational institution" means
  an institution described in 20 U.S.C. 1088 on
  August 5, 1997, if such institution is eligible
  to participate in a program under Title IV of the
  Higher Education Act of 1965. This definition may
  include some foreign institutions and proprietary
  institutions.

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Fitting a Round Peg in a Square Hole

• While there are many persons with disabilities
  that are attending higher education programs,
  this article assumes that the funds designated in
  a 529 plan will ultimately be used for purposes
  other than higher education.
• All materials on 529 plans including the IRC 529
  itself assume that funds will be used only for
  higher education1. 1 IRC 529(a)(3)

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What is a 529 plan?

• As long as the plan satisfies federal
  requirements, the federal tax law provides
  special tax benefits under Section 529 of the
  Internal Revenue Code.

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Penalties

• States are required by federal law to impose
  more than a de minimis penalty1 on any refund
  of earnings from the account which are not used
  for qualified higher education expenses.
• 1 The IRS has issued proposed regulations that
  provide guidance on when a penalty is more than
  de minimis, including a safe harbor providing
  that a penalty is more than de minimis if it is
  equal to or greater than 10 percent of the
  earnings portion of the distribution. Prop. Reg.
  Section 1.529-2(e)(2).
•  

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Penalties and Exceptions the 3 Ds

• Three exceptions to the nonqualified distribution
  penalty are distributions made on account of
• the disability of the designated beneficiary,
• death of the designated beneficiary, or
• distributions made on account of a scholarship to
  the extent the amount of the refund does not
  exceed the amount of the scholarship, allowance,
  or payment.

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Penalties and Exceptions what is Disability?

• What is the definition of disability?
• No one knows but even if there is a penalty for
  withdrawls the benefit of a completed gift and
  the tax free growth make 529s a desirable tool.

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Qualified Distributions

•  To qualify for tax-free treatment, distributions
  from a 529 plan must be used for tuition, room
  board, fees, books, equipment and supplies that
  are required for enrollment or attendance1
• Funds distributed from the account must either be
  paid to the institution or third party directly
  or, if paid to beneficiary, beneficiary must
  substantiate the expense within
  30 days of the distribution to
  qualify for tax-free treatment.2

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Qualified Distributions

• For taxable years beginning after December 31,
  2001, qualified expenses also include expenses of
  a special needs beneficiary3 that are necessary
  in connection with his or her enrollment or
  attendance at an eligible educational
  institution.4
•  3 Congress intends that IRS regulations will
  define a special needs beneficiary to include an
  individual who, because of a physical, mental, or
  emotional condition (including a learning
  disability) requires additional time to complete
  his education. H. Conf. Rep. 107-84, 107th Cong.,
  1st Sess. 156 (2001).
• 4 IRC 529(e)(3)(A).

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Non-Qualified Distributions

• Federal law imposes a 10 penalty on earnings for
  non-qualified distributions beginning in 2002.
  The practitioner needs to look at the state plan
  rules on the specifics of how the penalty is
  assessed.
• Many states say the account owner will be
  responsible for the penalty, while others allow
  the beneficiary to be responsible for the
  penalty.

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Can a Special Needs Trust Own the 529 Account?

• The beneficiary of the 529 plan must be an
  individual1.
• The participant is the account owner or contract
  purchaser.
• Any person including a trust, estate,
  partnership, association or corporation can be
  the account owner or contract purchaser of a 529
  plan account2 dependent upon limitations made
  by each state plan.
• 1 IRC 529(e)(1)(A)
• 2IRC 529(b)(1)(A). See also IRC 7701(a)(1).

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Can a Special Needs Trust Own the 529 Account?

• Generally the participant and contributor dont
  have to be the same person. Others can contribute
  to the account.
• Most states allow trusts to own 529 plan
  accounts. In 2001, Arizona, Delaware, Indiana,
  Iowa, Louisiana, Massachusetts, Michigan,
  Minnesota, Missouri, New Hampshire, New York,
  Oklahoma, Rhode Island and Tennessee did not
  allow trusts to own a 529 plan account. Many of
  these states are expected to change their
  policies.

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How much Can be Contributed?

• The intent of 529 plans is that contributions be
  limited to a reasonable amount needed for higher
  education. Each plan does have maximum amounts
  that can be contributed to the 529 plan.
• For instance, Pennsylvania allows residents
  outside of Pennsylvania to participate in their
  plan and has a maximum limit of 290,000 that can
  be contributed.

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How much Can be Contributed?

• There currently are no restrictions on having
  multiple plans in multiple states, but many
  commentators expect that congress will eventually
  eliminate this loophole.

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Gift and Estate Tax Consequences

• Contribution made within the guidelines of IRC
  529 is not treated as gifts of a future
  interest1. Contributions to a 529 plan are
  treated as completed gifts to the beneficiary and
  are eligible for the gift tax exclusion2.
• If gifts are made via a 529 plan, a contributor
  can make gifts of, 11,000 per year, per
  beneficiary tax free annually or through gift
  splitting and contribute 22,000 per
  beneficiary.3

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Gift and Estate Tax Consequences

• Gifts to 529 plans are out of contributors
  estate for estate tax purposes4. The account
  will be included in the gross estate of the
  beneficiary5.

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Gift and Estate Tax Consequences

• A unique feature in 529 plans is that a
  contributor can make a lump sum of up to 55,000
  in one year if no other contributions are made
  for following five years. Therefore, a large
  amount of money can be moved out of a client's
  estate without owing tax and any appreciation is
  removed from the estate if the client makes an
  election on a gift-tax return.

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Gift and Estate Tax Consequences

• For example, a couple could put 110,000 into a
  529 plan for their disabled granddaughter this
  year, tax-free, if they elect to spread this gift
  over five years and file gift-tax returns each
  year.
• If the account owner dies before the fifth year,
  a portion of the gift would come back into his or
  her taxable estate."

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Checklist for Financial Advisor

• Here is a list of question that the financial
  professional must address prior to implementing a
  specific plan for a Special Needs Trust.
• Will the plan allow a trust to own the plan?
• If nonqualified distributions are made, whom is
  the tax or penalty assessed against?
• What is the state plans definition of
  disability?
• Are there age limitations?
• What are the minimum and maximum distributions
  limitations of the plan?

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Conclusion

• Contributions from third parties are completed
  gifts for gift tax purposes
• Contributions to a 529 plan grow tax free
• Distributions to a disabled beneficiary may
  qualify as an exception to the statutory penalty
  requirements
• Even if a penalty is paid for a nonqualified
  distribution, the tax free growth most likely far
  outweighs the penalty
• 529 plans allow for extremely creative planning