QTP Contributions by Nonindividuals

By Peter J. Westort, Ph.D., CPA, Associate Professor of Accounting, University of WisconsinOshkosh, Oshkosh, WI, and Member, AICPA Tax Divisions Individual Income Taxation Technical Resource Panel

Sec. 529 qualified tuition programs (QTPs) provide a tax-favored way to invest for qualified higher education expenses (QHEEs). While contributions tend to be made by individuals on behalf of family members, it appears that nonindividuals may also make contributions. For example, employers may wish to make contributions to QTPs as fringe benefits for employees.¹ Employer contributions, however, raise a number of questions as to whether they are gross income to the employee and deductible by the employer, as well as other tax consequences.

Who Contributes?

Sec. 529(b)(1) refers to QTP contributions by a person; Sec. 7701(a)(1) defines that term to include a trust, estate, partnership, association, company or corporation, unless distinctly expressed to the contrary or manifestly inconsistent with intent. Because Sec. 529 does not define person, Sec. 7701(a)(1)s definition can be used, which includes nonindividuals. Thus, it appears nonindividuals may make contributions to QTPs.

Why Contribute?

As there is no income limit for taxpayers making contributions, QTPs offer an opportunity to provide additional fringe benefits to employees, including owner-employees. Sec. 529(b)(6) limits a contribution to the amount necessary to provide for the QHEEs of a designated beneficiary, although some state programs provide for lesser dollar amounts.

The benefits of contributing to QTPs are that the earnings accrue tax free under Sec. 529(c)(1), and distributions are tax free under Sec. 529(c)(3)(B)(i) when used to pay for a designated beneficiarys QHEEs. Sec. 529(e)(1)(A) requires the beneficiary to be identified when QTP participation commences; thus, an employer must make arrangements with one or more QTPs and an employee must open one or more accounts to identify the designated beneficiary. These decisions can be postponed somewhat if vesting is not immediate (discussed below).

Tax Treatment

Gift tax consequences: When a person other than an employee is a QTPs designated beneficiary, plan contributions are deemed completed gifts from the employee to the beneficiary under Sec. 529(c)(2)(A)(i) and, thus, eligible for the Sec. 2503(b) annual gift tax exclusion ($11,000 for 2004). Contributions in excess of this limit can be averaged over five years, according to Sec. 529(c)(2)(B). Taking full advantage of averaging, however, bars the donor from making other tax-free gifts to the same donee during the five-year period.

Employer contributions: How are employer contributions to QTPs on behalf of employees treated? There is no specific guidance. Under one possible treatment, transfers are completed gifts to a designated beneficiary but, under Sec. 102(c), transfers by or for an employer to, or for the benefit of, an employee are not excludible from income as gifts. Because Sec. 529 requires the designated beneficiary to be identified when participation begins, and because an employee would, presumably, choose such beneficiary, contributions to QTPs made on an employees behalf would be deemed compensation to him or her under Sec. 3401. Assuming immediate vesting, a cash-basis taxpayer and an arms-length transaction, the contribution would be ordinary income to the employee in the year paid and a completed gift to the designated beneficiary in the same year. The employer would deduct the amount in the year paid or accrued as a Sec. 162(a) ordinary and necessary business expense. For closely held corporations, the Sec. 267(a)(2) related-party restrictions and Sec. 162(a)(1) reasonable compensation limit would apply to the deduction. These contributions also appear to (1) be taxable fringe benefits subject to Sec. 3402(a) income tax withholding and (2) meet the Sec. 3121(a) definition of FICA wages subject to Social Security and Medicare taxes (subject to the formers wage-base limit). This increases the employers cost of providing such benefit.

Because immediate vesting results in the employee being treated as the account owner, all issues as to changing a beneficiary and early withdrawals are the same as if the employee had invested his or her own funds.

Vesting Issues

If there is no immediate vesting, several tax and nontax issues arise. The employer may make plan contributions, but maintains ownership of the account only until the employee vests. Sec. 83 provides for the (1) timing of recognition of both income and deductions and (2) amount recognized when property is transferred with a substantial risk of forfeiture. If full vesting is conditioned on the future performance of substantial services, the QTP contributions appear to meet the Sec. 83(c) definition of a substantial risk of forfeiture. In such cases, Sec. 83(a) would govern the year of employee income recognition (which is the year of vesting), assuming the employees rights to such property were no longer subject to a substantial risk of forfeiture in that year. Sec. 83(h) governs the employers deduction, which would be in the same year and amount as the employees income recognition.

There are two important issues here.² First, the employer would receive a phantom deduction for the increase in QTP account value before vesting. Second, the employee would recognize this value as income. The tax effect to the employee may be somewhat ameliorated by providing for vesting over time.

Termination before vesting: Practical questions arise, however, when plan contributions have been made and the employee terminates before vesting. Clearly, there is no tax effect on a terminating employee, as no income has been received. The employer may either transfer the related account balance for the benefit of another employee or take a distribution of the funds; in either case, the transaction will be treated as a distribution under Sec. 529(c)(3)(C)(ii), subjecting the employer to income tax on the accumulated earnings. Sec. 529(c)(6) also subjects the employer to a Sec. 530(d)(4) penalty tax. The income and penalty taxes might be avoided in family business situations, particularly if Sec. 529(c)(3)(C)(i) applies.³ Currently, it is unclear what happens to the funds if an employer declares bankruptcy.

Alternatively, the employer could simply provide for employees to earn credit toward a Sec. 529 contribution and refrain from actually making it until the employee qualified. This would simplify the accounting for the employer, as all tax effects would occur in the year of the actual contribution. However, employees would enjoy no tax-free growth of earnings until such contributions were actually made.

Conclusion

It appears that employers or others may make contributions to QTPs. Generally, such contributions are gifts from the transferor. However, employer contributions appear to be taxable compensation to the employee who, in turn, would be deemed to have made a gift to his or her designated beneficiary.

This may be particularly attractive for closely held corporations. First, contributions may provide another avenue for dealing with excessive compensation issues, as long as fringe benefits are treated differently from salary and wages. Second, if family members are also employees, this may be another method to shift income to relatives with lower marginal tax rates. Given that contributions do not appear to be excludible fringe benefits, there are no anti-discrimination provisions, which may allow more flexibility in deciding entitlement to this particular benefit. Additionally, from a family business perspective, this technique allows deductible contributions to QTPs and provides a disincentive to designated beneficiaries for uses other than education.