[Federal Register Volume 63, Number 163 (Monday, August 24, 1998)]
[Proposed Rules]
[Pages 45019-45032]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 98-22465]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-106177-97]
RIN 1545-AV18


Qualified State Tuition Programs

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking and notice of public hearing.

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SUMMARY: This document contains proposed regulations relating to 
qualified State tuition programs (QSTPs). These proposed regulations 
reflect changes to the law made by the Small Business Job Protection 
Act of 1996 and the Taxpayer Relief Act of 1997. The proposed 
regulations affect QSTPs established and maintained by a State or 
agency or instrumentality of a State, and individuals receiving 
distributions from QSTPs. This document also provides notice of a 
public hearing on these proposed regulations.

DATES: Written comments must be received by November 23, 1998. Outlines 
of topics to be discussed at the public hearing scheduled for 
Wednesday, January 6, 1999, at 10 a.m. must be received by December 16, 
1998.

ADDRESSES: Send submissions to CC:DOM:CORP:R (REG-106177-97), room 
5226, Internal Revenue Service, POB 7604, Ben Franklin Station, 
Washington DC 20044. Submissions may be hand delivered between the 
hours of 8 a.m. and 5 p.m. to: CC:DOM:CORP:R (REG-106177-97), Courier's 
Desk, Internal Revenue Service, 1111 Constitution Avenue, NW, 
Washington DC. Alternatively, taxpayers may submit comments 
electronically via the Internet by selecting the ``Tax Regs'' option on 
the IRS Home Page, or by submitting comments directly to the IRS 
Internet site at http://www.irs.ustreas.gov/prod/tax__regs/
comments.html. The public hearing will be held in room 2615, Internal 
Revenue Building, 1111 Constitution Avenue NW., Washington, DC.

FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations, 
Monice Rosenbaum, (202) 622-6070; concerning the proposed estate and 
gift tax regulations, Susan Hurwitz (202) 622-3090; concerning 
submissions and the hearing, Michael Slaughter, (202) 622-7190 (not 
toll-free numbers).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

    The collection of information contained in this notice of proposed 
rulemaking has been submitted to the Office of Management and Budget 
for review in accordance with the Paperwork Reduction Act of 1995 (44 
U.S.C. 3507(d)). Comments on the collection of information should be 
sent to the Office of Management and Budget, Attn: Desk Officer for the 
Department of the Treasury, Office of Information and Regulatory 
Affairs, Washington DC 20503, with copies to the Internal Revenue 
Service, Attn: IRS Reports Clearance Officer, OP:FS:FP, Washington, DC 
20224. Comments on the collection of information should be received by 
October 23, 1998. Comments are specifically requested concerning:
    Whether the proposed collection of information is necessary for the 
proper performance of the functions of the Internal Revenue Service, 
including whether the information will have practical utility;
    The accuracy of the estimated burden associated with the proposed 
collection of information;
    How the quality, utility, and clarity of the information to be 
collected may be enhanced;
    How the burden of complying with the proposed collection of 
information may be minimized, including through the application of 
automated collection techniques or other forms of information 
technology; and
    Estimates of capital or start-up costs and costs of operation, 
maintenance, and purchase or services to provide information.
    The collection of information in this proposed regulation is in 
Secs. 1.529-

[[Page 45020]]

2(e)(4), 1.529-2(f) and (i), 1.529-4, and 1.529-5(b)(2). This 
information is required by the IRS to verify compliance with sections 
529(b)(3), (4), (7) and (d). This information will be used by the IRS 
and individuals receiving distributions from QSTPs to determine that 
the taxable amount of the distribution has been computed correctly. The 
collection of information is required to obtain the benefit of being a 
QSTP described in section 529. The likely respondents and/or 
recordkeepers are state governments and distributees who receive 
distributions under the programs. The burden for reporting 
distributions is reflected in the burden for Form 1099-G, Certain 
Government Payments. The burden for electing to take certain 
contributions to a QSTP into account ratably over a five year period in 
determining the amount of gifts made during the calendar year is 
reflected in the burden for Form 709, Federal Gift Tax Return.
    Estimated total annual reporting/recordkeeping burden: 705,000 
hours.
    Estimated average annual burden per respondent/recordkeeper: 35 
hours, 10 minutes.
    Estimated number of respondents/recordkeepers: 20,051.
    Estimated annual frequency of responses: On occasion.
    An agency may not conduct or sponsor, and a person is not required 
to respond to, a collection of information unless it displays a valid 
control number assigned by the Office of Management and Budget.
    Books or records relating to a collection of information must be 
retained as long as their contents may become material in the 
administration of any internal revenue law. Generally, tax returns and 
tax return information are confidential, as required by 26 U.S.C. 6103.

Background

    This document contains proposed amendments to the Income Tax 
Regulations (26 CFR part 1) relating to qualified State tuition 
programs described in section 529. Section 529 was added to the 
Internal Revenue Code by section 1806 of the Small Business Job 
Protection Act of 1996, Public Law 104-188, 110 Stat. 1895. Section 529 
was modified by sections 211 and 1601(h) of the Taxpayer Relief Act of 
1997, Public Law 105-34, 111 Stat. 810 and 1092.
    Section 529 provides tax-exempt status to qualified State tuition 
programs (QSTPs) established and maintained by a State (or agency or 
instrumentality thereof) under which persons may (1) purchase tuition 
credits or certificates on behalf of a designated beneficiary entitling 
the beneficiary to a waiver or payment of qualified higher education 
expenses, or (2) contribute to an account established exclusively for 
the purpose of meeting qualified higher education expenses of the 
designated beneficiary. Qualified higher education expenses, for 
purposes of section 529, are tuition, fees, books, supplies, and 
equipment required for enrollment or attendance at an eligible 
educational institution, as well as certain room and board expenses for 
students who attend an eligible educational institution at least half-
time. An eligible educational institution is an accredited post-
secondary educational institution offering credit toward a bachelor's 
degree, an associate's degree, a graduate-level or professional degree, 
or another recognized post-secondary credential. The institution must 
be eligible to participate in Department of Education student aid 
programs.
    QSTPs established and maintained by a State (or agency or 
instrumentality thereof) must require all contributions to the program 
be made only in cash. Neither contributors nor designated beneficiaries 
may direct the investment of any contributions or any earnings on 
contributions. No interest in the program may be pledged as security 
for a loan. A separate accounting must be provided to each designated 
beneficiary in the program. A program must impose a more than de 
minimis penalty on refunds that are not used for qualified higher 
education expenses, not made on account of death or disability of the 
designated beneficiary, or not made on account of a scholarship or 
certain other educational allowances. A program must provide adequate 
safeguards to prevent contributions in excess of those necessary to 
provide for the qualified higher education expenses of the beneficiary. 
A specified individual must be designated as the beneficiary at the 
commencement of participation in a QSTP, unless the interests in the 
program are purchased by a State or local government or a tax-exempt 
organization described in section 501(c)(3) as part of a scholarship 
program operated by such government or organization under which 
beneficiaries to be named in the future will receive the interests as 
scholarships.
    Distributions under a QSTP are includible in the gross income of 
the distributee in the manner as provided under section 72 to the 
extent not excluded from gross income under any other provision. 
Distributions include in-kind benefits furnished to a designated 
beneficiary under a QSTP. Any distribution, or portion of a 
distribution, that is transferred within 60 days under a QSTP to the 
credit of a new designated beneficiary who is a member of the family of 
the old designated beneficiary shall not be treated as a distribution. 
A change in the designated beneficiary of an interest in a QSTP shall 
not be treated as a distribution if the new beneficiary is a member of 
the family of the old beneficiary. A member of the family means the 
spouse of the designated beneficiary or an individual who is related to 
the designated beneficiary as described in section 152(a)(1) through 
(8) or is the spouse of any of these individuals.
    Section 529, as added to the Code by the Small Business Job 
Protection Act of 1996 (1996 Act), contained provisions addressing the 
estate, gift, and generation-skipping transfer tax. The provisions were 
significantly revised, effective prospectively, by the Taxpayer Relief 
Act of 1997 (1997 Act).
    A contribution on behalf of a designated beneficiary to a QSTP 
which is made after August 20, 1996, and before August 6, 1997, is not 
treated as a taxable gift. Rather, the subsequent waiver (or payment) 
of qualified higher education expenses of a designated beneficiary by 
(or to) an educational institution under the QSTP is treated as a 
qualified transfer under section 2503(e) and is not treated as a 
transfer of property by gift for purposes of section 2501. As such, the 
contribution is not subject to the generation-skipping transfer tax 
imposed by section 2601.
    In contrast, under section 529 as amended by the 1997 Act, a 
contribution on behalf of a designated beneficiary to a QSTP after 
August 5, 1997, is a completed gift of a present interest in property 
under section 2503(b) from the contributor to the designated 
beneficiary and is not a qualified transfer within themeaning of 
section 2503(e). 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. For 
purposes of the annual exclusion, a contributor may elect to take 
certain contributions to a QSTP into account ratably over a five-year 
period in determining the amount of gifts made during the calendar 
year. Under section 529 as amended by the 1997 Act, a transfer which 
occurs by reason of a change in the designated beneficiary of a QSTP, 
or a rollover from the account of one beneficiary to the account of 
another beneficiary in a

[[Page 45021]]

QSTP, is not a taxable gift if the new beneficiary is a member of the 
family, as defined in section 529(e)(2), of the old beneficiary, and is 
assigned to the same generation, as defined in section 2651, as the old 
beneficiary. If the new beneficiary is assigned to a lower generation 
than the old beneficiary, the transfer is a taxable gift from the old 
beneficiary to the new beneficiary regardless of whether the new 
beneficiary is a member of the family of the old beneficiary. In 
addition, the transfer will be subject to the generation-skipping 
transfer tax if the new beneficiary is assigned to a generation which 
is two or more levels lower than the generation assignment of the old 
beneficiary. The five-year averaging election for purposes of the gift 
tax annual exclusion may be applied to the transfer.
    Regarding the application of the estate tax, the value of any 
interest in any QSTP which is attributable to contributions made by a 
decedent who died after August 20, 1996, and before June 9, 1997, is 
includible in the decedent's gross estate. In contrast, pursuant to the 
1997 Act amendments to section 529, the value of such an interest is 
not includible in the gross estate of a decedent who dies after June 8, 
1997, unless the decedent had elected the five-year averaging rule for 
purposes of the gift tax annual exclusion and died before the close of 
the five-year period. In that case, the portion of the contribution 
allocable to calendar years beginning after the decedent's date of 
death is includible in his gross estate.
    Also, pursuant to the 1997 Act amendments to section 529, the value 
of any interest in a QSTP held for a designated beneficiary who dies 
after June 8, 1997, is includible in the designated beneficiary's gross 
estate.
    The Federal estate and gift tax treatment of QSTP interests has no 
effect on the actual rights and obligations of the parties pursuant to 
the terms of the contracts under State law. In addition, the estate and 
gift tax treatment of contributions to a QSTP and interests in a QSTP 
is generally different from the treatment that would otherwise apply 
under generally applicable estate and gift tax principles. For example, 
under most contracts, the contributor may retain the right to change 
the designated beneficiary of an account, to designate any person other 
than the designated beneficiary to whom funds may be paid from the 
account, or to receive distributions from the account if no such other 
person is designated. Such rights would ordinarily cause the transfer 
to the account to fail to be a completed gift and mandate inclusion of 
the value of the undistributed interest in the QSTP in the gross estate 
of the contributor under sections 2036 and/or 2038. However, under 
section 529, the gross estate of a contributor who dies after June 8, 
1997, does not include the value of any interest in a QSTP attributable 
to contributions from the contributor (except amounts attributable to 
calendar years after death where the five-year averaging rule has been 
elected). Also, because a contribution after August 5, 1997, is a 
completed gift from the contributor to the designated beneficiary, any 
subsequent transfer which occurs by reason of a change in the 
designated beneficiary or a rollover from the account of the original 
designated beneficiary to the account of another beneficiary is 
treated, to the extent it is subject to the gift and/or generation-
skipping transfer tax, as a transfer from the original designated 
beneficiary to the new beneficiary. This is the result even though the 
change in beneficiary or the rollover is made at the direction of the 
contributor under the terms of the contract.

Comments From Notice 96-58

    In Notice 96-58, 1996-2 C.B. 226, the Internal Revenue Service 
invited comments on section 529 including the requirements for 
reporting distributions by QSTPs, the requirements for qualification 
and operation of programs, and the treatment of distributions made by 
programs for federal tax purposes. Eighteen comments were received. The 
comments addressed a broad range of issues, including but not limited 
to, those outlined by Notice 96-58, the concept of account ownership 
and gift tax rules, enforcement of penalties, accounting and 
recordkeeping, and transition relief for programs in existence on 
August 20, 1996. The summary below is not intended to be a complete 
discussion of the comments. However, all matters presented in the 
comments were considered in the drafting of this notice of proposed 
rulemaking.
    One commenter discussed in detail the requirements that a QSTP be 
``established and maintained'' by a State or agency or instrumentality 
of a State. The commenter recommended a list of factors to be 
considered in determining whether a State maintains the program. This 
commenter and others urged that the use of outside contractors or the 
holding of program deposits at a private financial institution selected 
by the State not be determinative of whether the program was maintained 
by the State.
    One commenter was endorsed by several others for suggesting two 
specific safe harbors to satisfy the requirement that a program impose 
more than a de minimis penalty on refunds. The first safe harbor was a 
5 percent of earnings penalty on refunds of earnings prior to the 
designated beneficiary matriculating, reduced to at least a 1 percent 
penalty on refunds of earnings only after the age of matriculation. The 
second safe harbor was a fixed-rate safe harbor equal to the lesser of 
$50 or 1 percent of the assets distributed. Another commenter suggested 
an additional safe harbor based on the return of Series EE savings 
bonds. That commenter also suggested that safe harbors are not 
necessarily the minimum acceptable penalties and that all facts and 
circumstances should be taken into account in determining the adequacy 
of penalties that are less than the safe harbor penalties.
    Commenters urged that regulations limit or avoid rules requiring 
programs to enforce penalties or require substantiation to ensure that 
disbursements are used to pay for qualified higher education expenses. 
Recognizing however that there may be some misuse in this area, 
commenters recommended that checks from QSTPs be marked with a special 
endorsement or be payable to both the educational institution and the 
designated beneficiary.
    Commenters suggested that the prohibition on investment direction 
not include a choice between a prepaid tuition program and a savings 
program (established and maintained in one State), a choice among 
options in a prepaid tuition program, a choice among options for the 
initial contribution to the program, or an opportunity to change 
investment strategies. One commenter suggested that the prohibition on 
investment direction not apply to prevent participation in the program 
by program board and staff members.
    Commenters suggested several approaches for satisfying the 
prohibition on excess contributions. Two safe harbors were proposed; 
one was based upon eight times the average annual undergraduate tuition 
and required fees at private four-year universities; the other was 
based upon five years of tuition, fees, books, supplies, and equipment 
at the highest cost institution allowed by the State's program. Other 
approaches proposed allowing the provision of adequate safeguards to 
prevent excess contributions to be left to the discretion of the 
program or allowing the contributor to certify that

[[Page 45022]]

no attempt would be made to overfund the account.
    Commenters made suggestions and raised concerns regarding: separate 
accounting rules including, but not limited to, the valuation and 
tracking of tuition units; the operating rules treating all programs in 
which an individual is a designated beneficiary as one program, and 
treating all distributions during a taxable year as one distribution; 
the application of section 72 to calculate distributions; and, income 
tax consequences relating to account ownership, penalties, and 
withholding.
    The modifications made to section 529 by the Taxpayer Relief Act of 
1997 have addressed, in large part, the issues raised by commenters 
concerning transition relief for programs in existence on August 20, 
1996, estate and gift tax consequences for contributors and designated 
beneficiaries, and definitions pertaining to family members and 
eligible educational institutions.

Explanation of Provisions

Qualification as Qualified State Tuition Program (QSTP): Unrelated 
Business Income Tax and Filing Requirements

    The proposed regulations provide guidance on the requirements a 
program must satisfy in order to be a QSTP described in section 529. A 
program that meets these requirements generally is exempt from income 
taxation. However, a QSTP is subject to the taxes imposed by section 
511 relating to imposition of tax on unrelated business income. For 
purposes of section 529 and these regulations, an interest in a QSTP 
shall not be treated as debt for purposes of section 514; consequently, 
investment income earned on contributions to the program by purchasers 
will not constitute debt-financed income subject to the unrelated 
business income tax. However, investment income of the QSTP shall be 
subject to the unrelated business income tax to the extent the program 
incurs indebtedness when acquiring or improving income-producing 
property. Earnings forfeited on educational contracts or savings, 
amounts collected as penalties on refunds or excess contributions, and 
certain administrative and other fees are not unrelated business income 
to the QSTP. A QSTP is not required to file Form 990, Return of 
Organization Exempt From Income Tax, however, this does not affect the 
obligation of a QSTP to file Form 990-T, Exempt Organization Business 
Income Tax Return.

Established and Maintained

    The proposed regulations provide that a program is established by a 
State or agency or instrumentality of the State if the program is 
initiated by State statute or regulation, or by an act of a State 
official or agency with the authority to act on behalf of the State. A 
program is maintained by a State or agency or instrumentality of a 
State if all the terms and conditions of the program are set by the 
State or agency or instrumentality and the State or agency or 
instrumentality is actively involved on an ongoing basis in the 
administration of the program, including supervising all decisions 
relating to the investment of assets contributed to the program. The 
proposed regulations set forth factors that are relevant in determining 
whether a State, agency or instrumentality is actively involved in the 
administration of the program. Included in the factors is the manner 
and extent to which it is permissible for the program to contract out 
for professional and financial services.

Penalties and Substantiation--Safe Harbors

    As required by section 529(b)(3), a more than de minimis penalty 
must be imposed on the earnings portion of any distribution from the 
program that is not used for the qualified higher education expenses of 
the designated beneficiary, not made on account of the death or 
disability of the designated beneficiary, or not made on account of a 
scholarship or certain other payments described in sections 
135(d)(1)(B) and (C) that are received by the designated beneficiary to 
the extent the amount of the refund does not exceed the amount of the 
scholarship, allowance, or payment. The penalty shall also not apply to 
rollover distributions described in section 529(c)(3)(C) which are 
discussed in the section titled Income Tax Treatment of Distributees, 
below. The proposed regulations provide that a penalty is more than de 
minimis if it is consistent with a program intended to assist 
individuals in saving exclusively for qualified higher education 
expenses. Whether any penalty is more than de minimis will depend upon 
the facts and circumstance of the particular program, including the 
extent to which the penalty offsets the federal income tax benefit from 
having deferred income tax liability on the earnings portion of any 
distribution. The proposed regulations provide a safe harbor penalty 
that a program may adopt for satisfying this requirement. For purposes 
of the safe harbor, a penalty imposed on the earnings portion of a 
distribution is more than de minimis if it is equal to or greater than 
10 percent of the earnings.
    To be treated as imposing a more than de minimis penalty as 
required by section 529(b)(3) a program must implement practices and 
procedures for identifying whether a distribution is subject to a 
penalty and collecting any penalty that is due. The proposed 
regulations, in the form of a safe harbor, set forth practices and 
procedures that may be implemented by a program. The safe harbor 
provides that distributions are treated as payments of qualified higher 
education expenses if the distribution is made directly to an eligible 
educational institution; the distribution is made in the form of a 
check payable to both the designated beneficiary and the eligible 
educational institution; the distribution is made after the designated 
beneficiary submits substantiation showing that the qualified higher 
education expenses were paid and the program reviews the 
substantiation; or the designated beneficiary certifies prior to 
distribution the amount to be used for qualified higher education 
expenses and the program requires substantiation of payment within 30 
days of making the distribution, the program reviews the 
substantiation, and the program retains an amount necessary to collect 
the penalty owed on the distribution if valid substantiation is not 
produced.
    The safe harbor procedure provides that a penalty be collected on 
all other distributions except where prior to distribution the program 
receives written third party confirmation that the designated 
beneficiary has died or become disabled or has received a scholarship 
or allowance or payment described in section 135(d)(1) (B) or (C). 
Alternatively, distributions may be made upon the certification of the 
account owner that the designated beneficiary has died or become 
disabled or has received a scholarship or allowance or payment 
described above, if the program withholds a portion of the distribution 
as a penalty. The penalty may be refunded after receipt of third party 
confirmation of the certification made by the account owner.
    The safe harbor procedure provides that a program may document 
amounts refunded from eligible educational institutions that were not 
used for qualified higher education expenses by requiring a signed 
written statement from the distributee identifying the amount of any 
refund received from an eligible educational institution at the end of 
each year in which distributions for qualified higher education 
expenses

[[Page 45023]]

were made and of the next year. A program must also have procedures to 
collect the penalty either by retaining a sufficient balance in the 
account to pay the penalty, withholding an amount equal to the penalty 
from a distribution, or collecting the penalty on a State income tax 
return.

Other Requirements for QSTP Qualification

    As described in section 529(b)(1)(A), the proposed regulations 
provide that contributions to the program can be placed into either a 
prepaid educational arrangement or contract, or an educational savings 
account, or both, but cannot be placed into any other type of account. 
Contributions may be made only in cash and not in property as provided 
in section 529(b)(2), however, the proposed regulations provide that a 
program may accept payment in cash, or by check, money order, credit 
card, or similar methods.
    Section 529(b)(4) requires that a program provide separate 
accounting for each designated beneficiary. Separate accounting 
requires that contributions for the benefit of a designated beneficiary 
and earning attributable to those contributions are allocated to the 
appropriate account. The proposed regulations provide that if a program 
does not ordinarily provide each account owner an annual account 
statement showing the transactions related to the account, the program 
must give this information to the account owner or designated 
beneficiary upon request.
    Section 529(b)(5) states that a program shall not be treated as a 
QSTP unless it provides that any contributor to, or designated 
beneficiary under, such program may not directly or indirectly direct 
the investment of any contributions to the program or any earnings 
thereon. A program will not violate the requirement of this paragraph 
if it permits a person who establishes an account to select between a 
prepaid educational services account and an educational savings 
account, or to select among different investment strategies designed 
exclusively by the program, at the time that an educational savings 
account is established. However, the proposed regulations clarify that 
a program will violate this requirement if, after an account with the 
program initially is established, the account owner, a contributor, or 
the designated beneficiary subsequently is permitted to select among 
different investment options or strategies. A program will not violate 
this requirement merely because it permits its board members, its 
employees, or the board members or employees of a contractor it hires 
to perform administrative services to purchase tuition credits or 
certificates or make contributions.
    Section 529(b)(6) provides that a program may not allow any 
interest in the program, or any portion of an interest in the program, 
to be used as security for a loan. The proposed regulations clarify 
that this restriction includes, but is not limited to, a prohibition on 
the use of any interest in the program as security for a loan used to 
purchase the interest in the program.
    Section 529(b)(7) requires a program to establish adequate 
safeguards to prevent contributions for the benefit of a designated 
beneficiary in excess of those necessary to provide for the qualified 
higher education expenses of the designated beneficiary. The proposed 
regulations provide a safe harbor that permits a program to satisfy 
this requirement if the program will bar any additional contributions 
to an account as soon as the account reaches a specified limit 
applicable to all accounts of designated beneficiaries with the same 
expected year of enrollment. The total contributions may not exceed the 
amount determined by actuarial estimates that is necessary to pay 
tuition, required fees, and room and board expenses of the designated 
beneficiary for five years of undergraduate enrollment at the highest 
cost institution allowed by the program. The safe harbor in the 
proposed regulations applies only to the program. Despite the fact that 
a program has met the safe harbor, a particular account established 
under the program may have a balance that exceeds the amount actually 
needed to cover the particular designated beneficiary's qualified 
higher education expenses. Distributions made that are not used for 
qualified higher education expenses of the designated beneficiary are 
subject to the penalty provisions of section 529(b)(3).

Income Tax Treatment of Distributees

    In accordance with section 529(c)(3), the proposed regulations 
provide that distributions made by a QSTP, including any benefit 
furnished in-kind, must be included in the gross income of the 
distributee to the extent that the distribution consists of earnings. 
The proposed regulations clarify that term ``distributee'' refers to 
the designated beneficiary or the account owner who receives or is 
treated as receiving a distribution from a QSTP. As required by section 
529(c)(3)(A), distributions under a QSTP must be included in income in 
the manner as provided under section 72. Therefore, deposits or 
contributions made into an account under a QSTP are recovered ratably 
over the period of time distributions are made. The amount of taxable 
earnings shall be determined by applying an earnings ratio, generally 
the earnings allocable to the account as of the close of the calendar 
year divided by the total account balance as of the close of the 
calendar year, to the distribution. In the case of a prepaid 
educational services account, this method of calculating taxable 
earnings utilizes an average value for each unit of education (e.g., 
credit, hour, semester, or other unit of education) that is distributed 
rather than the recovery of the cost of any particular unit of 
education.
    In accordance with section 529(c)(3)(C), the proposed regulations 
permit nontaxable rollover distributions. A rollover consists of a 
distribution or transfer from an account of a designated beneficiary 
that is transferred to or deposited within 60 days of the distribution 
into an account of another individual who is a member of the family of 
the designated beneficiary. A distribution is not a rollover 
distribution unless there is a change in beneficiary. The new 
designated beneficiary's account may be in a QSTP established or 
maintained by the same State or by another State. A transfer from the 
designated beneficiary to himself or herself, regardless of whether the 
transfer is to an account within the same QSTP or another QSTP in the 
same or another State, is not a rollover distribution and is taxable 
under the general rule. The Internal Revenue Service is concerned about 
the use of multiple rollovers to circumvent the restriction on 
investment direction. In particular, the Internal Revenue Service 
requests comments on this issue, including whether limits should be 
placed on the number of rollovers permitted within a certain time 
period or rollovers back to the original designated beneficiary. No 
taxable distribution will result from a change in designated 
beneficiary of an interest in a QSTP purchased by a State or local 
government or an organization described in section 501(c)(3) as part of 
a scholarship program.

Reporting Requirements

    The proposed regulations set forth recordkeeping and reporting 
requirements. A QSTP must maintain records that enable the program to 
produce an annual account balance for each account. See, requirements 
related to section 529(b)(4) above. A QSTP must report taxable earnings 
on Form 1099-G, Certain Government Payments, to distributees. Any 
reporting

[[Page 45024]]

requirements promulgated under section 529(d) apply in lieu of any 
other reporting requirement for a program that may apply with respect 
to information returns or payee statements or distributions. The 
proposed regulations contain more detail on how the information must be 
reported.

Estate and Gift Tax

    The proposed regulations provide guidance on the gift and 
generation-skipping transfer tax consequences of contributions to a 
QSTP, a change in the designated beneficiary of a QSTP, and a rollover 
from the account of one beneficiary to the account of another 
beneficiary under a QSTP. The proposed regulations also provide 
guidance on whether and to what extent the value of an interest in a 
QSTP is includible in the gross estate of a contributor to a QSTP or 
the gross estate of a designated beneficiary of a QSTP. Because of the 
amendments to section 529 made by the Taxpayer Relief Act of 1997, 
different gift tax rules apply to contributions made after August 20, 
1996, and before August 6, 1997, than apply to contributions made after 
August 5, 1997. Also, estates of decedents dying after August 20, 1996, 
and before June 9, 1997, are treated differently from estates of 
decedents dying after June 8, 1997. Comments are requested specifically 
on whether there is a need for more detailed guidance with respect to 
the estate, gift, and generation-skipping transfer tax provisions.

Transition Rules

    In accordance with section 1806(c) of the Small Business Job 
Protection Act of 1996 and section 1601(h) of the Taxpayer Relief Act 
of 1997, special transition rules apply to programs in existence on 
August 20, 1996. The proposed regulations provide that no income tax 
liability will be asserted against a QSTP for any period before the 
program meets the requirements of section 529 and these regulations if 
the program qualifies for the transition relief. A program shall be 
treated as meeting the transition rule if it conforms to the 
requirements of section 529 and these regulations by the date of final 
regulations.
    The proposed regulations provide transition rules that grandfather 
certain provisions in contracts issued and accounts opened before 
August 20, 1996. These contracts may be honored without regard to the 
definitions of ``member of the family'' and ``eligible educational 
institution'' used in section 529(e) (2) and (3), and without regard to 
section 529(b)(6) which prohibits the pledging of a QSTP interest as 
security for a loan. However, regardless of the terms of any agreement 
executed before August 20, 1996, distributions made by the QSTP are 
subject to tax according to the rules of Sec. 1.529-3 and subject to 
the reporting requirements of Sec. 1.529-4.

Proposed Effective Date

    These regulations are proposed to be effective on the date they are 
published in the Federal Register as final regulations. Taxpayers may, 
however, rely on the proposed regulations for taxable years ending 
after August 20, 1996. Programs that were in existence on August 20, 
1996, may also rely upon the transition rules provided.

Special Analyses

    It has been determined that this notice of proposed rulemaking is 
not a significant regulatory action as defined in Executive Order 
12866. Therefore, a regulatory assessment is not required. It has also 
been determined that section 553(b) of the Administrative Procedure Act 
(5 U.S.C. chapter 5) does not apply to these regulations, and, because 
the regulations do not impose a collection of information on small 
entities, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not 
apply. Pursuant to section 7805(f) of the Internal Revenue Code, this 
notice of proposed rulemaking will be submitted to the Chief counsel 
for Advocacy of the Small Business Administration for comment on its 
impact on small business.

Comments and Public Hearing

    Before these proposed regulations are adopted as final regulations, 
consideration will be given to any written comments (a signed original 
and eight (8) copies) that are submitted timely to the IRS. All 
comments will be available for public inspection and copying.
    A public hearing has been scheduled for Wednesday, January 6, 1999, 
beginning at 10 a.m. in room 2615 of the Internal Revenue Building, 
1111 Constitution Avenue, NW., Washington, DC. Because of access 
restrictions, visitors will not be admitted beyond the Internal Revenue 
Building lobby more than 15 minutes before the hearing starts.
    The rules of 26 CFR 601.601(a)(3) apply to the hearing.
    Persons who wish to present oral comments at the hearing must 
submit written comments and an outline of the topics to be discussed 
and the time to be devoted to each topic (signed original and eight (8) 
copies) by December 16, 1998.
    A period of 10 minutes will be allotted to each person for making 
comments.
    An agenda showing the scheduling of the speakers will be prepared 
after the deadline for receiving outlines has passed. Copies of the 
agenda will be available free of charge at the hearing.

Drafting Information

    The principal authors of these proposed regulations are Monice 
Rosenbaum, Office of Associate Chief Counsel (Employee Benefits and 
Exempt Organizations) and Susan Hurwitz, Office of the Associate Chief 
Counsel (Passthroughs and Special Industries). However, other personnel 
from the IRS and Treasury Department participated in their development.

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Proposed Amendments to the Regulations

    Accordingly, 26 CFR part 1 is proposed to be amended as follows:

PART 1--INCOME TAXES

    Paragraph 1. The authority citation for part 1 continues to read in 
part as follows:

    Authority: 26 U.S.C. 7805 * * *

    Par. 2. An undesignated centerheading and Secs. 1.529-0 through 
1.529-6 are added to read as follows:

Qualified State Tuition Programs


Sec. 1.529-0  Table of contents.

    This section lists the following captions contained in Secs. 1.529-
1 through 1.529-6:

Sec. 1.529-1  Qualified State tuition program, unrelated business 
income tax and definitions.

(a) In general.
(b) Unrelated business income tax rules.
(1) Application of section 514.
(2) Penalties and forfeitures.
(3) Administrative and other fees.
(c) Definitions.

Sec. 1.529-2  Qualified State tuition program described.

(a) In general.
(b) Established and maintained by a State or agency or 
instrumentality of a State.
(1) Established.
(2) Maintained.
(3) Actively involved.
(c) Permissible uses of contributions.
(d) Cash contributions.
(e) Penalties on refunds.
(1) General rule.
(2) More than de minimis penalty.
(i) In general.
(ii) Safe harbor.

[[Page 45025]]

(3) Separate distributions.
(4) Procedures for verifying use of distributions and imposing and 
collecting penalties.
(i) In general.
(ii) Safe harbor.
(A) Distributions treated as payments of qualified higher education 
expenses.
(B) Treatment of all other distributions.
(C) Refunds of penalties.
(D) Documentation of amounts refunded and not used for qualified 
higher education expenses.
(E) Procedures to collect penalty.
(f) Separate accounting.
(g) No investment direction.
(h) No pledging of interest as security.
(i) Prohibition on excess contributions.
(1) In general.
(2) Safe harbor.

Sec. 1.529-3  Income tax treatment of distributees.

(a) Taxation of distributions.
(1) In general.
(2) Rollover distributions.
(b) Computing taxable earnings.
(1) Amount of taxable earnings in a distribution.
(i) Educational savings account.
(ii) Prepaid educational services account.
(2) Adjustment for programs that treated distributions and earnings 
in a different manner for years beginning before January 1, 1999.
(3) Examples.
(c) Change in designated beneficiaries.
(1) General rule.
(2) Scholarship program.
(d) Aggregation of accounts.

Sec. 1.529-4  Time, form, and manner of reporting distributions 
from QSTPs and backup withholding.

(a) Taxable distributions.
(b) Requirement to file return.
(1) Form of return.
(2) Payor.
(3) Information included on return.
(4) Time and place for filing return.
(5) Returns required on magnetic media.
(6) Extension of time to file return.
(c) Requirement to furnish statement to the distributee.
(1) In general.
(2) Information included on statement.
(3) Time for furnishing statement.
(4) Extension of time to furnish statement.
(d) Backup withholding.
(e) Effective date.

Sec. 1.529-5  Estate, gift, and generation-skipping transfer tax 
rules relating to qualified State tuition programs.

(a) Gift and generation-skipping transfer tax treatment of 
contributions after August 20, 1996, and before August 6, 1997.
(b) Gift and generation-skipping transfer tax treatment of 
contributions after August 5, 1997.
(1) In general.
(2) Contributions that exceed the annual exclusion amount.
(3) Change of designated beneficiary or rollover.
(c) Estate tax treatment for estates of decedents dying after August 
20, 1996, and before June 9, 1997.
(d) Estate tax treatment for estates of decedents dying after June 
8, 1997.
(1) In general.
(2) Excess contributions.
(3) Designated beneficiary decedents.

Sec. 1.529-6  Transition rules.

(a) Effective date.
(b) Programs maintained on August 20, 1996.
(c) Retroactive effect.
(d) Contracts entered into and accounts opened before August 20, 
1996.
(1) In general.
(2) Interest in program pledged as security for a loan.
(3) Member of the family.
(4) Eligible educational institution.

Sec. 1.529-1  Qualified State tuition program, unrelated business 
income tax and definitions.

    (a) In general. A qualified State tuition program (QSTP) described 
in section 529 is exempt from income tax, except for the tax imposed 
under section 511 on the QSTP's unrelated business taxable income. A 
QSTP is not required to file Form 990, Return of Organization Exempt 
From Income Tax, Form 1041, U.S. Income Tax Return for Estates and 
Trusts, or Form 1120, U.S. Corporation Income Tax Return. A QSTP may be 
required to file Form 990-T, Exempt Organization Business Income Tax 
Return. See Secs. 1.6012-2(e) and 1.6012-3(a)(5) for requirements for 
filing Form 990-T.
    (b) Unrelated business income tax rules. For purposes of section 
529, this section and Secs. 1.529-2 through 1.529-6:
    (1) Application of section 514. An interest in a QSTP shall not be 
treated as debt for purposes of section 514. Consequently, a QSTP's 
investment income will not constitute debt-financed income subject to 
the unrelated business income tax merely because the program accepts 
contributions and is obligated to pay out or refund such contributions 
and certain earnings attributable thereto to designated beneficiaries 
or to account owners. However, investment income of a QSTP shall be 
subject to the unrelated business income tax as debt-financed income to 
the extent the program incurs indebtedness when acquiring or improving 
income-producing property.
    (2) Penalties and forfeitures. Earnings forfeited on prepaid 
educational arrangements or contracts and educational savings accounts 
and retained by a QSTP, or amounts collected by a QSTP as penalties on 
refunds or excess contributions are not unrelated business income to 
the QSTP.
    (3) Administrative and other fees. Amounts paid, in order to open 
or maintain prepaid educational arrangements or contracts and 
educational savings accounts, as administrative or maintenance fees, 
and other similar fees including late fees, service charges, and 
finance charges, are not unrelated business income to the QSTP.
    (c) Definitions. For purposes of section 529, this section and 
Secs. 1.529-2 through 1.529-6:
    Account means the formal record of transactions relating to a 
particular designated beneficiary when it is used alone without further 
modification in these regulations. The term includes prepaid 
educational arrangements or contracts described in section 
529(b)(1)(A)(i) and educational savings accounts described in section 
529(b)(1)(A)(ii).
    Account owner means the person who, under the terms of the QSTP or 
any contract setting forth the terms under which contributions may be 
made to an account for the benefit of a designated beneficiary, is 
entitled to select or change the designated beneficiary of an account, 
to designate any person other than the designated beneficiary to whom 
funds may be paid from the account, or to receive distributions from 
the account if no such other person is designated.
    Contribution means any payment directly allocated to an account for 
the benefit of a designated beneficiary or used to pay late fees or 
administrative fees associated with the account. In the case of a tax-
free rollover, within the meaning of this paragraph (c), into a QSTP 
account, only the portion of the rollover amount that constituted 
investment in the account, within the meaning of this paragraph (c), is 
treated as a contribution to the account as required by Sec. 1.529-
3(a)(2).
    Designated beneficiary means--
    (1) The individual designated as the beneficiary of the account at 
the time an account is established with the QSTP;
    (2) The individual who is designated as the new beneficiary when 
beneficiaries are changed; and
    (3) The individual receiving the benefits accumulated in the 
account as a scholarship in the case of a QSTP account established by a 
State or local government or an organization described in section 
501(c)(3) and exempt from taxation under section 501(a) as part of a 
scholarship program operated by such government or organization.
    Distributee means the designated beneficiary or the account owner 
who receives or is treated as receiving a distribution from a QSTP. For 
example, if a QSTP makes a distribution directly

[[Page 45026]]

to an eligible educational institution to pay tuition and fees for a 
designated beneficiary or a QSTP makes a distribution in the form of a 
check payable to both a designated beneficiary and an eligible 
educational institution, the distribution shall be treated as having 
been made in full to the designated beneficiary.
    Distribution means any disbursement, whether in cash or in-kind, 
from a QSTP. Distributions include, but are not limited to, tuition 
credits or certificates, payment vouchers, tuition waivers or other 
similar items. Distributions also include, but are not limited to, a 
refund to the account owner, the designated beneficiary or the 
designated beneficiary's estate.
    Earnings attributable to an account are the total account balance 
on a particular date minus the investment in the account as of that 
date.
    Earnings ratio means the amount of earnings allocable to the 
account on the last day of the calendar year divided by the total 
account balance on the last day of that calendar year. The earnings 
ratio is applied to any distribution made during the calendar year. For 
purposes of computing the earnings ratio, the earnings allocable to the 
account on the last day of the calendar year and the total account 
balance on the last day of the calendar year include all distributions 
made during the calendar year and any amounts that have been forfeited 
from the account during the calendar year.
    Eligible educational institution means an institution which is 
described in section 481 of the Higher Education Act of 1965 (20 U.S.C 
1088) as in effect on August 5, 1997, and which is eligible to 
participate in a program under title IV of such Act. Such institutions 
generally are accredited post-secondary educational institutions 
offering credit toward a bachelor's degree, an associate's degree, a 
graduate level or professional degree, or another recognized post-
secondary credential. Certain proprietary institutions and post-
secondary vocational institutions also are eligible institutions. The 
institution must be eligible to participate in Department of Education 
student aid programs.
    Final distribution means the distribution from a QSTP account that 
reduces the total account balance to zero.
    Forfeit means that earnings and contributions allocable to a QSTP 
account are withdrawn by the QSTP from the account or deducted by the 
QSTP from a distribution to pay a penalty as required by Sec. 1.529-
2(e).
    Investment in the account means the sum of all contributions made 
to the account on or before a particular date less the aggregate amount 
of contributions included in distributions, if any, made from the 
account on or before that date.
    Member of the family means an individual who is related to the 
designated beneficiary as described in paragraphs (1) through (9) of 
this definition. For purposes of determining who is a member of the 
family, a legally adopted child of an individual shall be treated as 
the child of such individual by blood. The terms brother and sister 
include a brother or sister by the halfblood. Member of the family 
means--
    (1) A son or daughter, or a descendant of either;
    (2) A stepson or stepdaughter;
    (3) A brother, sister, stepbrother, or stepsister;
    (4) The father or mother, or an ancestor of either;
    (5) A stepfather or stepmother;
    (6) A son or daughter of a brother or sister;
    (7) A brother or sister of the father or mother;
    (8) A son-in-law, daughter-in-law, father-in-law, mother-in-law, 
brother-in-law, or sister-in-law; or
    (9) The spouse of the designated beneficiary or the spouse of any 
individual described in paragraphs (1) through (8) of this definition.
    Person has the same meaning as under section 7701(a)(1).
    Qualified higher education expenses means--
    (1) Tuition, fees, and the costs of books, supplies, and equipment 
required for the enrollment or attendance of a designated beneficiary 
at an eligible educational institution; and
    (2) The costs of room and board (as limited by paragraph (2)(i) of 
this definition) of a designated beneficiary (who meets requirements of 
paragraph (2)(ii) of this definition) incurred while attending an 
eligible educational institution:
    (i) The amount of room and board treated as qualified higher 
education expenses shall not exceed the minimum room and board 
allowance determined in calculating costs of attendance for Federal 
financial aid programs under section 472 of the Higher Education Act of 
1965 (20 U.S.C. 108711) as in effect on August 5, 1997. For purposes of 
these regulations, room and board costs shall not exceed $1,500 per 
academic year for a designated beneficiary residing at home with 
parents or guardians. For a designated beneficiary residing in 
institutionally owned or operated housing, room and board costs shall 
not exceed the amount normally assessed most residents for room and 
board at the institution. For all other designated beneficiaries the 
amount shall not exceed $2,500 per academic year. For this purpose the 
term academic year has the same meaning as that term is given in 20 
U.S.C. 1088(d) as in effect on August 5, 1997.
    (ii) Room and board shall be treated as qualified higher education 
expenses for a designated beneficiary if they are incurred during any 
academic period during which the designated beneficiary is enrolled or 
accepted for enrollment in a degree, certificate, or other program 
(including a program of study abroad approved for credit by the 
eligible educational institution) that leads to a recognized 
educational credential awarded by an eligible educational institution. 
In addition, the designated beneficiary must be enrolled at least half-
time. A student will be considered to be enrolled at least half-time if 
the student is enrolled for at least half the full-time academic 
workload for the course of study the student is pursuing as determined 
under the standards of the institution where the student is enrolled. 
The institution's standard for a full-time workload must equal or 
exceed the standard established by the Department of Education under 
the Higher Education Act and set forth in 34 CFR 674.2(b).
    Rollover distribution means a distribution or transfer from an 
account of a designated beneficiary that is transferred to or deposited 
within 60 days of the distribution into an account of another 
individual who is a member of the family of the designated beneficiary. 
A distribution is not a rollover distribution unless there is a change 
in beneficiary. The new designated beneficiary's account may be in a 
QSTP in either the same State or a QSTP in another State.
    Total account balance means the total amount or the total fair 
market value of tuition credits or certificates or similar benefits 
allocable to the account on a particular date. For purposes of 
computing the earnings ratio, the total account balance is adjusted as 
described in this paragraph (c).


Sec. 1.529-2  Qualified State tuition program described.

    (a) In general. To be a QSTP, a program must satisfy the 
requirements described in paragraphs (a) through (i) of this section. A 
QSTP is a program established and maintained by a State or an agency or 
instrumentality of a State under which a person--

[[Page 45027]]

    (1) May purchase tuition credits or certificates on behalf of a 
designated beneficiary that entitle the beneficiary to the waiver or 
payment of qualified higher education expenses of the beneficiary; or
    (2) May make contributions to an account that is established for 
the purpose of meeting the qualified higher education expenses of the 
designated beneficiary of the account.
    (b) Established and maintained by a State or agency or 
instrumentality of a State--(1) Established. A program is established 
by a State or an agency or instrumentality of a State if the program is 
initiated by State statute or regulation, or by an act of a State 
official or agency with the authority to act on behalf of the State.
    (2) Maintained. A program is maintained by a State or an agency or 
instrumentality of a State if--
    (i) The State or agency or instrumentality sets all of the terms 
and conditions of the program, including but not limited to who may 
contribute to the program, who may be a designated beneficiary of the 
program, what benefits the program may provide, when penalties will 
apply to refunds and what those penalties will be; and
    (ii) The State or agency or instrumentality is actively involved on 
an ongoing basis in the administration of the program, including 
supervising all decisions relating to the investment of assets 
contributed to the program.
    (3) Actively involved. Factors that are relevant in determining 
whether a State, agency or instrumentality is actively involved 
include, but are not limited to: whether the State provides services or 
benefits (such as tax, student aid or other financial benefits) to 
account owners or designated beneficiaries that are not provided to 
persons who are not account owners or designated beneficiaries; whether 
the State or agency or instrumentality establishes detailed operating 
rules for administering the program; whether officials of the State or 
agency or instrumentality play a substantial role in the operation of 
the program, including selecting, supervising, monitoring, auditing, 
and terminating any private contractors that provide services under the 
program; whether the State or agency or instrumentality holds the 
private contractors that provide services under the program to the same 
standards and requirements that apply when private contractors handle 
funds that belong to the State or provide services to the State; 
whether the State provides funding for the program; and, whether the 
State or agency or instrumentality acts as trustee or holds program 
assets directly or for the benefit of the account owners or designated 
beneficiaries. If the State or an agency or instrumentality thereof 
exercises the same authority over the funds invested in the program as 
it does over the investments in or pool of funds of a State employees' 
defined benefit pension plan, then the State or agency or 
instrumentality will be considered actively involved on an ongoing 
basis in the administration of the program.
    (c) Permissible uses of contributions. Contributions to a QSTP can 
be placed into either a prepaid educational arrangement or contract 
described in section 529(b)(1)(A)(i) or an educational savings account 
described in section 529(b)(1)(A)(ii), or both, but cannot be placed 
into any other type of account.
    (1) A prepaid educational services arrangement or contract is an 
account through which tuition credits or certificates or other rights 
are acquired that entitle the designated beneficiary of the account to 
the waiver or payment of qualified higher education expenses.
    (2) An educational savings account is an account that is 
established exclusively for the purpose of meeting the qualified higher 
education expenses of a designated beneficiary.
    (d) Cash contributions. A program shall not be treated as a QSTP 
unless it provides that contributions may be made only in cash and not 
in property. A QSTP may accept payment, however, in cash, or by check, 
money order, credit card, or similar methods.
    (e) Penalties on refunds--(1) General rule. A program shall not be 
treated as a QSTP unless it imposes a more than de minimis penalty on 
the earnings portion of any distribution from the program that is not--
    (i) Used exclusively for qualified higher education expenses of the 
designated beneficiary;
    (ii) Made on account of the death or disability of the designated 
beneficiary;
    (iii) Made on account of the receipt of a scholarship (or allowance 
or payment described in section 135(d)(1) (B) or (C)) by the designated 
beneficiary to the extent the amount of the distribution does not 
exceed the amount of the scholarship, allowance, or payment; or
    (iv) A rollover distribution.
    (2) More than de minimis penalty--(i) In general. A penalty is more 
than de minimis if it is consistent with a program intended to assist 
individuals in saving exclusively for qualified higher education 
expenses. Except as provided in paragraph (e)(2)(ii) of this section, 
whether any particular penalty is more than de minimis depends on the 
facts and circumstances of the particular program, including the extent 
to which the penalty offsets the federal income tax benefit from having 
deferred income tax liability on the earnings portion of any 
distribution.
    (ii) Safe harbor. A penalty imposed on the earnings portion of a 
distribution is more than de minimis if it is equal to or greater than 
10 percent of the earnings.
    (3) Separate distributions. For purposes of applying the penalty, 
any single distribution described in paragraph (e)(1) of this section 
will be treated as a separate distribution and not part of a single 
aggregated annual distribution by the program, notwithstanding the 
rules under Sec. 1.529-3 and Sec. 1.529-4.
    (4) Procedures for verifying use of distributions and imposing and 
collecting penalties--(i) In general. To be treated as imposing a more 
than de minimis penalty as required in paragraph (e)(1) of this 
section, a program must implement practices and procedures to identify 
whether a distribution is subject to a penalty and collect any penalty 
that is due.
    (ii) Safe harbor. A program that falls within the safe harbor 
described in paragraphs (e)(4)(ii) (A) through (E) of this section will 
be treated as implementing practices and procedures to identify whether 
a more than de minimis penalty must be imposed as required in paragraph 
(e)(1) of this section.
    (A) Distributions treated as payments of qualified higher education 
expenses. The program treats distributions as being used to pay for 
qualified higher education expenses only if--
    (1) The distribution is made directly to an eligible educational 
institution;
    (2) The distribution is made in the form of a check payable to both 
the designated beneficiary and the eligible educational institution;
    (3) The distribution is made after the designated beneficiary 
submits substantiation to show that the distribution is a reimbursement 
for qualified higher education expenses that the designated beneficiary 
has already paid and the program has a process for reviewing the 
validity of the substantiation prior to the distribution; or
    (4) The designated beneficiary certifies prior to the distribution 
that the distribution will be expended for his or her qualified higher 
education expenses within a reasonable time after the distribution; the 
program requires the designated beneficiary to provide substantiation 
of payment of qualified higher education expenses within 30 days after 
making the distribution and has a process for reviewing the

[[Page 45028]]

substantiation; and the program retains an account balance that is 
large enough to collect any penalty owed on the distribution if valid 
substantiation is not produced.
    (B) Treatment of all other distributions. The program collects a 
penalty on all distributions not treated as made to pay qualified 
higher education expenses except where--
    (1) Prior to the distribution the program receives written third 
party confirmation that the designated beneficiary has died or become 
disabled or has received a scholarship (or allowance or payment 
described in section 135(d)(1) (B) or (C)) in an amount equal to the 
distribution; or
    (2) Prior to the distribution the program receives a certification 
from the account owner that the distribution is being made because the 
designated beneficiary has died or become disabled or has received a 
scholarship (or allowance or payment described in section 135(d)(1) (B) 
or (C)) received by the designated beneficiary (and the distribution is 
equal to the amount of the scholarship, allowance, or payment) and the 
program withholds and reserves a portion of the distribution as a 
penalty. Any penalty withheld by the program may be refunded after the 
program receives third party confirmation that the designated 
beneficiary has died or become disabled or has received a scholarship 
or allowance (or payment described in section 135(d)(1) (B) or (C)).
    (C) Refunds of penalties. The program will refund a penalty 
collected on a distribution only after the designated beneficiary 
substantiates that he or she had qualified higher education expenses 
greater than or equal to the distribution, and the program has reviewed 
the substantiation.
    (D) Documentation of amounts refunded and not used for qualified 
higher education expenses. The program requires the distributee, 
defined in Sec. 1.529-1(c), to provide a signed statement identifying 
the amount of any refunds received from eligible educational 
institutions at the end of each year in which distributions for 
qualified higher education expenses were made and of the next year.
    (E) Procedures to collect penalty. The program collects required 
penalties by retaining a sufficient balance in the account to pay the 
amount of penalty, withholding an amount equal to the penalty from a 
distribution, or collecting the penalty on a State income tax return.
    (f) Separate accounting. A program shall not be treated as a QSTP 
unless it provides separate accounting for each designated beneficiary. 
Separate accounting requires that contributions for the benefit of a 
designated beneficiary and any earnings attributable thereto must be 
allocated to the appropriate account. If a program does not ordinarily 
provide each account owner an annual account statement showing the 
total account balance, the investment in the account, earnings, and 
distributions from the account, the program must give this information 
to the account owner or designated beneficiary upon request. In the 
case of a prepaid educational arrangement or contract described in 
section 529(b)(1)(A)(i) the total account balance may be shown as 
credits or units of benefits instead of fair market value.
    (g) No investment direction. A program shall not be treated as a 
QSTP unless it provides that any account owner in, or contributor to, 
or designated beneficiary under, such program may not directly or 
indirectly direct the investment of any contribution to the program or 
directly or indirectly direct the investment of any earnings 
attributable to contributions. A program does not violate this 
requirement if a person who establishes an account with the program is 
permitted to select among different investment strategies designed 
exclusively by the program, only at the time the initial contribution 
is made establishing the account. A program will not violate the 
requirement of this paragraph (g) if it permits a person who 
establishes an account to select between a prepaid educational services 
account and an educational savings account. A program also will not 
violate the requirement of this paragraph (g) merely because it permits 
its board members, its employees, or the board members or employees of 
a contractor it hires to perform administrative services to purchase 
tuition credits or certificates or make contributions as described in 
paragraph (c) of this section.
    (h) No pledging of interest as security. A program shall not be 
treated as a QSTP unless the terms of the program or a state statute or 
regulation that governs the program prohibit any interest in the 
program or any portion thereof from being used as security for a loan. 
This restriction includes, but is not limited to, a prohibition on the 
use of any interest in the program as security for a loan used to 
purchase such interest in the program.
    (i) Prohibition on excess contributions--(1) In general. A program 
shall not be treated as a QSTP unless it provides adequate safeguards 
to prevent contributions for the benefit of a designated beneficiary in 
excess of those necessary to provide for the qualified higher education 
expenses of the designated beneficiary.
    (2) Safe harbor. A program satisfies this requirement if it will 
bar any additional contributions to an account as soon as the account 
reaches a specified account balance limit applicable to all accounts of 
designated beneficiaries with the same expected year of enrollment. The 
total contributions may not exceed the amount determined by actuarial 
estimates that is necessary to pay tuition, required fees, and room and 
board expenses of the designated beneficiary for five years of 
undergraduate enrollment at the highest cost institution allowed by the 
program.


Sec. 1.529-3  Income tax treatment of distributees.

    (a) Taxation of distributions--(1) In general. Any distribution, 
other than a rollover distribution, from a QSTP account must be 
included in the gross income of the distributee to the extent of the 
earnings portion of the distribution and to the extent not excluded 
from gross income under any other provision of chapter 1 of the 
Internal Revenue Code. If any amount of a distribution is forfeited 
under a QSTP as required by Sec. 1.529-2(e), this amount is neither 
included in the gross income of the distributee nor deductible by the 
distributee.
    (2) Rollover distributions. No part of a rollover distribution is 
included in the income of the distributee. Following the rollover 
distribution, that portion of the rollover amount that constituted 
investment in the account, defined in Sec. 1.529-1(c), of the account 
from which the distribution was made is added to the investment in the 
account of the account that received the distribution. That portion of 
the rollover amount that constituted earnings of the account that made 
the distribution is added to the earnings of the account that received 
the distribution.
    (b) Computing taxable earnings--(1) Amount of taxable earnings in a 
distribution--(i) Educational savings account. In the case of an 
educational savings account, the earnings portion of a distribution is 
equal to the product of the amount of the distribution and the earnings 
ratio, defined in Sec. 1.529-1(c). The return of investment portion of 
the distribution is equal to the amount of the distribution minus the 
earnings portion of the distribution.
    (ii) Prepaid educational services account. In the case of a prepaid 
educational services account, the earnings portion of a distribution is 
equal to the value of the credits, hours,

[[Page 45029]]

or other units of education distributed at the time of distribution 
minus the return of investment portion of the distribution. The value 
of the credits, hours, or other units of education may be based on the 
tuition waived or the cash distributed. The return of investment 
portion of the distribution is determined by dividing the investment in 
the account at the end of the year in which the distribution is made by 
the number of credits, hours, or other units of education in the 
account at the end of the calendar year (including all credits, hours, 
or other units of education distributed during the calendar year), and 
multiplying that amount by the number of credits, hours, or other units 
of education distributed during the current calendar year.
    (2) Adjustment for programs that treated distributions and earnings 
in a different manner for years beginning before January 1, 1999. For 
calendar years beginning after December 31, 1998, a QSTP must treat 
taxpayers as recovering investment in the account and earnings ratably 
with each distribution. Prior to January 1, 1999, a program may have 
treated distributions in a different manner and reported them to 
taxpayers accordingly. In order to adjust to the method described in 
this section, if distributions were treated as coming first from the 
investment in the account, the QSTP must adjust the investment in the 
account by subtracting the amount of the investment in the account 
previously treated as distributed. If distributions were treated as 
coming first from earnings, the QSTP must adjust the earnings portion 
of the account by subtracting the amount of earnings previously treated 
as distributed. After the adjustment is made, the investment in the 
account is recovered ratably in accordance with this section. If no 
previous distribution was made but earnings were treated as taxable to 
the taxpayer in the year they were allocated to the account, the 
earnings treated as already taxable are treated as additional 
contributions and added to the investment in the account.
    (3) Examples. The application of this paragraph (b) is illustrated 
by the following examples. The rounding convention used (rounding to 
three decimal places) in these examples is for purposes of illustration 
only. A QSTP may use another rounding convention as long as it 
consistently applies the convention. The examples are as follows:

    Example 1. (i) In 1998, an individual, A, opens a prepaid 
educational services account with a QSTP on behalf of a designated 
beneficiary. Through the account A purchases units of education 
equivalent to eight semesters of tuition for full-time attendance at 
a public four-year university covered by the QSTP. A contributes 
$16,000 that includes payment of processing fees to the QSTP. In 
2011 the designated beneficiary enrolls at a public four-year 
university. The QSTP makes distributions on behalf of the designated 
beneficiary to the university in August for the fall semester and in 
December for the spring semester. Tuition for full-time attendance 
at the university is $7,500 per academic year in 2011 and 2012, 
$7,875 for the academic year in 2013, and $8,200 for the academic 
year in 2014. The only expense covered by the QSTP distribution is 
tuition for four academic years. The calculations are as follows:


                        2011                                            
                                                                        
Investment in the account as of 12/31/2011..........   =         $16,000
Units in account....................................   =               8
Per unit investment.................................   =          $2,000
Units distributed in 2011...........................   =               2
Investment portion of distribution in 2011 ($2,000                      
 per unit  x  2 units)..............................   =          $4,000
Current value of two units distributed in 2011......   =          $7,500
Earnings portion of distribution in 2011 ($7,500-                       
 $4,000)............................................   =          $3,500
                                                                        
                        2012                                            
                                                                        
Investment in the account as of 12/31/2012 ($16,000-                    
 $4,000)............................................   =         $12,000
Units in account....................................   =               6
Per unit investment.................................   =          $2,000
Units distributed in 2012...........................   =               2
Investment portion of distribution in 2012 ($2,000                      
 per unit  x  2 units)..............................   =          $4,000
Current value of two units distributed in 2012......   =          $7,500
Earnings portion of distribution in 2012 ($7,500-                       
 $4,000)............................................   =          $3,500
                                                                        
                        2013                                            
                                                                        
Investment in the account as of 12/31/2013 ($12,000-                    
 $4000).............................................   =          $8,000
Units in account....................................   =               4
Per unit investment.................................   =          $2,000
Units distributed in 2013...........................   =               2
Investment portion of distribution in 2013 ($2,000                      
 per unit  x  2 units)..............................   =          $4,000
Current value of two units distributed in 2013......   =          $7,875
Earnings portion of distribution in 2013 ($7,875-                       
 $4,000)............................................   =          $3,875
                                                                        
                        2014                                            
                                                                        
Investment in the account as of 12/31/2014 ($8,000-                     
 $4000).............................................   =          $4,000
Units in account....................................   =               2
Per unit investment.................................   =          $2,000
Units distributed in 2014...........................   =               2
Investment portion of distribution in 2014 ($4,000                      
 per unit  x  2 units)..............................   =          $4,000
Current value of two units distributed in 2014......   =          $8,200
Earnings portion of distribution in 2014 ($8,200-                       
 $4,000)............................................   =          $4,200
                                                                        
          12/31/2014 (after distributions)                              
                                                                        
Investment in the account as of 12/31/2014 ($4,000-                     
 $4000).............................................   =               0
                                                                        

    (ii) In each year the designated beneficiary includes in his or 
her gross income the earnings portion of the distribution for 
tuition.
    Example 2. (i) In 1998, an individual, B, opens a college 
savings account with a QSTP on behalf of a designated beneficiary. B 
contributes $18,000 to the account that includes payment of 
processing fees to the QSTP. On December 31, 2011, the total balance 
in the account for the benefit of the designated beneficiary is 
$30,000 (including

[[Page 45030]]

distributions made during the year 2011). In 2011 the designated 
beneficiary enrolls at a four-year university. The QSTP makes 
distributions on behalf of the designated beneficiary to the 
university in August for the fall semester and in December for the 
spring semester. Tuition for full-time attendance at the university 
is $7,500 per academic year in 2011 and 2012, $7,875 for the 
academic year in 2013, and $8,200 for the academic year in 2014. The 
only expense covered by the QSTP distributions is tuition for four 
academic years. On the last day of the calendar year the account is 
allocated earnings of 5% on the total account balance on that day. 
Under the terms of the QSTP, a penalty of 15% is applied to the 
earnings not used to pay tuition. The calculations are as follows:


                        2011                                            
                                                                        
Investment in the account...........................   =         $18,000
Total account balance as of 12/31/2011..............   =         $30,000
Earnings as of 12/31/2011...........................   =         $12,000
Distributions in 2011...............................   =          $7,500
Earnings ratio for 2011 ($12,000$30,000)....   =             40%
Earnings portion of distributions in 2011 ($7,500 x                     
 .4)................................................   =          $3,000
Return of investment portion of distributions in                        
 2011 ($7,500-$3,000)...............................   =          $4,500
                                                                        
                        2012                                            
                                                                        
Investment in the account as of 12/31/2012 ($18,000-                    
 $4,500)............................................   =         $13,500
Total account balance as of 12/31/12 [($30,000-                         
 $7,500) x 105%]....................................   =         $23,625
Earnings as of 12/31/2012...........................   =         $10,125
Distributions in 2012...............................   =          $7,500
Earnings ratio for 2012 ($10,125$23,625)....   =           42.9%
Earnings portion of distributions in 2012 ($7,500 x                     
 .429)..............................................   =       $3,217.50
Return of investment portion of distributions in                        
 2012 ($7,500-$3,217.50)............................   =       $4,282.50
                                                                        
                        2013                                            
                                                                        
Investment in the account as of 12/31/2013 ($13,500-                    
 $4,282.50).........................................   =       $9,217.50
Total account balance as of 12/31/13 [($23,625-                         
 $7,500) x 105%]....................................   =      $16,931.25
Earnings as of 12/31/2013...........................   =       $7,713.75
Distributions in 2013...............................   =          $7,875
Earnings ratio for 2013                                                 
 ($7,713.75$16,931.25)......................   =           45.6%
Earnings portion of distributions in 2013 ($7,875 x                     
 .456)..............................................   =          $3,591
Return of investment portion of distributions in                        
 2013 ($7,875-$3,591)...............................   =          $4,284
                                                                        
                        2014                                            
                                                                        
Investment in the account as of 12/31/2014                              
 ($9,217.50-$4,284).................................   =       $4,933.50
Total account balance as of 12/31/14 [($16,931.25-                      
 $7,875) x 105%]....................................   =       $9,509.06
Earnings as of 12/31/2014...........................   =       $4,575.56
Distributions in 2014 for qualified higher education                    
 expenses (QHEE)....................................   =          $8,200
Distributions in 2014 not for qualified higher                          
 education expenses (Non-QHEE)......................   =       $1,309.06
Total distributions.................................   =       $9,509.06
Earnings portion of QHEE distribution in 2014                           
 [($8,200$9,509.06) x $4,575.56]............   =       $3,945.68
Return of investment portion of QHEE distribution in                    
 2014...............................................   =       $4,254.32
Earnings portion of Non-QHEE distribution subject to                    
 penalty [($1,309.06$9,509.06) x $4,575.56)]   =         $629.89
Return of investment portion of non-QHEE                                
 distribution in 2014...............................   =         $679.17
                                                                        

    (ii) In years 2011 through 2013 the designated beneficiary 
includes in gross income the earnings portion of the distributions 
for tuition. In year 2014 the designated beneficiary includes in 
gross income the earnings portion of the distribution for tuition, 
$3,945.68, plus the earnings portion of the distribution that was 
not used for tuition after reduction for the penalty, i.e. $535.41 
($629.89 minus a 15% penalty of $94.48).

    (c) Change in designated beneficiaries--(1) General rule. A change 
in the designated beneficiary of a QSTP account is not treated as a 
distribution if the new designated beneficiary is a member of the 
family of the transferor designated beneficiary. However, any change of 
designated beneficiary not described in the preceding sentence is 
treated as a distribution to the account owner, provided the account 
owner has the authority to change the designated beneficiary. For rules 
related to a change in the designated beneficiary pursuant to a 
rollover distribution see Secs. 1.529-1(c) and 1.529-3(a)(2).
    (2) Scholarship program. Notwithstanding paragraph (c)(1) of this 
section, the requirement that the new beneficiary be a member of the 
family of the transferor beneficiary shall not apply to a change in 
designated beneficiary of an interest in a QSTP account purchased by a 
State or local government or an organization described in section 
501(c)(3) as part of a scholarship program.
    (d) Aggregation of accounts. If an individual is a designated 
beneficiary of more than one account under a QSTP, the QSTP shall treat 
all contributions and earnings as allocable to a single account for 
purposes of calculating the earnings portion of any distribution from 
that QSTP. For purposes of determining the effect of the distribution 
on each account, the earnings portion and return of investment in the 
account portion of the distribution shall be allocated pro rata among 
the accounts based on total account value as of the close of the 
current calendar year.


Sec. 1.529-4  Time, form, and manner of reporting distributions from 
QSTPs and backup withholding.

    (a) Taxable distributions. The portion of any distribution made 
during the calendar year by a QSTP that represents earnings shall be 
reported by the payor as described in this section.
    (b) Requirement to file return--(1) Form of return. A payor must 
file a return required by this section on Form 1099-G. A payor may use 
forms containing provisions similar to Form 1099-G if it complies with 
applicable revenue procedures relating to substitute Forms 1099. A 
payor must file a separate return for each distributee who receives a 
taxable distribution.
    (2) Payor. For purposes of this section, the term ``payor'' means 
the officer or employee having control of the program, or their 
designee.
    (3) Information included on return. A payor must include on Form 
1099-G--
    (i) The name, address, and taxpayer identifying number (TIN) (as 
defined in section 7701(a)(41)) of the payor;

[[Page 45031]]

    (ii) The name, address, and TIN of the distributee;
    (iii) The amount of earnings distributed to the distributee in the 
calendar year; and
    (iv) Any other information required by Form 1099-G or its 
instructions.
    (4) Time and place for filing return. A payor must file any return 
required by this paragraph (b) on or before February 28 of the year 
following the calendar year in which the distribution is made. A payor 
must file the return with the IRS office designated in the instructions 
for Form 1099-G.
    (5) Returns required on magnetic media. If a payor is required to 
file at least 250 returns during the calendar year, the returns must be 
filed on magnetic media. If a payor is required to file fewer than 250 
returns, the prescribed paper form may be used.
    (6) Extension of time to file return. For good cause, the 
Commissioner may grant an extension of time in which to file Form 1099-
G for reporting taxable earnings under section 529. The application for 
extension of time must be submitted in the manner prescribed by the 
Commissioner.
    (c) Requirement to furnish statement to the distributee--(1) In 
general. A payor that must file a return under paragraph (b) of this 
section must furnish a statement to the distributee. The requirement to 
furnish a statement to the distributee will be satisfied if the payor 
provides the distributee with a copy of the Form 1099-G (or a 
substitute statement that complies with applicable revenue procedures) 
containing all the information filed with the Internal Revenue Service 
and all the legends required by paragraph (c)(2) of this section by the 
time required by paragraph (c)(3) of this section.
    (2) Information included on statement. A payor must include on the 
statement that it must furnish to the distributee--
    (i) The information required under paragraph (b)(3) of this 
section;
    (ii) The telephone number of a person to contact about questions 
pertaining to the statement; and
    (iii) A legend as required on the official Internal Revenue Service 
Form 1099-G.
    (3) Time for furnishing statement. A payor must furnish the 
statement required by paragraph (c)(1) of this section to the 
distributee on or before January 31 of the year following the calendar 
year in which the distribution was made. The statement will be 
considered furnished to the distributee if it is mailed to the 
distributee's last known address.
    (4) Extension of time to furnish statement. For good cause, the 
Commissioner may grant an extension of time to furnish statements to 
distributees of taxable earnings under section 529. The application for 
extension of time must be submitted in the manner prescribed by the 
Commissioner.
    (d) Backup withholding. Distributions from a QSTP are not subject 
to backup withholding.
    (e) Effective date. The reporting requirements set forth in this 
section apply to distributions made after December 31, 1998.


Sec. 1.529-5  Estate, gift, and generation-skipping transfer tax rules 
relating to qualified State tuition programs.

    (a) Gift and generation-skipping transfer tax treatment of 
contributions after August 20, 1996, and before August 6, 1997. A 
contribution on behalf of a designated beneficiary to a QSTP (or to a 
program that meets the transitional rule requirements under Sec. 1.529-
6(b)) after August 20, 1996, and before August 6, 1997, is not treated 
as a taxable gift. The subsequent waiver of qualified higher education 
expenses of a designated beneficiary by an educational institution (or 
the subsequent payment of higher education expenses of a designated 
beneficiary to an educational institution) under a QSTP is treated as a 
qualified transfer under section 2503(e) and is not treated as a 
transfer of property by gift for purposes of section 2501. As such, the 
contribution is not subject to the generation-skipping transfer tax 
imposed by section 2601.
    (b) Gift and generation-skipping transfer tax treatment of 
contributions after August 5, 1997--(1) In general. A contribution on 
behalf of a designated beneficiary to a QSTP (or to a program that 
meets the transitional rule requirements under Sec. 1.529-6(b)) after 
August 5, 1997, is a completed gift of a present interest in property 
under section 2503(b) from the person making the contribution to the 
designated beneficiary. As such, the contribution is eligible for the 
annual gift tax exclusion provided under section 2503(b). 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. A contribution to a QSTP after August 5, 
1997, is not treated as a qualified transfer within the meaning of 
section 2503(e).
    (2) Contributions that exceed the annual exclusion amount. (i) 
Under section 529(c)(2)(B) a donor may elect to take certain 
contributions to a QSTP into account ratably over a five year period in 
determining the amount of gifts made during the calendar year. The 
provision is applicable only with respect to contributions not in 
excess of five times the section 2503(b) exclusion amount available in 
the calendar year of the contribution. Any excess may not be taken into 
account ratably and is treated as a taxable gift in the calendar year 
of the contribution.
    (ii) The election under section 529(c)(2)(B) may be made by a donor 
and his or her spouse with respect to a gift considered to be made one-
half by each spouse under section 2513.
    (iii) The election is made on Form 709, Federal Gift Tax Return, 
for the calendar year in which the contribution is made.
    (iv) If in any year after the first year of the five year period 
described in section 529(c)(2)(B), the amount excludible under section 
2503(b) is increased as provided in section 2503(b)(2), the donor may 
make an additional contribution in any one or more of the four 
remaining years up to the difference between the exclusion amount as 
increased and the original exclusion amount for the year or years in 
which the original contribution was made.
    (v) Example. The application of this paragraph (b)(2) is 
illustrated by the following example:

    Example. In Year 1, when the annual exclusion under section 
2503(b) is $10,000, P makes a contribution of $60,000 to a QSTP for 
the benefit of P's child, C. P elects under section 529(c)(2)(B) to 
account for the gift ratably over a five year period beginning with 
the calendar year of contribution. P is treated as making an 
excludible gift of $10,000 in each of Years 1 through 5 and a 
taxable gift of $10,000 in Year 1. In Year 3, when the annual 
exclusion is increased to $12,000, P makes an additional 
contribution for the benefit of C in the amount of $8,000. P is 
treated as making an excludible gift of $2,000 under section 
2503(b); the remaining $6,000 is a taxable gift in Year 3.

    (3) Change of designated beneficiary or rollover. (i) A transfer 
which occurs by reason of a change in the designated beneficiary, or a 
rollover of credits or account balances from the account of one 
beneficiary to the account of another beneficiary, is not a taxable 
gift and is not subject to the generation-skipping transfer tax if the 
new beneficiary is a member of the family of the old beneficiary, as 
defined in Sec. 1.529-1(c), and is assigned to the same generation as 
the old beneficiary, as defined in section 2651.

[[Page 45032]]

    (ii) A transfer which occurs by reason of a change in the 
designated beneficiary, or a rollover of credits or account balances 
from the account of one beneficiary to the account of another 
beneficiary, will be treated as a taxable gift by the old beneficiary 
to the new beneficiary if the new beneficiary is assigned to a lower 
generation than the old beneficiary, as defined in section 2651, 
regardless of whether the new beneficiary is a member of the family of 
the old beneficiary. The transfer will be subject to the generation-
skipping transfer tax if the new beneficiary is assigned to a 
generation which is two or more levels lower than the generation 
assignment of the old beneficiary. The five year averaging rule 
described in paragraph (b)(2) of this section may be applied to the 
transfer.
    (iii) Example. The application of this paragraph (b)(3) is 
illustrated by the following example:

    Example. In Year 1, P makes a contribution to a QSTP on behalf 
of P's child, C. In Year 4, P directs that a distribution from the 
account for the benefit of C be made to an account for the benefit 
of P's grandchild, G. The rollover distribution is treated as a 
taxable gift by C to G, because, under section 2651, G is assigned 
to a generation below the generation assignment of C.

    (c) Estate tax treatment for estates of decedents dying after 
August 20, 1996, and before June 9, 1997. The gross estate of a 
decedent dying after August 20, 1996, and before June 9, 1997, includes 
the value of any interest in any QSTP which is attributable to 
contributions made by the decedent to such program on behalf of a 
designated beneficiary.
    (d) Estate tax treatment for estates of decedents dying after June 
8, 1997--(1) In general. Except as provided in paragraph (d)(2) of this 
section, the gross estate of a decedent dying after June 8, 1997, does 
not include the value of any interest in a QSTP which is attributable 
to contributions made by the decedent to such program on behalf of any 
designated beneficiary.
    (2) Excess contributions. In the case of a decedent who made the 
election under section 529(c)(2)(B) and paragraph (b)(3)(i) of this 
section who dies before the close of the five year period, that portion 
of the contribution allocable to calendar years beginning after the 
date of death of the decedent is includible in the decedent's gross 
estate.
    (3) Designated beneficiary decedents. The gross estate of a 
designated beneficiary of a QSTP includes the value of any interest in 
the QSTP.


Sec. 1.529-6  Transition rules.

    (a) Effective date. Section 529 is effective for taxable years 
ending after August 20, 1996, and applies to all contracts entered into 
or accounts opened on August 20, 1996, or later.
    (b) Programs maintained on August 20, 1996. Transition relief is 
available to a program maintained by a State under which persons could 
purchase tuition credits, certification or similar rights on behalf of, 
or make contributions for educational expenses of, a designated 
beneficiary if the program was in existence on August 20, 1996. Such 
program must meet the requirements of a QSTP before the later of August 
20, 1997, or the first day of the first calendar quarter after the 
close of the first regular session of the State legislature that begins 
after August 20, 1996. If a State has a two-year legislative session, 
each year of such session shall be deemed to be a separate regular 
session of the State legislature. The program, as in effect on August 
20, 1996, shall be treated as a QSTP with respect to contributions (and 
earnings allocable thereto) pursuant to contracts entered into under 
the program. This relief is available for contributions (and earnings 
allocable thereto) made before, and the contracts entered into before, 
the first date on which the program becomes a QSTP. The provisions of 
the program, as in effect on August 20, 1996, shall apply in lieu of 
section 529(b) with respect to such contributions and earnings. A 
program shall be treated as meeting the transition rule if it conforms 
to the requirements of section 529, Secs. 1.529-1 through 1.529-5 and 
this section by the date this document is published as final 
regulations in the Federal Register.
    (c) Retroactive effect. No income tax liability will be asserted 
against a QSTP for any period before the program meets the requirements 
of section 529, Secs. 1.529-1 through 1.529-5 and this section if the 
program qualifies for the transition relief described in paragraph (b) 
of this section.
    (d) Contracts entered into and accounts opened before August 20, 
1996--(1) In general. A QSTP may continue to maintain agreements in 
connection with contracts entered into and accounts opened before 
August 20, 1996, without jeopardizing its tax exempt status even if 
maintaining the agreements is contrary to section 529(b) provided that 
the QSTP operates in accordance with the restrictions contained in this 
paragraph (d). However, distributions made by the QSTP, regardless of 
the terms of any agreement executed before August 20, 1996, are subject 
to tax according to the rules of Sec. 1.529-3 and subject to the 
reporting requirements of Sec. 1.529-4.
    (2) Interest in program pledged as security for a loan. An interest 
in the program, or a portion of an interest in the program, may be used 
as security for a loan if the contract giving rise to the interest was 
entered into or account was opened prior to August 20, 1996 and the 
agreement permitted such a pledge.
    (3) Member of the family. In the case of an account opened or a 
contract entered into before August 20, 1996, the rules regarding a 
change in beneficiary, including the rollover rule in Sec. 1.529-3(a) 
and the gift tax rule in Sec. 1.529-5(b)(3), shall be applied by 
treating any transferee beneficiary permitted under the terms of the 
account or contract as a member of the family of the transferor 
beneficiary.
    (4) Eligible educational institution. In the case of an account 
opened or contract entered into before August 20, 1996, an eligible 
educational institution is an educational institution in which the 
beneficiary may enroll under the terms of the account or contract.
Michael P. Dolan,
Deputy Commissioner of Internal Revenue.
[FR Doc. 98-22465 Filed 8-21-98; 8:45 am]
BILLING CODE 4830-01-U