Can a 529 Plan Help with Estate Planning?

Parents and grandparents use 529 education savings plans to help with the cost of college expenses. However, they are also a good tool for estate planning, according to a recent article, “Reap The Recently-Created Planning Advantages Of 529 Plans” from Forbes.

There’s no federal income tax deduction for contributions to a 529 account. However, 35 states provide a state income tax benefit—a credit or deduction—for contributions, as long as the account is in the state’s plan. Six of those 35 states provide income tax benefits for contributions to any 529 plan, regardless of the state it’s based in.

Contributions also receive federal estate and gift tax benefits. A contribution qualifies for the annual gift tax exclusion, which is $16,000 per beneficiary for gifts made in 2022. Making a contribution up to this amount avoids gift taxes and, even better, doesn’t reduce your lifetime estate and gift tax exemption amount.

Benefits don’t stop there. If it works with the rest of your estate and tax planning, in one year, you can use up to five years’ worth of annual gift tax exclusions with 529 contributions. You may contribute up to $80,000 per beneficiary without triggering gift taxes or reducing your lifetime exemption.

You can, of course, make smaller amounts without incurring gift taxes. However, if this size gift works with your estate plan, you can choose to use the annual exclusion for a grandchild for the next five years. Making this move can remove a significant amount from your estate for federal estate tax purposes.

While the money is out of your estate, you still maintain some control over it. You choose among the investment options offered by the 529 plan. You also have the ability to change the beneficiary of the account to another family member or even to yourself, if it will be used for qualified educational purposes.

The money can be withdrawn from a 529 account if it is needed or if it becomes clear the beneficiary won’t use it for educational purposes. The accumulated income and gains will be taxed and subject to a 10% penalty but the original contribution is not taxed or penalized. It may be better to change the beneficiary if another family member is more likely to need it.

As long as they remain in the account, investment income and gains earned compound tax free. Distributions are also tax free, as long as they are used to pay for qualified education expenses.

In recent years, the definition of qualified educational expenses has changed. When these accounts were first created, many did not permit money to be spent on computers and internet fees. Today, they can be used for computers, room, and board, required books and supplies, tuition and most fees.

The most recent expansion is that 529 accounts can be used to pay for a certain amount of student debt. However, if it is used to pay interest on a loan, the interest is not tax deductible.

Finally, a 2021 law made it possible for a grandparent to set up a 529 account for a grandchild and distributions from the 529 account are not counted as income to the grandchild. This is important when students are applying for financial aid; before this law changed, the funds in the 529 accounts would reduce the student’s likelihood of getting financial aid.

Two factors to consider: which state’s 529 is most advantageous to you and how it can be used as part of your estate plan.

Reference: Forbes (Oct. 27, 2022) “Reap The Recently-Created Planning Advantages Of 529 Plans”

What Happens If a Trust Is Invalid?

Lessons about gifting, blended families, entity formalities, trusts and estate planning may all be found in the outcome of a tax case described in The Dallas Morning News’ article “The Smaldino case: Tax court opinion leads to estate planning angst.” The case involves gift taxes, and more particularly, a gift of LLC interest to a dynasty trust. The interest started out in the husband’s trust, transferred to the wife, who then transferred them to a dynasty trust, created to benefit some of the husband’s children from a prior marriage.

You may know that taxpayers are not required to report gifts between spouses. The husband’s gift to his spouse was, therefore, not reported to the IRS. The wife did report her gift to the IRS, but she didn’t need to pay any gift taxes because the reported value didn’t exceed her own lifetime gift tax exemption. Therefore, no gift taxes were due or paid on the transfer of the LLC interest to the trust.

The IRS assessed the husband a $1,154,000 gift tax deficiency, which was subsequently held up by the tax court. What was wrong?

The IRS and the tax court found a number of red flags. For starters, the wife held her LLC interest for only one day, before transferring it to the trust.

In testimony before the court, the wife said she had committed to transferring the shares to the trust even before she received the assignment of the shares. She clearly stated that she would have not changed her mind about transferring the assets, which were to benefit her stepchildren. Her timing was too hasty, however.

The husband, who was in control of the LLC, neglected to amend the LLC documents to reflect his wife’s owning an interest in the LLC. As a result, she was never recognized formally as a member of the LLC. The LLC documents made a clear distinction between the roles and duties of an assignee and a member. He executed the assignment of the interest, but she never became a member of the LLC.

The tax court also found a number of the corporate documents simply unbelievable. Several were undated. Others had an “effective date,” but lacked the date of signing.

One could say the IRS was being picky, but the IRS doesn’t have the ability to disregard documents, for two reasons. One is the doctrine of the tax court known as “substance over form.” The substance of a transaction, rather than the form it is presented in, determines the tax determination. The second is something families need to take seriously: when transactions involve family members, the IRS uses a fine-tooth comb to be sure transactions are legitimate.

When estate planning entities are created and transactions take place, consistency in actions is needed to demonstrate intent. All of the rules and practices must be followed, and when family members are involved, those involved must go above and beyond to avoid any appearance of impropriety.

An estate planning attorney with experience in creating LLCs, transferring interests and procedures required by the IRS, does more than create documents. He or she educates clients and explain how the transactions should be carried out to ensure that proper procedures are being followed. In this case, the mistakes far outweighed any benefits from the transaction.

Reference: The Dallas Morning News (Dec. 19, 2021) “The Smaldino case: Tax court opinion leads to estate planning angst”