529 plan distribution and support test

[Taxfun]

80% of the college tuition was paid from the 529 plan distributions. Is the distribution from 529 plan considered as a parent support or student support? Form 1099-Q and Form 1098-T are all issued under the student's name. Is any one aware of any new development in this issue?  If the distribution is considered as a student support, the student paid more than half supports , so his parents cannot claim him as a dependent. He also had some earned and unearned income and will be subject to kiddie tax.

Thanks!

[itonewbie · Accepted solution]

I suppose there are different opinions out there.  I am in the camp that this is the student's own support.

Why do I say that?  If I look at §529(c)(2), this is what it says (emphasis added):

529(c)(2)Gift tax treatment of contributions.—

For purposes of chapters 12 and 13 -

529(c)(2)(A)In general.—

Any contribution to a qualified tuition program on behalf of any designated beneficiary -

529(c)(2)(A)(i) shall be treated as a completed gift to such beneficiary which is not a future interest in property, and

529(c)(2)(A)(ii) shall not be treated as a qualified transfer under section 2503(e).

If these contributions are a complete gift, it is no longer the contributors' money.

Some argue that since these accounts are usually owned by the contributor and the contributor is permitted to change the designated beneficiary for such accounts, ultimate disbursements from these accounts should constitute support.  To me, §529(c)(2) seals the fate.  I may have missed it but I don't think I've seen anyone putting forward the technical basis for the alternative position.

[rbynaker]

I think it's unsettled law, although I'd be curious to know if anyone has a court case on point.

From an old JoA article:

https://www.journalofaccountancy.com/issues/2012/mar/20114558.html

"The IRS has not given guidance on how distributions from Sec. 529 plans affect the support tests. These distributions can be substantial. If the distribution is counted as support provided by the beneficiary (child), it could prevent the child from qualifying as a dependent. Sec. 529 plans allow the owner (usually a parent or grandparent) to change the beneficiary. This provides some support for the argument that Sec. 529 plan distributions should count as support from the account owner and not count as support provided by the child, but tax practitioners are still waiting for a definitive answer from the IRS."

I'd venture a guess to say the answer is muddied in state law (since the majority of 529 plans are state run plans).  I'm also thinking the answer may lie in how the money flows.  An account owner can take a distribution from the plan, then use those funds to pay the tuition of their child.  Or an account owner can direct the plan to pay the school directly.  Oddly enough the same end result (school gets paid) results in opposing positions in 1099-Q reporting.  For the former, the 1099-Q is issued in the parent's (owner's) name.  For the latter, the 1099-Q is issued to the student.

As a thought experiment this may be something of a Schrodinger's Cat problem.  The funds are both owner's and beneficiary's until the act of making a distribution determines their fate.

Rick

[itonewbie]

For the sake of discussion though, whether the distribution goes directly from the account to the school or flows through the owner who would then pay for the designated beneficiary's qualified expenses is merely a form factor.  The substance remains the same and the latter still operates within the confines of §529(c)(3), which does not provide for a different gift or estate tax treatment.

In fact, when §529 was first enacted as part of Small Business Job Protection Act of 1996, contributions to the program were treated as incomplete gift until distribution.  Similarly, such contribution were to be included in the contributor's estate.  These were subsequently amended and the current section reflects a completely different view of how the contributions and assets in such account are treated for gift and estate tax purposes.

IMHO, it would be difficult to argue that one can bifurcate on the treatment of these contributions being a complete gift while taking advantage of the tax-free treatment of the plan's earnings and distribution.

Outside the tax realm, for purposes of FAFSA, however, I can see that 529 is treated differently.  But given how the tax treatments are codified and in light of the legislative history, I am not so sure that is a tenable position.

[Taxfun]

thank you very much for your input. If the parent doesn't claim the child as a dependent, the child will file the tax return on his own. In that case, the child will be still subject to kiddie tax if his unearned income is over the threshold?

[Taxfun]

Thank you for your input especially for the state part!

[rbynaker]

I'm not sure we can apply legislative history beyond what was actually written by the legislature.  Congress certainly has the authority and ability to write tax law that specifies how 529 plan assets and distributions should be considered for the purposes of determining support.  They did not do so.  What they did was to carve out how contributions and assets are to be treated FOR GIFT TAX PURPOSES in Chapter 12 of the IRC (and GST purposes in Chapter 13), as codified in 529(c)(2).  Again, they had the opportunity to specify how the law operates for other purposes (such as section 152) but they did not do so.  The IRS has the ability to issue regulations in this area, the closest we might have are some ideas regarding gift taxation issues presented in an Advance Notice of Proposed Rulemaking (that do not specifically address this situation but do help to clear up some other open items):

https://www.govinfo.gov/content/pkg/FR-2008-01-18/pdf/E8-859.pdf

To the best of my knowledge, the proposed rulemaking never actually happened, we're just left with "here's what someone at the IRS was thinking about back in 2008."

To be clear, I'm not arguing for one side or the other, my argument is simply that we don't know.  Personally I think there exists a reasonable basis for whichever position you want to take here so I would opt for the position that benefits the taxpayer the most.

[itonewbie]

I don't have a definitive answer either - this discussion is purely academic.  What is evident is that this is not high on the Congress' or IRS' agenda.  The Congress and IRS both had ample opportunities but both failed to provide clarity on the subject matter.

If it is determined that there is a reasonable basis for taking a position, it will generally also mean a F.8275 disclosure would be necessary (although I recall reading somewhere that a more aggressive position to not disclose may be taken where there is simple no legislative guidance at all but I am not certain if this is one of those cases).

I would, however, be cautious, IMHO, in adopting different positions on different taxpayer's returns (or even the same taxpayer's return in different years).

[TC12]

Here are my thoughts for what it’s worth.  Let’s take an example in which my daughter is a sophomore in college in 2020.  She doesn’t work and has very little savings (less than $1k).  Assume we use 529 distributions to pay $40k for 100% of her college (tuition, room and board, books, etc).  The question is whether she is our dependent.  Below are the reasons I believe the answer should be “yes” regardless of whether the distribution is paid to her, directly to the college or me (as the account owner).

1. In a very real sense, she is entirely dependent on me (within the non-tax meaning of the word).  If I don’t provide the funds for her to go to college (either by paying for it myself or directing the 529 admin to make distributions) she would not be able to attend college.  Her “dependency” is not based on whether the distribution is made to her or whether it’s made to me.  In all events, she is dependent on me (again, within the non-tax meaning of that word) to cause the 529 account to make a distribution.
2. The gift tax consequences of a contribution should not be dispositive.  First, I’ve seen nothing to lead me to believe Congress meant to change the income tax consequences of a contribution by treating the contribution as a completed gift for gift tax purposes.  Second, it’s hard to square the idea that the beneficiary of the 529 account is the “income tax owner” of the account at the time of contribution when (A) the income tax consequences of any earnings won’t be known until a payee of a distribution is designated by the account owner and (B) the account owner can change the designated beneficiary at any time (including by naming himself beneficiary) and (C) the account owner can distribute the money to himself at any time.  
3. There are many circumstances in income tax law in which the state law owner of property isn’t the income tax owner of the property because another person bears the economic upside and downside of the property or another person has such control of the property that such person should be treated as the income tax owner even though he/she doesn’t have legal ownership (examples include deep in-the-money options and revocable trusts).  In the case of a 529 account, it seems the account owner has BOTH legal title and control and can capture all of the upside (by naming himself beneficiary or distributing funds to himself). Thus, it doesn’t seem appropriate to look at gift tax consequences for determining income tax consequences (e.g., dependency). 
4. Treas. Reg. section 1.152 likely wasn’t intended to cover the income (or excluded income) from a section 529 account distribution.  Even if this regulation has some bearing on the current dependency issue, however, it would seem the regulation only applies to treat the earnings (1099-Q Box 2) as excluded income (and therefore beneficiary self-support) and the portion of the distribution that is tax basis (1099-Q Box 3) would not seem governed by the regulation because tax basis isn’t excluded from income (because return of tax basis isn't income in the first place).  
5. If I didn’t have a 529 account and I deposited $40k into my daughter’s bank account to pay her college invoices, that would seem to be parent support even though the money arguably becomes her money until she actually pays the invoices.  If I instead direct the 529 account to make a distribution to my daughter and she then pays the invoices, is the substance any different?
6. Assume I paid the $40k invoices out of my own funds and then made a distribution from the 529 account on December 31, should the dependency question really hinge on whether I make the distribution to myself or I make the distribution to my daughter and my daughter then gives the money back to me?
7. Consider the 2020 tax year in which non-dependents might be entitled to a Recovery Rebate Credit (because he/she didn’t get a stimulus check because he/she was a dependent in 2019).  The Recovery Rebate Credit is $1,200 and potentially another $600 (or more) if currently proposed legislation is signed by Trump.  In my example, should my daughter really get the Recovery Rebate Credit?  Although I might the lose the AOTC and the credit for other dependents, this Recovery Rebate Credit is more than the sum of (A) the refundable portion of the AOTC and (B) the non-refundable credit for other dependents.  Since we can't use all of our nonrefundable credits, we would be better off if she wasn’t a dependent (but that seems like the wrong answer).

In conclusion, I'm struggling to think of a single fact set in which a person was treated as the income tax owner of property where someone else (1) had legal ownership of the property; (2) had total control over the property; and (3) could capture all of the economic upside of the property (and suffered the economic downside of the property).  Thus, it makes more sense to me to treat the account owner as providing support to the student regardless of how the cash distributions flow.

[clobber88]

Your post was really good. Just a couple of observations that are not nearly as eloquent as what you wrote:

1) You are trying to mix logic into law and guidance.  Much of the tax code has no logic. Hence we have things like AMT, tax cliffs, etc.

2) Regarding your  #5. What is the point of a "completed gift" then? Even if it is only a paper trail, there has to be a difference in gifting a child $15k and them using it for tuition vs. you paying the $15k to the institution.

[TC12]

Agree that the tax code often isn't logical.

In respect of #5, it's my belief that the gift tax consequences are a red herring.  I don't believe Congress meant to change the income tax consequences by specifying the gift tax consequences. 

I don't see any difference (for income tax purposes) between (A) giving the money to my daughter and her paying her tuition or (B) me paying the tuition directly.  In both cases the money came from me and was used to pay the tuition.  I'm retired and too lazy to back this up with a citation.  Maybe look at the step-transaction doctrine as a start.  In both cases, the "end result" is that the money originates with me and ends up at the university.  The intervening step of giving it to my daughter doesn't seem to have any substance.       

[clobber88]

I do agree with you, logically. Your examples make sense.

But - for example, what about something like the backdoor Roth IRA? In this case it does matter the path of the contribution Money->Roth (no), Money->tIRA->Roth (yes).

[TC12]

With the back door roth, the intervening step (contribution to a traditional IRA) arguably has independent substance because the money was totally unrestricted before the contribution but becomes subject to the rules for IRAs when contributed.  At least that is how I would distinguish between the two fact sets.

[TC12]

I received a lot of questions on this topic so I gave it some additional thought.  I think the question can be narrowed to the following: When (if ever) did the beneficiary become the "income tax owner" of the funds in the 529 account?

It seems there can only be two answers: (1) at the time of contribution or (2) at the time of distribution.

Is the beneficiary the tax owner of the funds at the time of contribution? While section 529 treats a contribution as a completed gift, section 529(c)(2) applies for "gift tax purposes." If Congress intended for the beneficiary to be treated as the income tax owner at contribution, it would have been easy to modify section 529(c)(2) to say as much. Moreover, general principals of income tax law would not treat someone as the income tax owner of property where the person (1) did not have legal title to the property; and (2) had no benefits and burdens of ownership (i.e., no risk of loss and, in fact, no economic upside or downside in the property whatsoever and no control over the property). The "income tax ownership" factors overwhelmingly support the conclusion that the account owner is also the tax owner at the time of contribution.

Is the beneficiary the tax owner at the time of distribution? Maybe? Probably? Does it really matter?  I'd argue it really doesn't matter so long as the beneficiary wasn't the income tax owner of the funds at the beginning of the tax year. If the account owner was the income tax owner at the beginning of the tax year and the beneficiary becomes the tax owner (because for example the funds are distributed to the beneficiary), then it would still be support from the account owner. Thus, I'd argue it's irrelevant who is designated on the 1099-Q and pays the tax (if any) on the distribution.

In fact, for those people who argue that the beneficiary is the income tax owner at the time of contribution, why would distributing the money to the account owner make a difference in the support test? For example, account owner contributes $20k to 529 plan. For argument's sake (and contrary to what I believe), let's say beneficiary is the income tax owner of the funds at the time of contribution. The funds grow to $30k at which point the funds are distributed to the account owner and the account owner uses the funds to pay the beneficiaries tuition. If beneficiary was the income tax owner of the funds at the beginning of the year in which the distribution occurs, isn't it still self support if the beneficiary merely gives the beneficiary's funds to the account owner who then makes a payment of the beneficiary's tuition? The intervening step of giving the money to the account owner to pay tuition has no substance whatsoever. We wouldn't argue for self-self where the parent takes $30k from parent's bank account and transfers it to student's bank account to pay student's tuition so we shouldn't argue for parent support when the student gives the student's $30k to the parent to pay the student's tuition. In my mind, who is distributed the money is a total red herring.  

Wishing the IRS would weigh in.

[tacopa]

just curious. Do we know how many people did this...meaning

(1) treating the 529 distribution (made to student) as student support, or

(2) treating it as parent support

I am more interested in people who have done (1) and if IRS questioned that or not in the past!

[szaf12]

I have a college student who is 18 and received a distribution from a 529 plan with earnings. Subject to the kidde tax?

[itonewbie]

@szaf12 What you have is a different question and this is a very old post.  Please create a new post for your question instead.

[szaf12]

I have a college student who is 18 at the end of 2021. She has a distribution from a 529 plan with earnings. She used the total distribution for qualified college expenses. The software indicates that she is subject to kidde tax. Is there an exception somewhere? Or does this situation fall into the blackhole in the legislation?

[clobber88]

I have done all the support test calculations on the side. When I include 529 distributions as support provided by the student, the student is no longer able to be claimed as a dependent by the parent (which is advantageous in this case). If I choose to implement this solution in Turbo Tax filing as the student, what are the correct steps? I am using TT desktop 2021 in practice for 2022 and I think it goes something like this:

1) Q: Can anyone claim you as a dependent on their tax return.

    A:  No

2) Q: Did you support yourself in 2021? Did you provide over half of your own support with earned income during 2021?

    A: Yes

This is the correct way to get Turbo Tax to implement the solution. Right?