Probate & Trust Law Section Conference Manual ... - Minnesota CLE

states that do not base their income tax on federal income concepts, the
taxation of annual income and qualified distributions would be determined
on a state-by-state basis.
4. Annual Taxation on Nonqualified Distributions. Section 529(c)(3)(A)
provides that any distribution under a qualified tuition program shall be
includible in the gross income of the distributee in the manner as provided
under Code section 72 to the extent not excluded from gross income
because it is a qualified distribution. Subject to sections 72(e)(2)(B) and
72(e)(9), distributions are treated as consisting of two components:
1) principal or contributions, which are generally not taxed, and
2) earnings, which may be subject to tax. Code §§ 72(e)(2)(B) and (e)(9).
a. Distributee’s Tax Rate. Nonqualified distributions are taxed at
the distributee’s tax rate.
b. Losses. If a nonqualified distribution is taken from an account that
has a loss, the distributee can claim the loss as a miscellaneous
itemized deduction.
5. Federal Penalty on Nonqualified Distributions. Section 529 imposes a
ten percent federal penalty on the earnings portion of a nonqualified
distribution. Code § 529(c)(6). The federal penalty works in the same
manner as the penalty for nonqualified distributions from a Coverdell
Education Savings Account under section 530(d)(4).
B. Gift Taxation of Section 529 Savings Accounts
1. No Section 2503(e) Exclusion. Contributions to section 529 accounts
after August 5, 1997 do not qualify for the tuition exclusion from gift tax
under section 2503(e).
2. Gift Tax Annual Exclusion. Contributions to a section 529 account are
treated as completed present interest gifts from the donor to the
beneficiary. Code § 529(c)(2)(A)(i); Prop. Treas. Reg. § 1.529-5(b)(1).
The account owner is able to take advantage of the annual exclusions
while still retaining the rights to revoke the account, to control
distributions and to change the beneficiary of the account. Prop. Treas.
Reg. § 1.529, Comment at paragraph [29].
3. GST Annual Exclusion. The portion of a contribution excludible from
taxable gifts under section 2503(b) also satisfies the requirements of
section 2642(c)(2) and, therefore, is also excludible for purposes of the
generation-skipping transfer tax imposed under section 2601. Prop. Treas.
Reg. § 1.529-5(b).
4. Five-Year Election. Section 529 provides that a donor can elect to have
contributions to an account treated as if made ratably over five years
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