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California ScholarShare Revisited

By Melvin S. Spears

The Economic Growth and Tax Relief Reconciliation Act of 2001 (the "Act") was passed by Congress on May 26, 2001 and became law upon President Bush's signing the Act on June 7, 2001. Among the many changes effectuated by the Act were changes to the tax treatment of Qualified Tuition Programs ("QTPs") established under Section 529 of the Internal Revenue Code, such as California's Golden State ScholarShare program. This article updates my article entitled "ScholarShare: A Tax Deferred Program To Fund Higher Education" printed in the Ervin, Cohen & Jessup LLP "Legal Update, Winter 2001 edition".

The Act made a number of changes to Section 529, which makes the use of QTPs even more beneficial than before. These include:

1. The Act expands the definition of "qualified tuition program" to include certain prepaid tuition programs established and maintained by one or more eligible educational institutions (which may be private institutions) which satisfy the requirements of Section 529 and which hold the assets of the plan in a qualified trust. Prior to the Act, only state sponsored programs, such as the ScholarShare program, qualified.
2. Under prior law, distributions from a QTP were taxable to the recipient. Under the Act, distributions from QTPs made after December 31, 2001 from state established plans, and after December 31, 2003 from institution established plans, are tax-free when used for qualified higher education expenses ("QHEEs"). Thus, not only is the build-up within the plan itself tax-free, but, to the extent the distributions are used to pay qualified higher education expenses, the beneficiary will not be subject to taxes upon receiving distributions.
3. The definition of QHEEs has been broadened to include the current costs of room and board in addition to tuition, books and fees (instead of the lower dollar limitations on board and room under prior law).
4. The definition of QHEEs has been expanded to include expenses of a special needs beneficiary that are necessary in connection with the beneficiary's enrollment or attendance at an eligible institution.
5. A beneficiary's "family" has been expanded to include cousins, permitting a shifting of benefits to a broader group than previously allowed.
6. The Act allows a taxpayer to claim a "Hope" credit or "Lifetime Learning" credit for a taxable year and to exclude from gross income amounts distributed (both the principal and the earnings portions) from a qualified tuition program on behalf of the same student as long as the distribution is not used for the same expenses for which the credit is claimed.
7. Under the Act, credits or other amounts can be rolled over from one qualified tuition program to another qualified tuition program for the benefit of the same beneficiary. This transfer will not be considered to be a distribution if the rollover is made within 60 days of the distribution (prior law permitted rollover treatment only if the account was transferred to another designated beneficiary). A maximum of one rollover each 12 month period is allowed with respect to rollovers for the same designated beneficiary.
8. The Act changes the penalty on distributions not used for higher education expenses to the same additional tax that applies to educational IRAs (i.e., 10% of the portion of the distribution not used for QHEEs). The prior law used a vague test that the penalty had to be "more than a de minimus penalty". Thus, an account holder who terminates a plan or a beneficiary who receives a distribution which is not used for QHEEs can calculate with certainty what the penalty will be.

The changes, particular the change granting tax-free treatment to distributions used for qualified higher education expenses, have eliminated some of the objections to which Section 529 programs were previously subject, such as the conversion to ordinary income of what would have been capital gains or the problem of how the tax payments attributable to a distribution would be funded if the entire distribution was applied to educational expenses. By granting tax-free treatment to distributions used for QHEEs and broadening the definition of expenses to include room and board, QTPs have become an even more attractive way of providing for a student's higher education.

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This article is published by the law firm of Ervin, Cohen & Jessup LLP. The topics discussed are intended to present an overview of current legal trends and should not be construed as representing advice on specific, individual matters, but rather as general commentary on the subject discussed. Articles are not a substitute for the sound advice of compentent legal counsel. Your questions and comments are always welcome. Articles may be reprinted with permission. Copyright © 2000 Ervin, Cohen & Jessup LLP.