Weird 529 Situation

[Kram BergGold]

Grandfather set up 529 for grandson. In 2016 a $16,000 check was sent to grandson from the 529 after he graduated for which there are no qualified education expenses. The 1099-Q is in in the name of the grandson which is as it should be. The grandson returned the $16,000 to the Grandfather. Grandfather put the $16,000 in his bank account and forgot about it. I am thinking that the grandson needs to file a gift tax return for the $16,000 he gave to grandfather. Does anyone disagree?
Then, grandson has to pay tax and penalty on the $7,000 of earnings on the $16,000 section 529 distribution. Grandson has $17,000 of wages. Prior to the $16,000 distribution there were qualified education costs paid from the 529 plan of $29,000. The question is, did the grandson provide over 50% of his own support or do the parents claim him as a dependent? The parents are subject to AMT so the exemption is worthless to them. Either way, the grandson will largely wipe out the Federal tax with the AOC. My concern is if he can't claim himself the $7,000 will be subject to Kiddie Tax, correct?

[Uncle Sam]

Weird 529 Situation

The Kiddie Tax is mainly for children under age 18, under 19 and doesn't support him/herself, and under age 24 if full-time student and doesn't support him/herself.
You didn't state what age grandson is, and whether the graduation was from high school or college.

[Kram BergGold]

Answers for Uncle Sam

The student graduated from college and was 23 years old.

[TaxGuyBill]

I agree, a Gift Tax return is probably in order.

I am assuming the grandson was under age 24 and a full-time student. You or the client need to fill out he Support Worksheet to determine if he paid over 50% of his own support. If he provided over 50% of his own support, he claims his own exemption.

However, I also want to point out that unless he provided over 50% of his own support with Earned Income, he does NOT qualify for the refundable part of the AOC and he IS subject to the Kiddie Tax. So even if he provided over 50% of his own support, if it wasn't over 50% with Earned Income, he can't claim the refundable portion of the AOC and he pays the Kiddie Tax.

https://www.irs.gov/pub/irs-pdf/p501.pdf#page=16

[Kram BergGold]

Support Issue

TaxGuyBill,
Regarding the support issue. The 29k spent on tuition from a 529 plan show's up in a 1099-Q in the grandson's name. Is this considered money he provided for his support or is it money provided by Grandpa? Maybe the income component is allocated to him and the principal component to his grandpa. That kind of makes sense to me.
As for the 16k distribution, since the kid is paying tax on the $7,000 of earnings, I would think this is money he should count as money he provided for his support, except that he returned the $7,000 to his grandpa. Maybe in this case, only the income tax and 10% penalty he will pay is considered as money used for support.

[TaxGuyBill]

These is a few years old, but as of then, it seems like there isn't really an "answer" to that.

A 2012 AICPA article says "The IRS has not given guidance on how distributions from Sec. 529 plans affect the support tests ... tax practitioners are still waiting for a definitive answer from the IRS".

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

A 2010 AICPA article says "The IRS has not yet addressed the treatment of QTP distributions for support purposes in any publication or release". Here is the larger except of the second article, including a lengthy discussion about it:



Under Regs. Sec. 1.152-1(a)(2)(ii), any amount contributed by an individual for his or her support is considered, including income that is ordinarily excludable from gross income. Since the student is taxed on the distributions from the QTP or the distributions are excluded from the student’s gross income, the regulation supports the position that the QTP funds (total distributions from the Sec. 529 plan) are contributed by the student for his or her support.

The other line of reasoning is that the account owner retains control over the funds, including the withdrawal of the assets from the QTP. According to Prop. Regs. Sec. 1.529-1(c):

Account owner means the person who, under the terms of the QSTP or any contract setting forth the terms under which contributions may be made to an account for the benefit of a designated beneficiary, is entitled to select or change the designated beneficiary of an account, to designate any person other than the designated beneficiary to whom funds may be paid from the account, or to receive distributions from the account if no such other person is designated.

Typically a parent or grandparent is the account owner, but anyone can set up a QTP for either a related or an unrelated individual. The argument could be made that because the account owner controls whether a distribution is made and the amount of the distribution, and can even withdraw funds for himself or herself, the distribution from a QTP should be considered provided by the account owner for purposes of the support test. However, the estate and gift tax treatment of QTPs discussed below supports the position that the student should be treated as the person providing the support.

This possible treatment of QTP funds is similar to the incidents of ownership analysis for the estate tax treatment of life insurance. Under Sec. 2042, life insurance proceeds are included in the decedent’s estate if at the time of death he or she possessed any incidents of ownership. Regs. Sec. 20.2042-1(c)(2) provides that “incidents of ownership” refers to the right of the insured or his or her estate to the economic benefits of the policy. It includes the power to change beneficiaries, to pledge the policy as security for a loan, or to surrender or cancel the policy. Any one of those “string” powers results in the decedent’s being treated as owning the policy, resulting in the inclusion of the life insurance in the estate. In the case of a QTP, the account owner has the power to change beneficiaries and to cancel the plan by withdrawing the assets on his or her own behalf, thus strongly indicating direct and unrestrictive ownership.

From a gift and estate perspective, Sec. 529(c)(2) provides that contributions to QTPs are treated as completed gifts of a present interest to the plan beneficiary when the money is contributed to the plan, making the contribution eligible for the annual gift tax exclusion. By treating the contribution as a completed gift, generally no amount of the QTP is included in the gross estate of the account owner. 18 However, if the donor elects to treat the contributions to a QTP as made over a five-year period and dies within that five-year period, the portion of the contribution allocated to the period after death is included in the donor’s estate. 19

The gift and estate tax treatment of QTPs was one of the changes made under the Taxpayer Relief Act of 1997. 20 Prior to these changes, contributions to a QTP were treated as incomplete gifts, and the gift tax consequences were determined at the time a distribution was made from the account. 21 In addition, the value of a QTP attributable to the contributions made by the individual was included in the contributor’s estate if the contributor died before such amounts were distributed. 22 The Joint Committee on Taxation’s explanation for all the 1997 QTP changes was to “allow greater flexibility in the use of such programs.” 23 The changes in the gift and estate tax consequences of QTP contributions made the plans more attractive as college savings vehicles. On the other hand, completed gift treatment at the time of contribution weakens the argument that the funds belong to the account owner for purposes of the support test, even though the owner still has unrestricted control over the funds in the QTP.

The estate and gift tax treatment of a change in beneficiaries follows the completed gift treatment of the contribution, providing additional support for the position that QTP distributions will be treated as funds provided by the student. Prop. Regs. Sec. 1.529-5(b)(3) states that

a transfer which occurs by reason of a change in the designated beneficiary, or a rollover of credits or account balances from the account of one beneficiary to the account of another beneficiary, will be treated as a taxable gift by the old beneficiary to the new beneficiary if the new beneficiary is assigned to a lower generation than the old beneficiary.

Treating the “old beneficiary” as the transferor for gift tax purposes supports treating the student as the provider of the QTP funds for purposes of the support test.

The dichotomy between transfer tax treatment and account ownership raises concern over the potential for dubious tax avoidance schemes. For instance, a taxpayer could set up multiple QTPs, each with unique beneficiaries, utilize the
five-year annual exclusion, and later change all the account beneficiaries to one individual. 24 The advance notice of proposed rulemaking for the proposed regulations under Sec. 529 (advance notice) indicates that the forthcoming rules will deal with this potential abuse. 25 The IRS has not yet addressed the treatment of QTP distributions for support purposes in any publication or release, and it does not do so in the advance notice. 26 To date there are no court cases involving education account distributions and the support issue. Whether the withdrawals from a QTP are sourced to the parent or the student will in many cases determine whether the student meets the definition of a qualifying child.

http://www.thetaxadviser.com/issues/2010/aug/nichols-aug-2010.html

[Kram BergGold]

Thanks

This is one time in my life where having no definitive answer is actually helpful.
THANKS.