Federal tax advantages for qualified state tuition programs.

The Small Business Job Protection Act of 1996 (SBJPA), enacted Aug. 20, 1996, substantially enhances the attractiveness of college prepaid tuition programs. Previously, 12 states had established some form of a prepaid tuition program for their residents. Until the SBJPA, the IRS had refused to allow a Federal tax exemption for the investment income build-up in the trust established to pay for the plan, causing many states to postpone adopting such programs. In addition, uncertainties as to the application of the original issue discount (OID) contingent payment regulations to the plans raised the possibility that plan purchasers or beneficiaries might be taxed on income prior to any actual distribution of tuition payments.

The new law allows states to create a tax-exempt qualified state tuition program (QSTP) and provides other important tax advantages for investing in QSTPs. These tax benefits should boost the availability and popularity of QSTPs. Many states must modify their existing programs to comply with the new law, but others are likely to establish new QSTPs. Tax advisers will be called on to provide tax, estate or financial planning advice to clients regarding their states, QSTPs.

Background

In Michigan v. United States, 40 F3d 817 (1994), the Sixth Circuit held that the Michigan Education Trust (Trust), an entity created by the State of Michigan to operate a prepaid tuition payment program, was an integral part of the state and, thus, the investment income realized by the Trust was not currently subject to Federal income tax. The Trust was established to receive advance payments of college tuition, invest the money, and ultimately make disbursements under a program that allowed beneficiaries to attend any of the states public colleges or universities without further tuition costs for a year or more (depending on the terms of the contract). However, IRS personnel generally believed this case to be wrongly decided, and refused to issue letter rulings allowing such an exemption for other state prepaid tuition plans. In addition, Service personnel indicated in conferences on these rulings that possibly the then recently proposed contingent payment OID regulations might apply to the plans. If so, purchasers or beneficiaries would have to include income from the prepaid tuition plan program prior to any payment from the program.

On June 11, 1996, the Treasury Department issued final regulations specifically providing that the OID provisions of the Code do not apply to contracts issued pursuant to state-sponsored prepaid tuition programs, whether or not the contracts are debt instruments. In addition, the IRS suspended issuing advance rulings or determination letters on state-sponsored prepaid tuition plans in anticipation of congressional action on the matter.

QSTPs

Under the SBJPA, a tax-exempt QSTP is a program established and maintained by a state under which persons may (1) purchase tuition credits or certificates on behalf of a designated beneficiary that entitle the beneficiary to a waiver or payment of qualified higher education expenses of the beneficiary or (2) make contributions to an account established for the purpose of meeting qualified higher education expenses of the beneficiary (Sec. 529). Qualified higher education expenses are defined as tuition, fees, books, supplies and equipment required for the enrollment or attendance at a college or university for certain vocational schools); expenses for room and board are not covered. The SBJPA specifically provides that a QSTP generally is exempt from Federal income tax, although it may be subject to the unrelated business income tax (UBIT). However, in applying UBIT, an interest in a QSTP win not be treated as debt for purposes of the UBIT debt-financed property rules under Sec. 514.

Contributions, Accounts and

Distributions

A QSTP is required to provide that purchases or contributions may only be made in cash. The QSTP must provide adequate safeguards to prevent contributions in excess of those necessary to provide for the beneficiarys qualified higher education expenses. Contributors and beneficiaries are not allowed to direct any investments made on their behalf by the QSTP. The QSTP is required to maintain a separate accounting for each beneficiary. A specified individual must be designated as the beneficiary on participation in a QSTP, unless interests in the QSTP are purchased by a state or local government or a tax-exempt charity described in Sec. 501(c) (3) as part of a scholarship program operated by such government or charity under which beneficiaries to be named in the future win receive such interests as scholarships. A transfer of credits (or other amounts) from one account benefiting one beneficiary or to another account benefiting a different beneficiary or a change in the beneficiary will be considered a distribution, unless the new beneficiary is a member of the old beneficiarys family. Earnings on an account may be refunded to a contributor or beneficiary, but the state or instrumentality must impose a more than de minimis monetary penalty unless the refund is (1) used for the beneficiary's qualified higher education expenses, (2) made on account of the beneficiary's death or disability or (3) made on account of a scholarship or allowance or payment received by the beneficiary to the extent the amount refunded does not exceed the amount of the scholarship, allowance or payment. A QSTP may not allow any interest in the QSTP to be used as security for a loan.

Income Tax Treatment

The SBJPA provides that no amount will be included in the gross income of a contributor to, or beneficiary of, a QSTP with respect to any distribution from, or earnings under, such QSTP, except that (1) amounts distributed or educational benefits provided to a beneficiary (e.g., when the beneficiary attends college) will be included in the beneficiary's gross income (unless excludible under another Code section), to the extent such amount or the value of the educational benefits exceeds contributions made on behalf of the beneficiary as determined under Sec. 72 and (2) amounts distributed to a contributor (e.g., when a parent or other relative receives a refund) will be included in the contributors gross income to the extent such amounts exceed contributions made by that person. If matching-grant amounts are distributed to for on behalf of) a beneficiary as part of a QSTP, such matching-grant amounts still may be excluded from the beneficiary's gross income as a scholarship under Sec. 117.

Estate and Gift Tax Treatment

Contributions made to a QSTP will be treated as incomplete gifts for Federal gift tax purposes. Thus, any Federal gift tax consequences will be determined at the time a distribution is made from an account under the QSTP. The waiver (or payment) of qualified higher education expenses of a beneficiary by (or to) an educational institution under a QSTP will be treated as a qualified transfer for purposes of Sec. 2503(e) and excluded as a gift. Amounts contributed to a QSTP (and earnings thereon) will be included in the contributors estate for Federal estate tax purposes in the event that the contributor dies before such amounts are distributed under the QSTP.

Effective Date

The provision is effective for tax years ending after Aug. 20, 1996. The SBJPA also includes a transition rule providing that if (1) a state maintains (on Aug. 20, 1996) a prepaid tuition plan similar to a QSTP and (2) such plan meets the requirements of a QSTP before the later of (a) Aug. 20, 1997 or (b) the first day of the first calendar quarter after the close of the first regular session of the State legislature that begins after Aug. 20, 1996, the SBJPA's provisions will apply to contributions (and allocable earnings) made before the date the plan meets the QSTP requirements, without regard to whether the requirements are satisfied with respect to such contributions and earnings (e.g., even if the interest in the tuition or educational savings plan covers not only qualified higher education expenses but also room and board expenses).

Summary

A QSTP offers these Federal tax advantages, which should boost their popularity:

[] A QSTP ordinarily will not be subject to Federal tax on the earnings of funds invested for the benefit of participants.

[] Neither the contributor nor the beneficiary will be taxed on the earnings on funds invested in the QSTP until benefits are used or withdrawn to pay education expenses of the beneficiary or refunded to the contributor. At that time, the earnings are taxed to the beneficiary, typically at lower tax rates than those of the contributor (e.g., a parent or grandparent).

[] The contributions will escape estate tax in the estate of the contributor, provided the contributor does not the prior to their use for the education of the beneficiary.