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Practical tax planning for higher education costs.

Rising college tuition costs threaten to impose a severe financial burden on families in the US. According to a study by the General Accounting Office (GAO), the cost of a college education is rising at an annual 9% rate; thus, when a child born in 1994 reaches college age, the cost of a four-year education at a public university could be $128,000 ($268,000 at a private university).(1) Despite the ever-increasing importance of attaining higher education, the Code provides surprisingly few incentives for parents and other individuals faced with the cost of funding a college education: * The gross income test for dependency exemptions is waived under Sec. 151(c)(1)(B) for taxpayers whose children are fill-time students under age 24.(2) * Amounts received as a qualified scholarship by an individual who is a candidate for a degree at an educational organization can be excluded from gross income under Sec. 117(a).(3) * According to Regs. Sec. 1.162-5(a), an individual's expenditures for education may be deducted under Sec. 162 if the education (1) maintains or improves skills required by the taxpayer in his employment, trade or business or (2) is expressly required by the employer or by law to maintain the individual's current salary, status or position. * Under pre-Small Business Job Protection Act (SBJPA) Sec. 127(d), for tax years beginning before 1995, employees could exclude from gross income amounts paid or expenses incurred by their employer if the assistance was furnished by an educational assistance program set up by the employer. SBJPA Section 1202(a) retroactively restored this exclusion for tax years beginning after 1994 and extended it to tax years beginning before June 1, 1997. For tax years beginning in 1997, however, only expenses paid for courses beginning before July 1, 1997 may be excluded. The exclusion does not apply to graduate-level courses beginning after June 30, 1996.

This article examines the tax treatment and limitations of two financial planning strategies to provide funds for future education costs - Series EE US. Savings Bonds (EE bonds) and qualified state tuition programs (QSTPs) - and also briefly discusses a Treasury proposal to issue indexed bonds.

EE Bonds

Sec. 135(a) provides that an individual who pays qualified higher education expenses (QHEEs) must exclude from income interest on redemption proceeds of any "qualified U.S. savings bond." Such interest is taxable in the year the bonds are redeemed or, at the election of the taxpayer under Sec. 454, may be included in income annually as the interest accrues. Taxpayers who make the annual election probably would not receive much of a benefit from the exclusion.

A "qualified U.S. savings bond" is defined in Sec. 135(c)(1) as one issued (1) after 1989 (2) to an individual who reaches age 24 before the date of issuance and (3) at a discount under 31 USC Section 3105; thus, the bonds must be EE bonds.

According to Notice 90-7,(4) an individual who purchases a qualified bond may designate any individual (including a child) as the beneficiary (payable on death). However, the exclusion is not available if the bond (1) was purchased from another individual (un-less the purchase was from a spouse) or (2) is put into the name of a child or other dependent.(5)

The interest on an EE bond does not qualify for the exclusion if redemption proceeds were rolled over from a Series E U.S. savings bond.(6) Sec. 135(d)(2) provides that the exclusion is not available to married taxpayers filing separately; however, an individual may own a bond jointly with his spouse.(7)

Defining QHEEs

Sec. 135(c)(2)(A) defines QHEEs as tuition and fees for the enrollment or attendance of the taxpayer, his spouse or dependent (as defined in Sec. 151) at an "eligible educational institution." Sec. 135(c)(2)(B) excludes expenses with respect to any course or other education involving sports, games or hobbies, unless they are part of a degree program. Room and board and books and supplies appear to be excluded from the definition of QHEEs. QHEEs are net of employer-provided assistance under Sec. 127 and other reduction amounts.(8)

Sec. 135(c)(3) defines an "eligible educational institution" as (1) one defined under certain sections of the Higher Education Act of 1965 and (2) area vocational schools defined in certain portions of the Carl D. Perkins Vocational Education Act, as in effect on Oct. 21, 1988. According to Notice 90-7, this includes most public and nonprofit higher educational and post-secondary educational institutions eligible for Federal assistance under these two acts.

A wide variety of programs qualify for the exclusion, including nursing, two-year degree programs, one-year programs that prepare students for gainful employment and meet certain criteria, technical institutes and vocational programs.(9) All programs must have proper accreditation. However, a proprietary institution, as defined in 20 USC Section 1088(b), is not an eligible educational institution.(10)

Computing the Interest Exclusion

The bonds must be redeemed by the owner and not transferred directly to the educational institution.(11) Sec. 135(b)(1) states that when the redemption proceeds exceed the QHEEs paid during the year, the interest excludible cannot exceed the applicable fraction:

QHEEs paid by the taxpayer in the tax year x Interest received

Aggregate proceeds of EE bonds redeemed on redemption

by the taxpayer during the tax year

Example 1:(12) In 1996, R redeems an EE bond for $8,000 ($4,000 interest and ($4,000 principal) and incurs $6,000 of QHEEs. R can exclude $3,000 of the interest ($6,000/$8,000) X $4,000) and the $4,000 principal.

When QHEEs equal or exceed the total redemption proceeds, all of the interest is excludible.

Sec. 135(d)(1) provides that the QHEEs qualifying for the exclusion must be reduced by (1) Sec. 117 qualified scholar ships, (2) educational assistance under Chapters 30-32, 34 or 35 of Title 38 of the US. Code (i.e., veterans' benefits), (3) a payment (other than a gift, bequest, devise or inheritance within the meaning of Sec. 102(a)) for educational expenses, or attributable to attendance at an eligible educational institution exempt from income taxation by any US. law (e.g., employer payments under Sec. 127) or (4) a payment, waiver or reimbursement of QHEEs under a QSTP (within the meaning of Sec. 529(b); added by SBJPA Section 1806(b)(1)).

Example 2: In 1996, T has QHEEs of $8,000 and receives a $2,000 scholarship. T's QHEEs are reduced to $6,000.

The reduction for scholarships may not necessarily affect the amount of the interest exclusion.

Example 3: The facts are the same as in Example 2. T redeems an EE' bond for $6,000 in 1996, of which $3,000 is interest. All $3,000 of interest is excludible ($6,000/$6,000) X $3,000, as is the $3,000 principal.

One unaddressed issue is whether a qualified scholarship that includes books and supplies reduces QHEEs by the amount of books and supplies. As was noted, Sec. defines QHEES as expenses for tuition and fees, but not for books and supplies.

Example 4. In 1996, V has $10,000 in QHEEs and receives a $3,500 scholarship, of which $500 applies to books and supplies. Does V reduce QHEEs by $3,500 or $3,000?

Sec. 135(d)(1)(A) states that QHEEs must be reduced by the amount received under Sec. 117 that "is not includable in gross income," suggesting a $3,500 reduction; Sec. 117(b)(2)(B) excludes from gross income "fees, books, supplies and equipment required for courses of instruction...."

Exclusion Phase-out

Sec. 135(b)(2) provides a phase-out of the interest exclusion when modified adjusted gross income (MAGI) exceeds certain amounts. Sec. 135(c)(4) defines MAGI as adjusted gross income determined without regard to Sec. 135, the Sec. 911 foreign earned income exclusion, the Sec. 931 exclusion for income from Guam, American Samoa and Northern Mariana Islands, the Sec. 933 exclusion for income from Puerto Rico, and, for tax years beginning after 1996, the Sec. 137 exclusion for adoption assistance programs (added by SBJPA Section 1807(c)(2)). MAGI is determined after applying the (1) Sec. 86 partial exclusion for Social Security and tier I railroad benefits, (2) Sec. 219 deduction for an individual retirement account and (3) Sec. 469 passive activity rules.(13)

Sec. 135(b)(2)(B) states that the MAGI thresholds are indexed annually. Pre-SBJPA, the 1996 thresholds were as follows:

MAGI phaseout Taxpayer begins at ends at Single/Head of household $43,500 $58,500 Married filing jointly/Surviving spouse $65,250 $95,250

The phase-out ranges of $15,000 for individuals and heads of households and $30,000 for married couples and surviving spouses are not adjusted for inflation. Prior to enactment of the SBJPA, the phase-out amount was based on changes in the 1992 Consumer Price Index (CPI). Sec. 135(b)(2)(B)(ii), as amended by SBJPA Section 1703(d), now provides that the phase-out amounts must be adjusted based on the CPI for each year after 1989 (using 1989 as the base year). (At press time, the IRS had not yet issued the recomputed thresholds.)

Sec. 135(b)(2)(A) states that the interest excludible is reduced (but not below zero) by the following fraction:

MAGI - MAGI threshold x Interest received $15,000 (if single/head of household; on redemption $30,000 if joint return/surviving spouse)

Example 5: For 1996, J, a single taxpayer, has MAGI of $49,500 and $5,000 in EE bond interest. J must reduce the $5,000 of interest by $2,000 (([$49,500 - $43,500]/$15,000) X $5,000) and can exclude the remaining $3,000 of interest.

Example 6: In 1996, T and M, married filing jointly, have MAGI of $83,250 and $10,000 of EE bond interest. They must reduce the $10,000 of interest by $6,000 (([$83,250 - $65,250]/$30,000) X $10,000) and can exclude the remaining $4,000 of interest.

The MAGI phase-out applies after the reduction for redemption proceeds exceeding QHEEs and for qualified scholarships.

Example 7: J and K, married filing jointly, have 1996 MAGI of $77,250 and receive $10,000 in EE bond redemption proceeds, $5,000 of which is interest. Their son, B, has 1996 QHEEs of $8,000 and received a $2,000 scholarship for tuition, fees and books. The QHEEs are first reduced by the scholarship to $6,000. The excludible interest is then reduced to $3,000 ([$6,000/$10,000] X $5,000); thus, $3,000 of interest qualifies for the exclusion before the MAGI phase-out. The MAGI phase-out is $1,200 (([$77,250 - $65,250]/$30,000) X $3,000), leaving $1,800 of excludible interest.

Timing Issues

Sec. 135(a) requires that the QHEEs actually be paid when the bond proceeds are redeemed and in the year incurred.(14) Expenses incurred but not paid do not qualify.

Example 8: T attends college in 1995 and incurs QHEEs. In 1996, she redeems EE bonds and pays her 1995 expenses. T cannot use the exclusion unless she incurs QHEEs in 1996.

There is no limit on the number of times the exclusion can be used. A taxpayer who properly structures the purchase of EE bonds can use the exclusion each year QHEEs are paid and incurred.

Planning Opportunities

Taxpayers who are age 24 and older who purchase EE bonds can plan for their own education and maximize the tax benefits. Many individuals return to school to pursue a degree or special training. A taxpayer who decides that he may want to attend school might consider purchasing EE bonds as a method of financing. Even a taxpayer who goes to school only part-time can qualify for the Sec. 135 exclusion; however, a part-time student may lose part of the exclusion because the total redemption proceeds are more likely to exceed QHEEs.

Taxpayers who might otherwise lose part of the exclusion because of excessive MAGI may be able to obtain the maximum benefit by attending school full-time.

Example 9: If S, a single individual, worked for all of 1996, her MAGI would be $60,000 and she would not qualify for the exclusion. S leaves her job and enters law school in Fall 1996. S's MAGI may be reduced such that she can take all or part of the exclusion, because she worked for only eight months in 1996.

Filing and Documentation Requirements

Form 8818, Optional Form To Record Redemption of Series EE Savings Bonds Issued After 1989, allows a taxpayer to keep a record of EE bonds cashed. Taxpayers must keep a written record (i.e., a Form 8818) of each post-1989 EE bond cashed that includes the serial number, issue date, face value and total redemption proceeds of each bond. Taxpayers must also keep bills, receipts, canceled checks or other documentation showing that the QHEEs were paid during the year.(15) When claiming the Sec. 135 exclusion, the taxpayer must file with his return Form 8815, Exclusion of Interest From Series EE Savings Bonds Issued After 1989 (For Filers With Qualified Higher Education Expenses).

Prepaid Tuition Programs

One of the newest vehicles for funding education costs is the tuition guarantee program (or prepaid tuition program (PTP)), currently, 12 states operate such programs.(16) A typical PTP involves the purchase of a prepayment contract (usually an annuity) from a state or educational institution that provides that when the designated beneficiary enrolls in college, the contract can be redeemed to pay all (or a portion) of the college costs. Thus, the purchaser can "lock in" tuition costs at current prices. The cost of the contract varies with the age of the child; generally, the younger the child, the smaller the payment. The state, in turn, is gambling that it can invest the money and earn a rate of return greater than the inflation rate for tuition and other college fees.

Although most PTPs are similar, the details vary among states. Under one model, tuition benefits are sold by the credit-hour, the purchaser can buy up to four years' worth of tuition credits for each designated beneficiary. A model used by Florida offers tuition contracts for two years at a community college, two years at a community college plus two years at a state university, or four years at a state university. (Michigan, Wyoming and Alabama use similar plans.) Under most plans, cash refunds are provided under certain circumstances (e.g., if the child does not attend college).

Massachusetts offers a rather unique plan. A tax-exempt bond is purchased from the state equal to the current school tuition; the bond pays 2.5% interest plus a cost-of-living increase based on the CPI. When the bond is redeemed (i.e., when the child enrolls in college), participating schools accept an amount equal to the face value of the bond plus interest at 2% of the CPI. The remaining 0.5% is used to defray the program's operating costs. If the money is not used for tuition, the 2% interest is lost, but the face amount plus cost-of-living allowance is rebated.

Prior Law

Most initial state PTPs were established under the assumption that any income from the program (usually a trust) would be tax free. Under Sec. 501(c)(3), the earnings of corporations, funds, foundations, etc. with educational purposes generally are excluded from Federal income tax if they meet certain criteria. Additionally, Sec. 1151(1) generally excludes income derived from the exercise of any essential government function that accrues to a state or any political subdivision thereof. In Rev. Rul. 87-2,(17) the IRS ruled that income earned by a fund that is an integral part of a state or its political subdivision is generally not taxable in the absence of a specific authority for taxing such income. The Service held that income earned by a trust created and supervised by a state supreme court was not subject to Federal income tax.

However, in Letter Ruling 8825027,(18) requested by the Michigan Education Trust (MET), Michigan's tuition guarantee program, the Service ruled that the MET's accrued earnings were taxable income. A district court later agreed, holding the MET taxable as a corporation.(19) However, in a divided decision, the Sixth Circuit reversed the district court, holding that the MET was a political subdivision not subject to corporate income taxes.

In Letter Ruling 8825027, the Service also held that tuition prepayment by the purchaser should be treated as a completed gift for Federal gift tax purposes under Regs. Sec. 25,2503-6(b)(2) at the time the contract was purchased, but that because the payment would not constitute a gift of a present interest in property, under Regs. Sec. 25.2503-3(b), it would not be eligible for the Sec. 25.2503(b), $10,000 annual exclusion; further, although Sec. 2503(e)(2)(A) excludes from gift tax amounts paid on behalf of an individual as tuition to an educational organization(20) for the education of such individual, the payment would not qualify for the exclusion because it was not made directly to such organization.(21) Finally, the IRS ruled that the transfer was a gift for income tax purposes and was, therefore, excludible from the student's income, and that participants would not be currently taxable on the plans earnings. This issue seems to have been finally resolved by the issuance of the final original issue discount (OID) regulations(22); Regs. Sec. 1.1275-4(a)(2)(vii) excepts from OID treatment debt instruments of state-sponsored PTPs.

QSTPs

SBJPA Section 1806(a) created Sec. 529, which codifies the tax treatment of QSTPs and their participants. Sec. 529 does not apply to private universities. Sec. 529(a) generally provides tax-exempt status for QSTPs, but they can be subject to unrelated business income tax (UBIT). Sec. 529(c)(1) and (3) provide that a QSTP's investment earnings are not currently taxed to the participants; the contributor is taxed only if funds are refunded to him, and then only to the extent the refund exceeds contributions. The designated beneficiary is taxed on the QSTP's earnings when distributed or when educational benefits are provided. For estate tax purposes, however, Sec. 529(c)(4) states that amounts contributed to a QSTP, plus earnings, are includible in the contributors gross estate if not distributed before his death. Sec. 529(c)(5) provides that contributions to QSTPs are treated as qualified transfers under Sec. 2503(e) and are exempt from gift tax.

Defining a QSTP

Sec. 529(b)(1) defines a QSTP as a program established and maintained by a state (or agency or instrumentality thereof), under which a person may (1) purchase tuition credits or certificates for a designated beneficiary that entitle the beneficiary to the waiver or payment of QHEEs or (2) make contributions to an account established for the sole purpose of meeting QHEEs (as defined in Secs. 529(e)(3) and 135(c)(3)) of the designated beneficiary of the account. According to Sec. 529(b)(2), purchases or contributions can be made only in cash.

As defined in Sec. 529(e)(1) the designated beneficiary must be (1) the individual designated at the commencement of participation in the QSTP as the beneficiary of amounts paid into the program, (2) in the case of a change in beneficiaries, the individual who is the new beneficiary and (3) in the case of an interest in a QSTP purchased by a state or local government or an organization described in Sec. 501(c)(3) and exempt from taxation under Sec. 501(a) as part of a scholarship program operated by such government or organization, the individual receiving such interest as a scholarship.

Further, Sec. 529(b)(4), (5) and (6) provide that a QSTP must require that contributors and beneficiaries cannot direct any investment of contributions or their earnings; that no interest in the program can be used as security for a loan; and that the program must maintain separate accounting for each designated beneficiary. Additionally, under Sec. 529(b)(3) a QSTP must impose more than a de minimis penalty on any refund of earnings not (1) from an account used for the designated beneficiary's QHEEs, (2) made on account of the death or disability of the designated beneficiary,(23) or (3) made on account of a scholarship received by the designated beneficiary to the extent that the amount refunded does not exceed the amount of the scholarship used for QHEEs. Finally, Sec. 529(b)(7) requires a QSTP to provide safeguards ensuring that no contributions are permitted in excess of the designated beneficiary's QHEE needs.

Contributor's Tax Treatment

Example 10: During 1996, B purchases a prepaid tuition contract from a QSTP for $20,000. Under the contracts terms, the state will put the money into a trust and ensure that B's son, J, will receive four years of educational services at State University when he enrolls. Under Sec. 529(c)(2), B's contribution on behalf of J (the designated beneficiary) is treated as an incomplete gift, the gift tax consequences of which will be determined when the distribution is made from the QSTP.(24) If the distribution is used for J's QHEEs, Sec. 529(c)(5) provides for an exclusion from gift tax under Sec. 2503(e). If a refund is made to B for any reason other than those specified in Sec. 529(b)(3), she will have taxable income to B for any the extent the refund exceeds the amounts contributed.

Beneficiary's Tax Treatment

Sec. 529(c)(3)(A) states that amounts distributed to the designated beneficiary, including inikind distributions,(25) must be included in gross income under the rules of Sec. 72, to the extent not excluded from gross income by any other Code provision. Thus, if matching amounts are distributed to a beneficiary as part of a QSTP, they may be excludible as a scholarship under Sec. 117(26)

Sec. 72(b) excludes from gross income amounts invested in an annuity contract. Only distributions in excess of contributions made to a QSTP on the beneficiary's behalf are taxable to him.

Amounts contributed to the QSTP (i.e., basis) are recovered before my income is recognized.(27)

Example 11: The facts are the same as in Example 10. In August 2010, J enrolls in State University; at that time, the value of educational services for the first year is $12,000. J will incur no tax liability for the first year, and his basis in the program will be reduced to $8,000 ($20,000 - $12,000). If the value of educational services to J during the second, third and fourth years is $13,000 per year, J will recognize $5,000 ($13,000 - $8,000) of income for the second year, and income of $13,000 for each of the third and fourth years.

There are two exceptions to the general rule that distributions from QSTPs must be included in the designated beneficiary's gross income. First, a transfer of credits from one account benefitting one designated beneficiary to another account benefitting a different beneficiary is not a distribution if both beneficiaries are members of the same family.(28) Second, under Sec. 529(c)(3)(C)(ii), any change in the designated beneficiary of a QSTP is not a distribution for tax purposes if the new beneficiary is a member of the same family as the old beneficiary.

Example 12: The facts are the same as in Example 10. After making contributions to J's QSTP account, B transfers a portion of the funds in that account to the QTSP account of L, her daughter-in-law. The transfer is not a distribution, because J and L are members of the same family under Sec. 2032A(e)(2).(29)

Tax Treatment of QSTPs

Sec. 529(a) provides tax-exempt status for QSTPs established by state agencies to cover tuition costs, however, QSTPs may still be subject to UBIT Sec. 529(e)(4) provides that an interest in a QSTP is not debt for purposes of the Sec. 514 UBIT debt-financed property rules, this ensures that a QSTP's investment income will not be debt-financed property income subject to UBIT simply because the program accepts contributions and is obligated to pay them out (plus earnings) to designated beneficiaries or contributors. However, a QSTP's investment income could be subject to UBIT as debt-financed property income to the extent it acquires debt when investing contributed funds.

Effective Date

SBJPA Section 1806(c) provides that generally, Sec. 529 applies to tax years ending after Aug. 20, 1996. A transition rule under SBJPA Section 1806(c)(2) provides that, in effect, state tuition programs in existence on Aug.20, 1996 have until the later of (1) one year after the date of enactment or (2) 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, to bring their programs into compliance with Sec. 529. (If a state has a two-year legislative session, each year of the session is treated as a separate regular session.) For state tuition programs that meet the requirements for QSTPs by the dates set forth above, Sec. 529 applies to all contributions and earnings made prior to the date the program met the requirements, regardless of whether the amendments were met with respect to such contributions and earnings.

Example 13: The State A legislature was not in session on Aug. 20, 1996. The legislature's next regular session ends on Sept. 15, 1997. A's state tuition program must be in compliance with Sec. 529 no later than Oct. 1, 1997, to satisfy the transition rule.

The Next Step?

Despite the uncertainty generated by the financial difficulties of the MET,(30) state legislatures are forging ahead with plans for PTPs As was noted, at least 13 states have proposed or authorized programs that would allow family members to prepay a child's tuition, and lawmakers in California and New York have tuition plans under consideration.

Proponents of the plans profess that, in the long run, they allow beneficiaries to pay less tuition and owe less tax than if the money had been invested elsewhere. Opponents worry that state treasuries will have to pay back participants if investments falter and cite a GAO study showing that people who prepay tuition are middle- and upper-income families with discretionary income.(31) In the long run, the success or failure of QSTPs will probably hinge on whether they manage to avoid UBIT Assuming a 9% annual increase in education costs, a fund would need pretax earnings of approximately 13% to break even if its earnings were taxed at present rates.

Indexed Treasury Bonds

On May 16, 1996, Treasury announced plans to sell bonds that will be indexed for inflation and deflation.(32) The first issue of these 10-year Treasury Inflation-Protection Securities (TIPS) will be auctioned by Treasury on Jan. 15, 1997, and sold in $1,000 denominations.(33)

In general, TIPS will provide for semiannual payments of interest and a principal payment at maturity. The principal amount of a TIPS will be adjusted for inflation and deflation based on monthly changes in the nonseasonally adjusted US. City Average All Items Consumer Price Index for All Urban Consumers (CPI-U). Each semiannual interest payment will be determined by multiplying a single fixed rate of interest by the inflation-adjusted principal amount for the date of the interest payment. Thus, the interest rate will remain fixed, but the amount of each interest payment will vary with the CPI-U Notice 96-51(34) explains the content of planned proposed and temporary regulations that will apply to all inflation indexed bonds.

The treatment of inflation adjustments to principal will be the same as for OID. If the bonds principal increases due to inflation adjustments, the increase must be reported as interest income in the year it occurs, even though the holder will not receive a cash payment, thus, the holder will be taxed on proceeds that will not be received until an inflation adjustment is made when the bond matures.

Example 14: On Jan. 1, 1998, S purchases a $1,000 TIPS with a stated interest rate of 5%. Interest is paid on June 30 and December 31; the inflation-adjusted principal amounts on June 30, 1998 and Dec. 31, 1998 are $1,015 and $1,035, respectively. For 1998, S will receive interest payments of $25.38 ($1,015 x 2.5%) and $25.88 ($1,035 x 2.5%). S will also have $35 of reportable interest income ($1,035 x $1,000), the bonds increase in principal due to inflation adjustments.

TIPS will also provide for an additional payment at maturity if the security's inflation-adjusted principal amount for the maturity date is less than its principal amount at issuance. The additional payment is the excess of the TIPS principal amount at issuance over its inflation-adjusted principal amount at maturity.

TIPS will provide parents with one more way to save for their children's future education costs; as with PTPs, the bonds would serve as a risk-free hedge against escalating education costs. Unlike PTPs, appreciation and interest income from TIPS could be used to attend any college or university, not just those in a particular state, providing greater flexibility.

The earnings of most PTPs, however, are taxed to the student, who typically has a low marginal tax rate. Interest income from a TIPS, plus any appreciation in value, would be taxed to the investor, who presumably would be in a higher tax bracket. Further, recognition of earnings on PTPs is deferred until the child enters college. Finally, although the bonds would provide a hedge against inflation, many PTPs guarantee future tuition costs, no matter how much actual costs increase.

Conclusion

Proactive, early tax planning help reduce the sting of the costs of a higher education. Clients with children (and clients thinking about returning to school) should be advised that it is never too soon to plan how to finance future higher education costs.

EXECUTIVE SUMMARY

* Part or all of the interest on certain redeemed U.S. savings bonds may be excludible if the redemption proceeds are used to pay higher education costs. * In certain states, college costs can be controlled by investing in a prepaid or qualified state tuition program. * Treasury plans to issue inflation-indexed and other bonds that would help investors finance the costs of higher education.

(1) See, Garcia, "Uncertainty Continues To Surround Prepaid Tuition Plans." Tax Notes Today (8/31/95). (2) For this purpose, a "student" is a full-time student at an educational institution during some part of five calendar months of the year; see Regs. Sec. 1.151-3(b) and (c). (3) Sec. 170(b)(1)(A)(ii) defines an educational orginization as one that normally maintains a regular faculty and curriculum and has a regularly enrolled body of pupils or students in attendance where its educational activities are regularly carried on. Sec. 117(b)(1) provides that the qualified scholaship must be used for qualified tuition and related expenses, defined in Sec. 117(b)(2) as tuition and fees and required books, supplies and equipment. Prop. Regs. Sec. 1.117-6(c)(2) states that amounts received for room and board are includible and are earned income for purposes of calculating the standad deduction. (4) Notice 90-7, 10090-1 CB 304. (5) See H. Rep. No. 100-1104, 100th Cong., 2d Sess. 141 (1988) (hereinafter. "Conference Report"). (6) Id., p. 142. (7) Id., p. 141 (8) Id. (9) See 20 USC Sections 1088(a), and 1141(a) and 2471(3)(C) and (D), as in effect on Oct. 21, 1988. (10) Conference Report, note 5, p. 141. (11) Id. (12) See id. (13) See the instructions for Form 8815, Exclusion of Interest From Series EE Savings Bonds Issued After 1989 (For Filers With Qualified Higher Education Expenses), p. 2, Worksheet - Line 9. (14) Conference Report, note 5, p. 141. (15) See the Instructions for Form 8815, note 13, p. 2. (16) Alabama, Alaska, Florida, Kentucky, Louisiana, Massachusetts, Michigan, Ohio, Pennsylvania, Texas, Virginia and Wyoming; see Stratton, "Prepaid Tuition Programs Major in Political Science," 72 Tax Notes 153 (7/8/96). Mississippi is scheduled to begin a program in Fall 1996; see Healy, "Pay Now, Study Later," 42 The Chronicle of Higher Education A20 (5/31/96). (17) Rev. Rul. 87-2, 1987-1 CB18. (18) IRS Letter Ruling 8825027 (3/29/88). (19) State of Michigan and Its Educational Trust, 802 F Supp 120 (W.D. Mich. 1992) (70 AFTR2d 92-5120, 92-2 USTC para 50,424), rev'd sub. nom. State of Michigan and Michigan Educational Trust, 40 F3d 817 (6th Cir. 1994 (74 AFTR 2d 94-6801, 94-2 USTC para 50,583). (20) See note 3. (21) See Regs. Sec. 25.2503-6(c), Example 2. (22) TD 8674 (6/11/96). (23) Thus, no penalty would be imposed on refunds made to cover medical expenses incurred by (or on behalf of) a designated beneficiary who suffers a disabling illness; see H. Rep. No. 104-737, 104th Cong., 2d Sess. 120, n. 45 (1996) hereinafter, "SBJPA Conference Report"). (24) Id., p. 122. (25) Sec. 529(c)(3)(B) defines an in-kind distribution as any benefit furnished to a designated beneficiary under a QSTP. (26) SBJPA Conference Report, note 23, p. 122. (27) Id., p. 121. (28) Id., p. 120; Sec. 529(a)(3)(C)(i); Sec. 529(e)(2) provides that "family member" is defined in Sec. 2032A(e)(2). (29) Although not specifically mentioned in the Code, if a distributee beneficiary is not from the same family, presumably the earnings on the transferred portion will be taxed to him under Sec. 72 when distributed. (30) In the 1980s, the MET's drafters were extremely optimistic about investment returns; thus, its original contract prices were very low. In 1990, two years after it began operating, the MET became actuarially unsound and stopped accepting applications. It was revived in 1995, but without the investment guarantee originally offered. The new contracts, which cover an estimate of future tuition at a four-year state school, cost $15,000 to $20,000, approximately twice the cost of the original contracts; see Healy, note 16, p. A21. (31) This was of major concern to Mississippi, which structured its new plan so that contributors can prepay one years tuition at a state university for as little as $19 a month for 18 years; see Healy, note 16, p. A20. (32) See, e.g., Steuerle, "Indexed Bonds: A Potential Revolution in the Making," 71 Tax Notes 1249 (5/27/96). (33) See Donmoyer and Sheppard, "Inflation-Indexed Bonds Will Be Treated Like OID Instruments," 72 Tax Notes 1711 (9/30/96). (34) Notice 96-51, IRB 1996-43.
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Author:Zimmerman, John C.
Publication:The Tax Adviser
Date:Nov 1, 1996
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