IRS Issues Guidance Relating to Certain Tuition Program and Education Expense Rules

(Parker Tax Publishing August 2018)

The IRS announced its intention to issue regulations clarifying (1) the special rules for contributions of refunded qualified higher education expenses to a qualified tuition program; (2) the new rules permitting a rollover from a qualified tuition program to an ABLE account under Code Sec. 529A; and (3) the new rules that treat certain elementary or secondary school expenses as qualified higher education expenses. In the meantime, the IRS is providing guidance on what those regulations will say, and taxpayers may rely on such guidance immediately. Notice 2018-58.

Background

Under Code Sec. 529, a state or its agency or instrumentality may establish or maintain a program that permits a person to prepay or contribute to an account for a designated beneficiary's qualified higher education expenses (QHEEs). In addition, an eligible educational institution may establish or maintain a program that permits a person to prepay a designated beneficiary's QHEEs. These programs are collectively referred to as Section 529 qualified tuition programs (QTPs). Code Sec. 529(c)(3) provides that distributions (including any attributable earnings) from a QTP are not included in gross income if such distributions do not exceed the designated beneficiary's QHEEs. To the extent distributions exceed the designated beneficiary's QHEEs, a portion of the distribution is included in gross income.

Before the Tax Cuts and Jobs Act of 2017 (TCJA) was signed into law on December 22, 2017, Code Sec. 529(e)(3)(A) defined QHEEs to include tuition, fees, books, supplies, and equipment required for the enrollment or attendance of a designated beneficiary at an eligible educational institution, including certain computer equipment and software used primarily by the beneficiary during any years the beneficiary is enrolled at an eligible educational institution. In the case of a special needs beneficiary, QHEEs include expenses for special needs services that are incurred in connection with such enrollment or attendance. QHEEs also include reasonable costs for room and board for eligible students (i.e., generally, those who are enrolled at least half-time).

A tax-free rollover of a distribution from a QTP, made within 60 days of the distribution, can be made to another QTP for the benefit of either the same designated beneficiary or another designated beneficiary who is a member of the family of the original designated beneficiary. However, Notice 2001-81 provides that the distributing QTP must provide a breakdown of the earnings portion of the rollover amount to the recipient QTP and, until the recipient QTP receives appropriate documentation showing the earnings portion, the entire rollover amount is treated as earnings. Notice 2001-81 applies the same rule to a direct transfer (i.e., a trustee-to-trustee transfer) from a QTP to another QTP. Code Sec. 529(c)(3)(D) addresses situations in which QTP funds are distributed for a beneficiary's QHEEs, but some portion of those expenses is refunded to the beneficiary by the eligible educational institution. This could occur, for example, if the beneficiary were to drop a class mid-semester. Code Sec. 529(c)(3)(D) provides that the portion of such a distribution refunded to an individual who is the beneficiary of a QTP by an eligible educational institution is not subject to income tax to the extent that the refund is recontributed to a QTP of which that individual is the beneficiary not later than 60 days after the date of such refund and to the extent it does not exceed the refunded amount. Code Sec. 529(c)(3)(D) applies to refunds received after December 31, 2014, but there is a transition rule with regard to the deadline for recontributing a refund received after 2014 but before December 18, 2015. Specifically, those refunded distributions are exempt from income tax if they were recontributed to the beneficiary's QTP not later than February 16, 2016.

The Tax Cuts and Jobs Act of 2017 (TCJA) added Code Sec. 529(c)(3)(C)(i)(III) which provides that a distribution from a QTP made after December 22, 2017 (i.e., the date of enactment), and before January 1, 2026, is not subject to income tax if, within 60 days of the distribution, it is transferred to an ABLE account of a designated beneficiary or a member of the family of the designated beneficiary. An ABLE account is an account established under a Code Sec. 529A qualified ABLE program to pay the qualified disability expenses of an eligible individual who is blind or has a disability. The amount of any rollover to an ABLE account is limited to the amount that, when added to all other contributions made to the ABLE account for the tax year, does not exceed the contribution limit for the ABLE account (i.e., the annual gift tax exclusion).

In addition, TCJA expanded the definition of QHEEs to include tuition in connection with the designated beneficiary's enrollment or attendance at an elementary or secondary public, private, or religious school. TCJA also amended Code Sec. 529(e)(3)(A) to limit the total amount of these tuition distributions for each designated beneficiary to $10,000 per year from all QTPs of the designated beneficiary.

Recontribution of Refunded QHEEs Is Treated as Principal

QTP administrators expressed concern over the administrative burdens that would arise if a recontribution of a refunded QHEE is treated in the same manner as a rollover under Notice 2001-81, which requires a breakdown of the earnings portion of the recontribution. Because the amount is refunded by the eligible educational institution, which will have no information regarding the income portion of each tuition payment (whether made from a single or multiple QTPs), QTP administrators generally would be unable to determine the earnings portion of the recontribution.

To eliminate this burden, the IRS said it intends to issue regulations providing that the entire recontributed amount will be treated as principal. Furthermore, because the recontributed amount previously was taken into account in applying the overall contribution limit under Code Sec. 529(b)(6), the IRS anticipates that the regulations will provide that the recontributed amount does not count against the limit on contributions on behalf of the designated beneficiary under Code Sec. 529(b)(6). In addition, consistent with Code Sec. 529(c)(3)(D), the IRS anticipates that the regulations will confirm that the recontribution must be to a QTP for the benefit of the designated beneficiary who received the refund of QHEEs, although the recontribution need not be to the QTP from which the distributions for the QHEEs were made.

QTP Rollover to an ABLE Account May Be Tax Free If Certain Conditions Are Met

In accordance with new Code Sec. 529(c)(3)(C)(i)(III), the IRS said it intends to issue regulations providing that a distribution from a QTP made after December 22, 2017, and before January 1, 2026, to the ABLE account of the designated beneficiary of that QTP, or to a member of the family of that designated beneficiary, is not subject to income tax if the following two requirements are met:

(1) the distributed funds must be contributed to the ABLE account within 60 days after their withdrawal from the QTP; and

(2) the distribution, when added to all other contributions made to the ABLE account for the tax year that are subject to the limitation under Code Sec. 529A(b)(2)(B)(i) (i.e., the annual gift tax exclusion), must not exceed that limitation.

The IRS expects the regulations to provide that the sum of the distribution and all other contributions to the ABLE account for the tax year, other than contributions of the designated beneficiary's compensation, cannot exceed the annual gift tax exclusion for that tax year. Consistent with the longstanding approach of treating direct transfers similarly to rollovers in Notice 2001-81, the IRS also anticipates that the regulations will provide that the same rules will apply regardless of whether such a QTP distribution is rolled over to an ABLE account or instead is transferred by a direct transfer from a QTP to an ABLE account. To the extent that a direct transfer (or, in the case of a rollover, a contribution of the distributed amount) would cause the contribution limit to be exceeded, it would be subject to income tax and a 10 percent penalty tax under Code Sec. 529(c)(6), if applicable.

Therefore, the IRS anticipates that the regulations will require a QTP to prohibit the direct transfer of any amount that would cause the limit under Code Sec. 529A(b)(2)(B)(i) to be exceeded. Furthermore, a qualified ABLE program is prohibited from accepting certain contributions in excess of the limitations applicable to ABLE accounts, and any violation of those rules could cause the designated beneficiary to incur tax, and could impact adversely the ABLE beneficiary's eligibility for certain public benefits.

Compliance Tip: The IRS is encouraging a QTP designated beneficiary, in the case of a rollover, or the QTP, in the case of a direct transfer, to contact the qualified ABLE program before contributing any funds to the ABLE account to ensure that the contribution limit will not be exceeded.

The IRS anticipates that the regulations will provide that, in the case of a direct transfer, any excess contribution that is rejected by the qualified ABLE program and returned to the QTP will not be deemed to be a new contribution to the QTP for purposes of the contribution limit. The IRS also anticipates that the regulations will specify that, for purposes of identifying the ABLE accounts permitted to receive such a rollover from a designated beneficiary's QTP, a member of the family of the designated beneficiary means a member of the family as defined in Code Sec. 529(e)(2), rather than the more limited definition in Code Sec. 529A(e)(4) that applies for purposes of qualified ABLE programs.

Expansion of QHEEs to Include Elementary and Secondary Education Tuition Expenses

The IRS anticipates that the future regulations will provide that QHEEs include tuition in connection with the designated beneficiary's enrollment or attendance at an elementary or secondary public, private, or religious school, but that such QHEEs are limited to a total of $10,000 per year per designated beneficiary, regardless of the number of QTPs making such distributions for that same designated beneficiary.

The IRS said it intends to issue regulations defining the term "elementary or secondary" to mean kindergarten through grade 12 as determined under state law, consistent with the definition applicable for Coverdell education savings accounts. As the IRS noted, Coverdell education savings accounts are another type of tax-favored savings account governed under Code Sec. 530 and also may be established to pay for tuition and other expenses in connection with enrollment or attendance at an elementary or secondary public, private, or religious school. Applying the same definition to both a QTP and a Coverdell education savings account, the IRS said, will facilitate the allocation of expenses between those two accounts as is required by Code Sec. 530(d)(2)(C)(ii) if a designated beneficiary receives distributions from both a QTP and a Coverdell education savings account and those total distributions exceed the designated beneficiary's qualified expenses.

Taxpayers May Rely on Notice 2018-58 Immediately

The IRS advised that taxpayers, beneficiaries, and administrators of 529 and ABLE programs may rely on the rules described in Notice 2018-58, effective immediately.

For a discussion of QTPs and QHEEs, see Parker Tax ¶11,610. For a discussion of ABLE accounts, see Parker Tax ¶11,810.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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