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

Prop. Treas. Reg. § 1.529-1(c).
D. Time of Determination. Section 529(c)(3)(D) and the proposed regulations
provide that the earnings portion shall be determined as of the date of distribution.
I.R.S. Notice 2001-81, 2001-2 C.B. 617, provides:
In response to comments received on the proposed regulations, and
consistent with the Secretary’s authority under § 529(c)(3)(D)(iii) to adopt
a different rule, the Treasury Department and the Internal Revenue Service
expect that final regulations will revise the time for determining the
earnings portion of any distribution from a § 529 account. It is expected
that final regulations will provide that, effective for distributions made
after December 31, 2002, programs will be required to determine the
earnings portion of each distribution as of the date of distribution. In the
case of direct transfers between § 529 programs, this requirement is
effective for distributions made after December 31, 2001. In the case of
any State program for which this change would require legislation and
whose State legislature has a biennial legislative session, the program will
have until January 1, 2004, to conform to this method of calculating
earnings.
E. Tax as Ordinary Income. Note that the earnings portion is taxed as ordinary
income, regardless of what portion of the earnings is attributed to capital gains.
F. Advance Notice. However, the proposed rules in the Advance Notice would
subject the account owner to income tax on the entire distribution “except to the
extent that the account owner can substantiate that the [Account Owner] made
contributions to the section 529 account and, therefore, has an investment in the
account within the meaning of section 72.” Thus a successor account owner who
did not make any contributions to the account would be subject to tax on the
entire distribution. The ten percent penalty would apply to the entire amount
includible in income.
Where an account owner directs a nonqualified distribution to the beneficiary, for
example where the beneficiary has completed his or her education, how will the
income tax consequences to the beneficiary be determined? Generally, it has
been assumed that the beneficiary would pay income tax only on the earnings
portion of the account and not on the amount of the contributions made to the
account. Presumably, the IRS will treat the beneficiary as having made an
investment in the account equal to the amount of the contributions, which were
treated as a completed gift to the beneficiary when the contributions were made to
the account. This theory works well when the beneficiary receiving the
distribution was the beneficiary at the time contributions were made to the
account. But if the beneficiary was changed, so that the beneficiary receiving the
distribution was not the deemed recipient of the completed gift, by what
mechanism does the new beneficiary acquire the old beneficiary’s “investment” in
32