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Stephen C. Hartnett, J.D., LL.M., is the Associate Director of Education of the AmericanAcademy of Estate Planning Attorneys, a nationally recognized membership organization

for attorneys focusing on estate planning. He can be reached at steveh@aaepa.com.

Code Sec. 529 Plans:Estate Planning’s

Holy Grail?

By Stephen C. Hartnett©2003 S.C. Hartnett

For years, clients and estate plan-ners alike have sought estateplanning’s Holy Grail, a vehiclethat would allow the client to re-tain control while removing assetsfrom the estate and achieving in-come tax savings. Qualifiedtuition programs (QTPs), other-wise known as Code Sec. 529plans, may not be a veritable HolyGrail, but they are a unique, flex-ible estate planning toolcomplementing other time-hon-ored planning strategies.

HistoryThe current QTPs can be tracedback to 1986, when the state ofMichigan started a tuition pro-gram. Under the plan, parents ofMichigan students could deposita fixed amount into the MichiganEducation Trust and would beguaranteed to have future tuitioncosts covered. This payment wasrefundable upon the child’sdeath, the child’s failure to secureadmission to a Michigan stateuniversity or the child’s certifyingthat he or she would not be at-tending college.

Michigan was concerned aboutthe tax implications of the planand sought a private letter ruling.1

Despite an unfavorable letter rul-ing, Michigan went forward withthe program and challenged theIRS in court.2 The problems en-countered by the Michiganprogram prompted the inclusionof Code Sec. 529 by the SmallBusiness Job Protection Act of1996.3 Already, several changeshave been made to Code Sec. 529,including those made by the Tax-payer Relief Act of 1997 (TRA)4

and the Economic Growth and TaxRelief Reconciliation Act of 2001(EGTRRA).5

OverviewCode Sec. 529 provides that QTPsare exempt from taxation.6 As aresult, the earnings on contribu-tions to a QTP grow free from tax,as in a charitable remainder trust(CRT) or a Roth IRA (ROTH). LikeCRTs, QTPs are subject to tax onunrelated business income(UBIT).7 Distributions from QTPsare not included in income as longas they are for qualified higher

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education expenses. Further, giftsto QTPs qualify for the presentinterest annual exclusion for bothgift and generation-skipping trans-fer (GST) tax purposes.8 In fact, thecontributor can use five years ofannual exclusions up front, sub-ject to partial inclusion if notsurviving the term.9 The transfersare deemed to be a completed giftand qualifying for the annual ex-clusion even though the transferorcan substitute beneficiaries or getthe funds back.

Code Sec. 529 sets certain re-quirements that programs mustmeet in order to gain preferentialtax treatment. However, programscan and do vary significantly fromstate to state and even within astate. Programs can be and fre-quently are more restrictive thanCode Sec. 529 mandates.

Generally, QTPs may have thefollowing advantages, which willbe discussed more fully below:■ Earnings can be federal in-

come tax exempt.■ Earnings can be state income

tax exempt or deferred.■ The contributor can use up to

five years of annual exclusionsup front.

■ Contributions qualifying forthe gift tax annual exclusionalso qualify for the GST an-nual exclusion.

■ The account owner maintainscontrol over the identity of thebeneficiary.

■ The account owner can with-draw the funds.

■ If the student is not the ac-count owner, the assets maynot impact the student’s eligi-bility for financial aid.

■ The account owner, and notthe beneficiary, has controlover the timing and extent ofdistributions.

■ Contributions may qualify fora state income tax deduction.

Generally, QTPs may have thefollowing disadvantages, whichare discussed more fully below:■ Qualified distributions are

only for qualified higher edu-cation expenses.

■ Nonqualified distributionsmay incur a 10-percent pen-alty tax.

■ The account owner has onlylimited, indirect control of theinvestments.

■ Changes in beneficiary des-ignation, rollover, etc., canpose traps.

■ The assets may be included inthe beneficiary’s estate atdeath.

■ EGTRRA sunset—The federaltax exemption of earnings andthe inclusion of cousins as“members of the family” wereadded as part of EGTRRA andtherefore sunset after 2010.

■ This is a relatively new area oflaw with some uncertainties.

StatutoryRequirementsQTPs are creatures of statute andmust meet specific statutory re-quirements in order to get thefavored treatment under the Inter-nal Revenue Code. However,individual plans may have rulesmore restrictive than required un-der federal law. In reality, QTPrules vary considerably.

A QTP is a program that is estab-lished and maintained either by (1)a state or agency or instrumental-ity of the state,10 or (2) one or more“eligible educational institutions.”11

An “eligible educational institu-tion” is one “described in Section481 of the Higher Education Actof 1965 [20 USC § 1088] as in ef-fect on August 5, 1997, and whichis eligible to participate in a pro-gram under title IV of that Act.”12

In other words, an institution quali-fies if it qualifies for its students toreceive federal financial aid, suchas Pell grants, Perkins loans andother federal loan programs.13

There are two types of programsregardless of the offering entity: (1)tuition credits, commonly knownas prepaid tuition programs, and(2) educational savings account(ESA) programs.14

With a prepaid tuition program,a person purchases tuition creditsin advance based on today’s costsand an expected modest invest-ment return. The program allowsa person to be guaranteed againstfuture tuition increases. The tuitioncredits can be used only at speci-fied schools, typically schools inthat state’s public system. Whilethe prepaid tuition program mightwork out under some circum-stances, the ESA seems to be moreflexible and is the favored vehiclein most circumstances.

An ESA is an account to whichcontributions are made to pay forqualified educational expenses forthe designated beneficiary of theaccount. There is no requirementthat the funds actually be used foreducational purposes.

Contributions andDistributionsThe contribution must be cash15

and may not be made in stock orother property. If the donor hassuch property, he or she must sellthe property and recognize anygain prior to contributing the pro-ceeds. Once the contribution hasbeen made, the account ownermay not directly or indirectly par-ticipate in investment decisions.16

The owner can choose the initialinvestment options upon estab-lishing the plan17 and may changeinvestment options annually or

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upon a change in beneficiary des-ignation.18 However, the programmay only allow the account own-ers to select from broadinvestment strategies designed bythe program and it must establishprocedures and maintain recordsto prevent the account owner fromchanging more frequently thanannually. Finally, the owner canroll the funds from that plan to theplan of another state once peryear.19 The account owner cannotpledge or otherwise use the ac-count assets as collateral.20

The program must not allowcontributions in excess of thosereasonably necessary to fund thebeneficiary’s qualified higher edu-cation expenses.21 Plans setspecified limits, such as a cumu-lative cap on contributions or aprohibition on contributions oncean account exceeds a certain bal-ance.22 While the intent of theregulations is to prevent accumu-lating more funds than necessaryfor the beneficiary, they do notrequire the plan to consider fundsin other QTPs, and the plans donot do so.

Income Taxation

Contributions to a QTP do notqualify for a federal income taxdeduction. However, the plan isa tax-exempt entity, like an IRAor CRT. As such, the incomeearned inside the plan is not cur-rently taxable. The power of thistax deferral is illustrated by thefollowing example.

Example 1. A sets aside$50,000 for her child’s futurecollege and graduate educa-tion expenses. Assumptions:10-percent pre-tax rate of re-turn, earnings are currentlyrecognized as one-half ordi-nary income and one-halflong-term capital gain, mar-

ginal combined federal andstate income tax rate will be30 percent (37 percent for or-dinary income and 23 percentfor long-term capital gain). IfA invests the funds in a segre-gated account, A would have$169,000 saved for her child’seducation after 18 years. If Acontributes the funds to a QTP,the account would havegrown to $278,000 using thesame assumptions.

Prior to 2002, income becametaxable to the beneficiary upondistribution. In other words,QTP was treated much like anondeductible IRA. However, inthe wake ofEGTRRA, distri-butions forqualified highereducation ex-penses aregeneral ly notsubject to fed-eral incometaxation.23 Now,to the extent thed i s t r i b u t i o n swill be qualified, a QTP is morelike a ROTH: There is no deduc-tion for a contribution and theincome earned in the plan es-capes tax entirely.

“Qualified higher education ex-penses” may include expensesincurred while attending under-graduate, graduate, professional oreven vocational schools. The ex-pense must be related to aneligible educational institution andmust be made for tuition, fees,books, supplies and equipment.24

Expenses for special needs ser-vices qualify if a special needsbeneficiary is the student.25 Roomand board expenses are also quali-fied expenses if the beneficiarycarries a load of at least one-halffull-time. If the student is not in

school-owned housing, the roomand board expenses are limited bythe amount allowable for federalloan purposes.26 The withdrawalsfrom the plan must occur in thesame tax year in which the ex-penses were paid.

Nonqualified distributions aretaxed pursuant to the annuity rulesof Code Sec. 72.27 Each distribu-tion is treated as having twodistinct components: contribu-tions (principal) and earnings.28

The earnings portion of the ac-count is the total account valueless the contribution portion.29 Thetaxable portion of the distributionis the total distribution multipliedby the earnings ratio.30 To the ex-

tent earnings are distributed, theyare taxed at ordinary income rates,even though the earnings may beentirely attributable to gains,whether recognized or not, incapital assets, just as with an IRA.

In addition to inclusion in in-come, there is a 10-percentpenalty excise tax unless the fundsare (1) used for qualified educa-tion expenses for the designatedbeneficiary, (2) refunded on ac-count of the death or disability ofthe designated beneficiary, or (3)refunded due to and not exceed-ing a scholarship received by thebeneficiary.31

There is an interesting planningopportunity available for clientswho have a QTP with a loss. If theclient makes a complete liquida-

To the extent the proposed regulation isinterpreted by the IRS to cause inclusionfor the beneficiary where the assets are

not actually distributed to the beneficiaryor the beneficiary’s estate, the proposed

regulation should be invalid.

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tion of the account, he or she candeduct losses to the extent totaldistributions are less than unre-covered basis.32 However, thededuction is subject to the two-percent floor for miscellaneousdeductions. Further, the assetswould be back in the QTP owner’sestate for transfer tax purposes.

Approximately one-half of thestates provide an income tax de-duction for contributions to QTPs.Typically, the state requires that thetaxpayer be a resident and use thestate’s own QTP. For example, Illi-nois provides an unlimited incometax deduction. Other states providea limited income tax deduction.Many states, including New Yorkand Illinois, are examining recap-turing the income tax deduction iffunds are rolled over from thestate’s plan to another plan.

States vary regarding the taxa-tion of qualified distributions.But state income taxation, if lev-ied at all, is levied at the time ofdistribution. For this purpose, thestate of interest is not the statewhere the account owner residesor where the plan was set up, itis where the beneficiary resides.This is logical because to the ex-tent such distributions are taxed,they are included in thebeneficiary’s income. Of course,some states have no income tax.Other states have income taxsystems tied to the federal sys-tem. Because qualif ieddistributions from QTPs do notincrease federal adjusted grossincome, the distributions do notincrease gross income for statepurposes. However, at least onestate, Illinois, has enacted legis-lation causing even qualifieddistributions to be taxable, un-less the distributions come fromthat state’s own QTP. This com-plicates planning because it maybe difficult to predict where a

beneficiary might be living at thetime of distributions.

State taxation of nonqualifieddistributions should be taxable inaccordance with the calculationfor federal income tax purposes tothe extent the state is tied to thefederal system. Prior to EGTRRA,the state plans were required toimpose a penalty on mostnonqualified distributions. Whilefederal law no longer requires theplan to impose an additional pen-alty, neither does it prevent themfrom doing so.

Transfer Taxation

The account owner has nearlycomplete power over the account,including the power to revoke theaccount and change the benefi-ciary. Such powers wouldnormally result in the gift beingincomplete.33 However, due to aspecial override of the generalrule, contributions to a QTP aretreated as completed gifts from theaccount owner to the beneficiarythat qualify for the present inter-est annual exclusion of Code Sec.2503(b).34 The transfers alsoqualify for the GST annual exclu-sion.35 Further, the account ownercan elect36 to treat the contribu-tion as having been made ratablyover a five-year period beginningin the year the contribution wasactually made. Thus, the accountowner can make a contributionthis year and use future annualexclusions to cover it.37

It appears that contributions toQTPs do not qualify for the un-limited exclusion for payments fortuition paid directly to an educa-tional provider under Code Sec.2503(e). The plan is not the edu-cational provider itself, as requiredin the statute. Secondly, at least inthe case of ESAs, the plan assetsmay be used for expenses otherthan tuition.

Because the account owner mayrevoke the plan at any time, nor-mally the assets in the plan wouldbe included in his or her estate un-der Code Sec. 2038. However, aswith the gift tax, Code Sec. 529 over-rides the general rule and preventssuch assets from being included inthe account owner’s estate exceptunder one narrow exception.38 Tothe extent the account owner hadelected to treat a contribution ashaving been made ratably over afive-year period, there may be es-tate tax inclusion. However, onlythe contributions allocable to cal-endar years after the year of deathare included in the estate.39 Notenone of the growth on the contri-butions allocable to those years isincluded in the estate.

Code Sec. 529 only overridesthe basic estate taxation scheme toprevent inclusion in the estate ofan account owner. The statute doesnot cause inclusion where nonepreviously existed. Accordingly,the normal analysis should applyto determine if the account shouldbe included in the estate of thebeneficiary.40 Therefore, unless theassets in the plan are actually paidto the beneficiary during life or tothe beneficiary’s estate at death,there should be no inclusion.

However, according to the pro-posed regulations, “the gross estateof a designated beneficiary of a[QTP] includes the value of any in-terest in the [QTP].”41 The proposedregulations do not define abeneficiary’s interest. Presumably,the beneficiary only has a taxable“interest” if he or she would havetaxation under basic estate tax con-cepts. To the extent the proposedregulation is interpreted by the IRSto cause inclusion for the beneficiarywhere the assets are not actually dis-tributed to the beneficiary or thebeneficiary’s estate, the proposedregulation should be invalid.

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Asset ProtectionThe QTP must prohibit the planassets from being used as securityfor a loan.42 However, this doesnot necessarily preclude a credi-tor of the account owner fromattaching the assets. Some statesprovide statutory protection fromcreditors’ claims on QTPs. Forexample, the Maine statute spe-cifically excludes QTP assets fromexecution or levy by the creditorsof either the account owner orbeneficiary.43 Other states withprotection include Alaska, Colo-rado, Kentucky, Louisiana,Nebraska, Ohio, Pennsylvania,Tennessee, Virginia and Wiscon-sin. A QTP may have a spendthriftprovision that may be effective.

Other states have no statutoryprotection.44 In the absence ofstatutory protection and QTPspendthrift provisions, the assetswould be part of the bankruptcyestate and attachable by creditors.45

Financial Aid Planning

Financial aid is determined aftercompletion of the Free Applicationfor Federal Student Aid (FAFSA).Based on this FAFSA, the institu-tion determines the student’sexpected family contribution (EFC).The EFC includes 50 percent of thestudent’s income and 35 percentof the student’s assets. There aresome allowances for expenses.Some of the parents’ income and5.6 percent of the parents’ assets,excluding the family home, are in-cluded in the EFC. A QTP isconsidered an asset of the accountowner. This may be illustrated bythe following example.

Example 2. Student S is thebeneficiary of a QTP with abalance of $100,000. If S werethe account owner, $35,000of the QTP would be countedtowards the EFC. If S’s parent,

P, were the account owner,only $5,600 (5.6 percent of$100,000) would be includedin the EFC. If S’s grandparent,G, were the account owner,none of the funds would beconsidered part of the EFC.

Some state financial aid pro-grams, like Illinois, do not considerassets in that state’s own QTP ascountable assets, while they docount assets in other states’ pro-grams towards the EFC. This is afactor to consider when choosinga plan or planning for financial aid.Further, states vary regarding thetreatment of distributions as in-come of the beneficiary.

Medicaid Planning

It appears likely that a QTP wouldbe a countable asset of the ac-count owner for Medicaid/SSIpurposes. Because the accountowner has unbridled discretion totake a distribution from the ac-count, it is likely states wouldconsider it to be a countable as-set. Thus, while making agrandparent the owner of the QTPmay make an excellent financialaid strategy, it can backfire if Med-icaid issues are a concern.

Similarly, it appears unlikely thatthe QTP would be considered asan available asset for the desig-nated beneficiary. Note, it doesnot seem possible to completelyavoid this risk by naming a supple-mental needs trust (SNT) as thebeneficiary. While Code Sec. 529allows any “person” to be anowner, it only allows an “indi-vidual” to be the designatedbeneficiary.46

EGTRRA Sunset Uncertainty

EGTRRA sunsets after December31, 2010, and, after that date, theInternal Revenue Code is to beadministered as though EGTRRA

had never been passed. The fol-lowing are changes made byEGTRRA that affect QTPs: (1) theexemption of earnings from fed-eral income taxation; (2) theinclusion of cousins in the defini-tion of “member of the family”; (3)rollover of QTP to another planwithout changing beneficiary; (4)the inclusion of private institutionsas sponsors of QTPs; and (5) theelimination of the requirement ofstate-imposed penalties onnonqualified distributions.

On September 4, 2002, theHouse of Representatives rejectedlegislation that would have madepermanent EGTRRA’s provisionsregarding QTPs and other educa-tional incentives.47 In the unlikelyevent that EGTRRA is unchangedby December 31, 2010, it may beappropriate to make the maximumpossible qualified distributionsbefore that date. After that date, itappears that all of the earningswould be taxable, even though theearnings had accrued during aperiod in which distributionswould have been exempt.

Estate PlanningOpportunities:Changes andRolloverThe account owner can changethe beneficiary designation at anytime, again, subject to the termsof the particular program. Thismakes a QTP an extremely flex-ible vehicle for estate planning.

If the new beneficiary is a“member of the family” of the oldbeneficiary, there is no tax conse-quence to the change.48 A memberof the family includes:■ a son or daughter or a descen-

dant of either;■ a stepson or stepdaughter;

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■ a brother, sister, stepbrother orstepsister;

■ the father or mother, or anancestor of either;

■ a stepfather or stepmother;■ a cousin (new in EGTRRA);■ a son or daughter of a brother

or sister;■ a brother or sister of a father

or mother;■ a son-in-law, daughter-in-law,

father-in-law, mother-in-law,brother-in-law or sister-in-law;

■ the spouse of the designatedbeneficiary; or

■ the spouse of anyone de-scribed above.49

If the account owner changesthe beneficiary to someone whois not a member of the oldbeneficiary’s family, the changeconstitutes a nonqualified distri-bution to the account owner.50 This

nonqualified distribution willcause income taxation for the ac-count owner. The distribution alsowill be subject to the 10-percentpenalty unless the change wasprompted by the death, disabilityor scholarship receipt of the priorbeneficiary.

If the new beneficiary is one ormore generations below51 the oldbeneficiary, there is a gift tax eventeven if the new beneficiary is amember of the family of the oldbeneficiary.52 The proposed regu-lations indicate that the oldbeneficiary is the donor for gift taxpurposes. Similarly, a GST eventoccurs if the new beneficiary istwo or more generations belowthe old beneficiary. It is unclear

from the regulation who the trans-feror is if the new beneficiary isnot a member of the family of theold beneficiary.

This proposed regulation cancause some odd results as dem-onstrated by the followingexample.

Example 3. A sets up QTPs forher two children, B and C.Each plan starts with $50,000.B does not go to college andleads a life repugnant to A.Forty-five years after the con-tribution, when B is age 50,the balance of the account hasgrown to approximately $3.6million given a 10-percent an-nual return. A changes thebeneficiary of the QTP set upfor B, making the new benefi-ciary C’s child, D. Because D

is a generationbelow B, thetransfer is gifttaxable. Thus,B made a tax-able transfer of$3.6 millionresulting in theexhaustion of

B’s applicable exclusionamount and a gift tax of$1,275,000 under current law.To make matters worse, A wasnever required to notify B ofB’s original status as desig-nated beneficiary or thechange in designation trigger-ing the gift tax.

Clearly, a better result would befor the account owner to beconsidered the transferor underthese circumstances. However,that would require a change inthe proposed regulations.Meanwhile, this leaves the dooropen for significant planningopportunities as illustrated in thefollowing example.

Example 4. A has five chil-dren,53 B, C, D, E and F. Eachchild has a child of his or herown, B1, C1, D1, E1 and F1. Ais quite wealthy and wishes tobenefit his grandchildren. Ofcourse, A can set up a QTP foreach of the five grandchildren.Using five-year averaging andspousal gift-splitting, A cantransfer $11,000 x 5 (grandchil-dren QTPs) x 5 (five-yearaveraging election) x 2 (gift-splitting) using only annualexclusions, or a transfer of$440,000. Further, A can trans-fer an additional total of$440,000 into five QTPs foreach child using only annualexclusions.54

This example seems relativelystraightforward. However, A thencan change the designated ben-eficiary of each of the QTPs setup for the children to a grandchild.Because the child is the deemedtransferor, this will use the child’sannual exclusions to cover thedeemed transfer to the grandchild.If desired, this strategy could belimited to changing the benefi-ciary designation to grandchildrento whom the child did not intendto do other annual exclusion gift-ing. For example, it is unlikely thatthe children would be doing an-nual exclusion gifting to theirnephews and nieces. This seemsto achieve a multiplication of an-nual exclusion available to theclient without running afoul of thereciprocal trust doctrine.55

This strategy could be ex-tended further to set up QTPs forfamily members whom the cli-ent would not otherwise intendto benefit. For example, if theclient wanted to transfer assetsto a QTP for his or her child, theclient could set up accounts forthe child’s cousins, i.e., the

Trust ownership of a QTP has manyadvantages. The trust may contain a

spendthrift clause or special needs provisionsthat may protect the assets from creditors.

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client’s nephews and nieces.Later, the client could change thebeneficiary to his or her child.The change would be to a mem-ber of the original beneficiary’sfamily, a cousin, resulting in notriggering of income taxation.Further, the change would be tosomeone of the same generation,resulting in no gift taxation.

Upon death of the beneficiary, theaccount owner could make a dis-tribution to the beneficiary’s estateor to the account owner himself orherself. Such a distribution wouldbe nonqualified but would not besubject to the 10-percent penalty taxbecause it falls within the safe har-bor of the beneficiary’s death.56

Another option is to change thebeneficiary designation and leavethe funds in the account. As withother changes in beneficiary desig-nation, the new beneficiary must bea “member of the family” of the oldbeneficiary to avoid income taxa-tion. Further, if the new beneficiaryis one or more generations belowthe old beneficiary, there may be agift and/or GST tax.

Prior to EGTRRA, the accountowner could not roll over fromone state to another withoutchanging the beneficiary or itwould be treated as a nonqualifieddistribution. Post-EGTRRA, an ac-count can be rolled over from oneplan to another withoutnonqualified distribution treat-ment once in each 12 months perbeneficiary. Again, this is a perbeneficiary rule. This is illustratedby the following example.

Example 5. C is the benefi-ciary of two QTPs. One planwas set up by A and the otherby B. If B chooses to roll hisQTP, A cannot do so within 12months or face the conse-quences of a nonqualifieddistribution.

However, a rollover can beachieved at any time as part of achange of beneficiary. In otherwords, if A in the above examplewanted to roll over the QTP for Cfrom Plan X to Plan Y, she couldchange the beneficiary designa-tion for the plan from C to C’scousin, D, and contemporane-ously roll the plan to Plan Y.Because D is a member of thefamily of C and is not of a youngergeneration, there should be noincome, gift or GST tax conse-quences. Subsequently, A coulddo another beneficiary changefrom D back to C. Thus, Aachieves the rollover while avoid-ing the nonqualified distributionconsequences.

Changing the account ownerraises different issues than chang-ing the designated beneficiary. Theaccount owner is the person whocan authorize distributions,change the designated beneficiaryand make distributions to himselfor herself (or itself).57 Thus, theidentity of the account owner canbe quite important. During theaccount owner’s lifetime, mostprograms do not allow a changein the identity of the owner. Someplans allow the owner to designatea successor owner to manage theaccount during periods of theoriginal account owner’s incapac-ity.58 If the plan does notspecifically allow the designationof a successor owner, it may bewise to consider naming a trust asthe owner. Alternatively, the ac-count owner’s agent under apower of attorney may be givenauthority to manage the account.

The transfer tax consequences ofa lifetime change of ownership areunclear. It appears that such atransfer should be gift and GSTtaxable.59 However, if the accountowner already made a completedgift of the assets, as provided in

Code Sec. 529(c)(2), how can heor she make another gift of thesame assets? Further, it is not clearif a contribution by someone otherthan the account owner is a tax-able gift to the account owner.Again, this is not addressed by thestatute or the regulations.

It is not clear what happens ifthe account owner takes a with-drawal of funds contributed bysomeone else. Code Sec. 529(c)(5)provides that, except as specifi-cally provided in Code Sec. 529,distributions shall not be consid-ered to be taxable gifts. Thus, itappears that such a withdrawalwould not be taxable.

Trust Ownershipof the QTPCode Sec. 529 allows any “per-son” to establish a QTP andbecome the account owner. Un-der the Internal Revenue Code, a“person” includes not only indi-viduals, but also trusts and otherentities.60 Some QTPs allownonindividuals, such as a trust, toestablish plans.

In deciding whether to invest ina QTP, the trustee would be boundby the terms of the trust and theapplicable investment standard.The trustee should consider (1) thegoals of the trust, (2) the applicableinvestment standard (prudent per-son/prudent investor), (3) theinvestment choices inside theplan, (4) the costs of the plan, (5)the benefits of tax deferral, and (6)the possibility of taxation and pen-alty for nonqualified distributions.

Trust ownership of a QTP hasmany advantages. The trust maycontain a spendthrift clause orspecial needs provisions that mayprotect the assets from creditors.The account owner is a fiduciaryand cannot just withdraw the

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funds for his or her own purposes.The assets must still be used forthe beneficiaries of the trust,whether the distributions comefrom the plan or from the trust it-self. With a trust, it is simple tohave an enforceable way of hav-ing the funds be available for theeducation of multiple beneficia-ries. With multiple QTPs outsidea trust, there is nothing to keep theaccount owner from withdrawingthe assets, especially if the origi-nal beneficiary has died orotherwise has no need for thefunds. If the funds are removedfrom the plan via a nonqualifieddistribution, the funds would beback in the donor’s estate if thedonor is an individual. With anirrevocable trust as the accountowner, the funds remain outsidethe scope of the transfer tax.

Trust ownership may also haveseveral disadvantages. Code Sec.529 would not override the normalgift tax rules for the transfer into thetrust. If the individual were to makea direct contribution, it wouldqualify for the five-year election,while a contribution through anirrevocable trust would not. If theirrevocable trust did not haveCrummey61 powers, there wouldbe no present interest and no an-nual exclusions available. If therewere nonqualified distributions tobe taxed to the account owner, thetrust would be the taxpayer. Ofcourse, the standard income taxrules for trusts would apply.62 Dis-tributions to a nongrantor trustmight be taxed at a higher marginalrate (for example, if taxed to thetrust) or at a lower marginal rate(for example, if taxed to a low-in-come beneficiary) than thegrantor’s marginal rate.

In addition to the foregoing ad-vantages and disadvantages, usinga trust as the plan owner intro-duces additional uncertainties.

There is a very slight possibilitythat the estate tax exclusion ofCode Sec. 529(c)(4)(A) does notoverride the inclusion of assets ina taxpayer’s estate by reason ofCode Secs. 2036–2038. Essen-tially, Code Sec. 529 provides thatan interest in a QTP will not beincluded in the estate of any indi-vidual, except perhaps thebeneficiary. However, it is notcompletely clear that this requiresthe IRS to exclude that the valueof the QTP from the value of atrust, which is included underCode Secs. 2036–2038. Further, itis unclear what happens if the trusthas an inclusion ratio of greaterthan zero and the beneficiary ofthe plan is a skip person. It appearsthat there should not be a GSTevent, but that is not certain.63 Fi-nally, the interaction betweensubchapter J and Code Sec. 529is unclear. For example, it is un-clear whether a distribution ofDNI occurs upon contribution bythe trust to the QTP or upon dis-tribution from the plan to thebeneficiary.

Choosing a PlanCode Sec. 529 has no requirementof any nexus between the accountowner or designated beneficiaryand the state sponsoring the plan.This lack of a nexus requirementis important because of the differ-ences in plans and applicable lawsin the various jurisdictions. Moststates allow anyone to establish anaccount, regardless of residency.A few states only allow residentsto be the account owners or ben-eficiaries. Similarly, while there isno restriction in Code Sec. 529 it-self, a few plans require thebeneficiary to be under age 18upon account establishment.

In addition to state law and planstructure differences, plans vary

considerably in how they operatefrom a financial perspective. Feesvary from program to program.Some plans charge an asset-basedannual fee to cover program ex-penses. In most plans, there is anasset-based annual fee for the in-vestment services, similar to thatof a mutual fund. In some plans,there is an asset-based wrap feethat includes both the investmentand program expense compo-nents. Some programs charge feesto open an account or change abeneficiary or other administrativeservices.

Some states have more than oneprogram and the fee structure andoptions may vary between pro-grams in the same state. Forexample, a state may have a di-rect investment program offereddirectly and a different programsold only through a broker or fi-nancial planner. Of course, thestate pays the broker or financialplanner a commission. This pro-gram typically would have ahigher annual fee, a load or someother way to make up the com-mission paid. Similarly, theprogram marketed through thebroker or financial planner mayhave more flexibility or be other-wise more desirable in order tojustify the additional fees.

Comparing QTPsand OtherStrategiesThere are several main strategiesthat should be considered whenanalyzing the benefits of QTPs.These include:■ client retention of the funds,■ custodial UTMA/UGMA (Uni-

form Transfer to Minors Act/Uniform Gift to Minors Act)account (or outright gifts to anadult child),

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Estate Planning/August–September 2003

■ FLP/LLC planning,■ Code Sec. 2503(c) trust,■ Crummey trust, and■ Code Sec. 2503(e) transfers.

The following is a comparisonof the significant advantages anddisadvantages of the QTP vis-à-visthese competitors on issues ofimportance.

Client Control of Assets

A QTP allows the client to retaincomplete control of the funds. Asaccount owner, the client canchange the beneficiary designa-tion and can even use the assetsfor himself or herself. However,there may be a 10-percent pen-alty for nonqualified distributions.Client retention and Code Sec.2503(e) gifting also would allowthe client to retain control of thefunds. An UTMA/UGMA accountwould leave the client in controlonly if the client were custodian,resulting in estate tax inclusion.The trustee, not the client, wouldhave control over the funds in thetrusts. While UTMA/trust fiducia-ries may be realistically, thoughnot legally, controlled by the cli-ent, the assets may only be usedfor the purposes designated. Theclient could retain control overasset management with the FLP/LLC strategy by retaining the gen-eral partnership interest. However,the client would not be able toaccess all of the underlying value.

Investment Flexibility

A QTP account is limited to the of-ferings of the plan and only cashmay be contributed. All of the otherstrategies allow nearly completeinvestment control, subject only tofiduciary investment guidelines un-der state law. To the extent the clientor fiduciary could achieve a greaterreturn with investment flexibility, taxsavings would be offset to the ex-tent of the reduced return.64

Beneficiary’s Control of AssetsThe designated beneficiary has norights in the QTP, even if he or sheis incurring qualifying educationexpenses. A custodial account anda Code Sec. 2503(c) trust give thebeneficiary control over the assetsat age 18 or 21. The beneficiarywould have no right to demand adistribution from a completely dis-cretionary Crummey trust. Alimited partnership interest leavesthe beneficiary little control. TheFLP/LLC interest can be gifted toa discretionary trust to further limitcontrol.

Client’s Flexibility to Change

A QTP owner can change the ben-eficiary at any time. Such a changewould incur no penalty if it wereto a member of the priorbeneficiary’s family. The client caneven take a complete distributionto himself or herself. The custodialaccount is fixed. The FLP interest,once gifted, cannot be recalled.However, the FLP interest couldbe gifted in trust. This trust or aCrummey trust can give broad dis-cretion to the trustee or a specialco-trustee or trust protector to al-low change. However, the clientwould have to rely on others tomake the desired changes.

Income Taxation

Approximately one-half the statesprovide an income tax deductionfor a QTP contribution. None ofthe other strategies provide this.The QTP earnings grow tax-de-ferred. If distributions are made forqualifying expenses, the earningsare never taxed. With client reten-tion and Code Sec. 2503(e),income is taxed currently to theclient. With the trusts, income iseither taxed to the client/grantor,the trust or the beneficiary, de-pending upon the trust’s grantorstatus and the availability of DNI.

With the custodial account, theincome is taxed to the child,though at the parent’s rate if thechild is under age 14.

Gift Taxation

A QTP contribution qualifies fora present interest annual exclu-sion. However, unlike otherstrategies, the client can make agift of five annual exclusions upfront by electing averaging. Thetrusts and custodial accountwould qualify for the annual ex-clusion. The gift of the FLP/LLCinterest may not qualify for theannual exclusion, dependingupon the restrictions in the docu-ment.65 Code Sec. 2503(e)transfers qualify for an unlimitedgift tax exclusion. Note a QTPcould be used in conjunction withCode Sec. 2503(e) gifting. Whencollege years near, a client withsufficient other assets could doCode Sec. 2503(e) gifting for thetuition from other resources whileusing the QTP assets for all othereducational expenses. Finally, ju-dicious use of changes inbeneficiary designation can reapadditional annual exclusions.

Estate Taxation

A QTP is not included in the es-tate of the owner. Retained fundsand Code Sec. 2503(e) strategies(prior to gifting) would be in-cluded under Code Sec. 2033. Thecustodial accounts and trustswould not be included in thegrantor’s estate if structured prop-erly. The FLP/LLC would not beincluded unless structured poorlyand vulnerable to the IRS’s in-creasingly successful argumentsunder Code Sec. 2036.66

GST Taxation

A contribution to a QTP is apresent gift that qualifies for theGST annual exclusion. A change

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Editor’s ChoiceEditor’s Choice

in beneficiary would only resultin GST issues if the new benefi-ciary is two or more generationsbelow the original beneficiary andit exceeds any available annualexclusion. Code Sec. 2503(e)transfers are exempt from GST tax.Gifts of FLP/LLC interests wouldqualify for the GST annual exclu-sion to the extent they qualifiedfor the gift tax annual exclusion.Transfers in a Crummey trustwould not qualify for the GST an-nual exclusion and would requireallocation of GST exemption tomaintain a zero inclusion ratio forthe trust. Transfers to a Code Sec.2503(c) trust or custodial accountqualify for the GST annual exclu-sion. Finally, as with gift tax annual

exclusions, judicious use ofchanges in beneficiary can reapadditional GST annual exclusions.

Creditor Protection

The QTP is protected from the ac-count owner’s creditors in somestates. The QTP is protected fromthe beneficiary’s creditors. Assetsretained by the client are subjectto the client’s creditors. Assets in acustodial account are subject to thechild’s creditors but not thecustodian’s creditors. Assets in anFLP/LLC are not subject to theparent’s creditors and are only sub-ject to the child’s creditors to theextent of an assignee interest in theentity. Assets in the trusts are pro-tected from the parent’s creditors.

The trust assets may be subject tothe beneficiary’s creditors if fornecessaries or child support, de-pending on the jurisdiction.

ConclusionEach client has his or her ownpersonal, financial and estateplanning goals. QTPs can be avery powerful vehicle to help theclient achieve those goals. AQTP can allow the client to re-tain control while still achievingincome and transfer tax savings.While QTPs are not for everyclient or every situation, theyoffer unique opportunities toconsider in light of your clients’circumstances and goals.

ENDNOTES

1 LTR 8825027 (Mar. 29, 1988). The issueswere (1) whether the beneficiary child re-ceived income to the extent the services re-ceived exceeded the deposits, (2) whetherthe income generated by the plan during theperiod of administration was taxable to theMichigan Education Trust, and (3) whetherthe parents had made a completed gift ex-cludable under Code Sec. 2503(e)(2)(A). TheIRS ruled that (1) the child would recognizeincome to the extent services exceeded de-posits, (2) the Michigan Education Trustwould be taxable on the income during ad-ministration, and (3) a deposit in the funddid not qualify under Code Sec.2503(e)(2)(A) because the payment was notmade directly to an educational institution.

2 State of Michigan, CA-6, 94-2 USTC ¶50,583,40 F3d 817.

3 Act Sec. 1806(a) of the Small Business JobProtection Act of 1996 (P.L. 104-188).

4 Act Sec. 211 of the Taxpayer Relief Act of1997 (P.L. 105-34).

5 Act Sec. 402 of the Economic Growth andTax Relief Reconciliation Act of 2001 (P.L.107-16).

6 Code Sec. 529(a).7 Code Secs. 529(a) and 511.8 Code Secs. 2503(b) and 529(c)(2).9 Code Sec. 529(c)(2)(B), (4)(C).10 To qualify as a state-sponsored program, it

may be set up by a state or its instrumental-ity. Code Sec. 529(b)(1). Prior to EGTRRA,this was the only possibility. A plan quali-fies as “established” by the state if it is initi-ated by statute or regulation or by an act bya state official or agency. Proposed Reg.§1.529-2(b)(1). A plan qualifies as “main-tained” by the state if the state (1) sets all the

terms of the plan, including who can con-tribute, the benefits, who can be a benefi-ciary, etc., and (2) the state is actively in-volved with ongoing administration. Pro-posed Reg. §1.529-2(b)(2)(i) and (ii). The“active involvement” of the state is deter-mined by whether the state provides servicesto account holders in excess of those pro-vided to others, whether the state sets andenforces the rules for the program, etc. Pro-posed Reg. §1.529-2(b)(3).

11 Code Sec. 529(b)(1).12 Proposed Reg. §1.529-1(c).13 In addition to a state, after EGTRRA, one or

more eligible educational institutions alsomay qualify to sponsor a QTP. Unless other-wise provided in future regulations, a pro-gram sponsored by such institutions will notqualify unless (1) amounts are held in aqualified trust created in the United Statesand meet the requirements of Code Sec.408(a)(2) and (5), and (2) the program hasreceived a ruling from the IRS that it meetsthe requirements of Code Sec. 529. A con-sortium of approximately 300 private insti-tutions, including many Ivy League and otherhighly respected schools, already has re-ceived approval for its plan. The consortiumestablished an LLC having the schools as themembers. It plans to offer a prepaid tuitionprogram with tuition credits worth variousfractional tuition credits at various partici-pating schools.

14 Code Sec. 529(b)(1)(A).15 The contribution may be by cash itself,

check, money order or credit card. ProposedReg. §1.529-2(d). The contribution may bemade by electronic funds transfer or auto-matic payroll withdrawal.

16 Code Sec. 529(b)(4).17 Proposed Reg. §1.529-2(g).18 Notice 2001-55, 2001-2 CB 299.19 Code Sec. 529(c)(3)(C)(i), (iii).20 Code Sec. 529(b)(5).21 Code Sec. 529(b)(6).22 The proposed regulations provide a quasi

safe harbor: “the amount determined byactuarial estimates that is necessary to paythe [qualified higher education expenses]of the designated beneficiary for five yearsof undergraduate enrollment at the highestcost institution allowed by the program.”Proposed Reg. §1.529-2(i)(2). In order toavoid the quagmire of calculation uncer-tainties, plans avoid the actuarial test anduse set limits.

23 Note, if the plan sponsor is an eligible edu-cational institution rather than a state, evena qualified distribution is included in incomeif made prior to January 1, 2004. Qualifieddistributions in 2004 and thereafter are ex-cluded from income regardless of the typeof program sponsor.

24 Code Sec. 529(e)(3)(A)(i); Proposed Reg.§1.529-1(c).

25 Code Sec. 529(e)(3)(A)(ii).26 Code Sec. 520(e)(3)(B); 20 USC §1087.27 Code Sec. 529(c)(3)(A).28 Code Sec. 72(e)(2)(B) and (e)(9).29 Proposed Reg. §1.529-3(b).30 The proposed regulations had required this

ratio to be established at the end of the pre-ceding calendar year. However, pursuant toNotice 2001-81, 2001-2 CB 617, the earn-ings ratio now fluctuates and is calculatedanew with each distribution. Further, QTPaccounts are aggregated in order todetermine the earnings ratio only if the plans

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Estate Planning/August–September 2003

have (1) the same beneficiary, and (2) thesame account owner.

31 Code Sec. 529(c)(6). Due to apparent over-sight, attendance at a U.S. military academydoes not fit within the definition of a schol-arship. Corrective legislation is pending.H.R. 1307, 108th Cong., 1st Sess. (2003).

32 IRS Pub. 970, at 41 (2002). The client takesthe deduction on line 22 of Schedule A,Form 1040.

33 Reg. §25.2511-2; Burnet v. Guggenheim,SCt, 3 USTC ¶1043, 288 US 280, 53 SCt 369(1933).

34 Code Sec. 529(c)(2)(A)(i); Proposed Reg.§1.529-5(b)(1).

35 Code Sec. 2642(c)(1); Proposed Reg. §1.529-5(b)(1).

36 The election is made on the gift tax return,Form 709. See Form 709, Schedule A, Ques-tion B. You must attach an explanation with(1) the total amount contributed per benefi-ciary, (2) the amount for which the electionis being made, and (3) the name of the indi-vidual for whom the contribution was made.If the taxpayer and his or her spouse elect tosplit gifts, the spouse must also make thesame five-year election on his or her gift taxreturn. Proposed Reg. §1.529-5(b)(2).

37 In complex fact patterns, application of thefive-year averaging election becomes moredifficult. If you make a contribution of $30,000in year one and elect five-year treatment, it isnot clear whether you have made a contribu-tion of $6,000 in each of five years or a contri-bution of $11,000 in year one and then spreadout the remaining $19,000 over the remain-ing four years. It is not clear whether a donorwho has used his or her annual exclusion forthe year of contribution would divide the con-tribution over five years or the four future yearsfor which annual exclusions remain available.Finally, it is not clear if whether you can makeoverlapping five-year elections.

38 Proposed Reg. §1.529-5(d) adds an odd twistto the estate taxation analysis. It provides thatthe value of a QTP is excluded from the grossestate of the decedent to the extent of anyinterest in the plan “which is attributable tocontributions made by the decedent.” Thiscould cause some inclusion if the decedentwere the account owner of a plan receivingcontributions from other donors. However,it appears this regulation is in conflict withCode Sec. 529(c)(4)(A) which clearly states:

“No amount shall be includible in the grossestate of any individual for purposes of chap-ter 11 by reason of an interest in a qualifiedtuition program.” The only exception in thestatute is when the five-year election is inplace.

39 Code Sec. 529(c)(4)(C); Proposed Reg.§1.529-5(d)(2).

40 The beneficiary does not own the account,which would cause inclusion under CodeSec. 2033. Nor does the beneficiary haveany power that would rise to the level of ageneral power of appointment under CodeSec. 2042. Because the beneficiary neverowned the assets, Code Secs. 2036, 2037and 2038 should be inapplicable.

41 Proposed Reg. §1.529-5(d)(3).42 Code Sec. 529(b)(6).43 Me. Rev. Stat. Ann. tit. 20-A, §11478(1).44 For example, a Nevada Attorney General

Opinion indicates that a plan would be sub-ject to creditors in that state absent statutoryprovisions to the contrary.

45 11 USC §541(c)(2), In re Darby, 212 BR 382(Bankr. M.D. Ala. 1997) (holding prepaidtuition plan is included in the bankruptcyestate).

46 Code Sec. 529(e)(1). However, the IRS mightlook through the SNT to the individual,much like it does in the case of a charitableremainder trust (CRT).

47 H.R. 5203, 107th Cong., 2d Sess. (2002).48 Code Sec. 529(c)(3)(C)(ii); Proposed Reg.

§1.529-5(b)(3)(i).49 Code Sec. 529(e)(2); Proposed Reg.

§1.529-1(c).50 Proposed Reg. §1.529-3(c)(1).51 The proposed regulations appear to indicate that

a new beneficiary of a different generation maytrigger a gift event, even if the new generationis higher. It provides that there is no taxable trans-fer “if the new beneficiary is a member of thefamily of the old beneficiary … and is assignedto the same generation as the old beneficiary.”Proposed Reg. §1.529-5(b)(3)(i). While this istechnically correct, it appears to indicate a trans-fer to a new beneficiary is not a transfer tax eventonly when they are in the same generation. Thestatute clearly states that a gift tax is triggeredonly if the new beneficiary is in a lower gen-eration. To the extent the proposed regulationwould make a transfer to a higher generation atransfer tax event, it would contradict the stat-ute and, therefore, should be invalid.

52 Code Sec. 529(c)(5)(B); Proposed Reg.§1.529-5(b)(3)(ii).

53 Note, a familial relationship between theaccount owner and beneficiary is irrelevant.It is the relationship between the old ben-eficiary and the new beneficiary that mustbe considered.

54 A can transfer $11,000 x 5 (children QTPs)x 5 (five-year averaging election) x 2 (gift-splitting). Each of five QTPs for each childwould be funded with $22,000.

55 See J.P. Grace Est., SCt, 69-1 USTC ¶12,609,395 US 316, 89 SCt 1730.

56 Code Sec. 529(b)(3)(B).57 Proposed Reg. §1.529-1(c).58 A QTP has specific provisions regarding how

the owner should designate an owner to takeover upon his or her death. Typically, theplan has a form for the designation of thecontingent owner, similar to an IRA or lifeinsurance beneficiary designation. However,the designation may have to take place inthe account owner’s will. In the absence ofthe appropriate designation, the plan shouldprovide a default designation.

59 The account owner has a power to vest theassets in himself or herself. Thus, the ownerhas a general power of appointment overthe assets. A change of ownership would bea release of a general power of appointmentresulting in gift taxation. Code Sec. 2514(b).

60 Code Sec. 7701(a)(1) provides: “The term‘person’ shall be construed to mean and in-clude an individual, a trust, estate, partner-ship, association, company or corporation.”

61 See D.C. Crummey, CA-9, 68-2 USTC

¶12,541, 397 F2d 82.62 See generally Internal Revenue Code, sub-

chapter J. If the trust were a grantor trust,the income would be taxed directly to thegrantor. Code Secs. 671–677. If the trustwere a nongrantor trust, the income wouldbe taxed either to the beneficiaries of thetrust or to the trust itself. Code Secs. 661and 662.

63 Using a subtrust to hold a QTP would avoidthis issue.

64 This would significantly alter the result inExample 1.

65 See C.M. Hackl, 118 TC 279, Dec. 54,686(2002); cf. LTR 9751003 (Aug. 28, 1997);but see LTR 9131006 (Apr. 30, 1991).

66 See, e.g., C.E. Reichardt Est., 114 TC 144,Dec. 53,774 (2000).

ENDNOTES

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