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By Deborah M. Beers, Esq.
Buchanan Ingersoll & Rooney, PC, Washington, DC
In Karlen v. Comr.,1 the Tax Court, in a summary opinion that may not be appealed or cited as precedent,2 determined that distributions from the taxpayers' §529 plan accounts were includible in their gross income. The taxpayers were not, however, liable for the 10% penalty that is imposed on withdrawals not used for educational expenses.
Facts. During 2008, taxpayer Timothy John Karlen ("Taxpayer") and his spouse maintained an investment account with the North Carolina 529 Plan ("NC 529 Plan") for each of their three children. The NC 529 Plan is a qualified tuition program ("QTP") as defined in §529(b).
Also during 2008, Taxpayer, like many of his contemporaries, "started to experience financial difficulty when his income decreased because of the downturn in the national economy." To alleviate this difficulty, on September 4, 2008, Taxpayer requested distributions of $3,500 from each of his children's investment accounts in order to obtain additional cash to pay household and other living expenses. On the application forms, Taxpayer selected "Non-Qualified Withdrawal" rather than "Withdrawal for Rollover" as his reason for requesting the distributions. The NC 529 Plan issued the distributions to Taxpayer, mailing three checks, each dated September 9, 2008.
After consulting with his wife, Taxpayer changed his mind about withdrawing the funds from the accounts.
However, although Taxpayer informed the NC 529 Plan that he no longer wished to take the requested distributions, a representative for the NC 529 Plan informed Taxpayer that because no error had been made by the plan in processing his applications for distributions, the transactions could not be voided. The representative instructed Taxpayer to endorse the three checks and return them if he wished to redeposit the amounts, which Taxpayer did.
On September 19, 2008 (10 days after the checks were issued), the NC 529 Plan received the three checks and redeposited each one as a new, current-day contribution into the same account from which it had been withdrawn. Thereafter, Taxpayer received a Form 1099-Q, Payments From Qualified Education Programs (Under Sections 529 and 530), from the NC 529 Plan for each of the three distributions that he had received.
Law. Generally, distributions from a §529 QTP are includible in the distributee's gross income in the year of distribution and are taxed under the provisions of §72 dealing with annuity payments.3 There are, however, three ways to exclude a §529 QTP distribution from gross income: first, the distribution is excludible to the extent used for the payment of qualified higher education expenses paid by the distributee;4 second, the distribution is excludible to the extent that it is an "in-kind" distribution that consists of providing a benefit to the distributee which, if paid directly by the distributee, would constitute payment of a qualified higher education expense;5 and finally, the distribution is excludible to the extent that it is rolled over within 60 days of receipt to another QTP for the benefit of the original beneficiary or to the credit of a different beneficiary who is a member of the family of the original beneficiary.6
The Decision. In Karlen, Taxpayer asserted that, because he did not cash or deposit the checks with his bank, he never received the distributions. The court, however, found that Taxpayer, as a cash method taxpayer, had "constructively received" the distributions when the checks were received. Taxpayer's assertion, however, was misplaced. For taxpayers who use the cash receipts and disbursements method of accounting, such as Taxpayer, an item is includible in gross income in the year in which the item is actually or constructively received.7 "Accordingly, [Taxpayer] received the funds even though [he] did not cash or deposit the distribution checks."
The court also rejected Taxpayer's contention that the distributions were "rolled over" and were therefore not taxable. However, Taxpayer admitted that he requested the distributions because he needed cash to pay household expenses and that he never contemplated any rollover of the distributions. "Indeed, on Taxpayer's request forms he selected `Non-Qualified Withdrawal' rather than `Withdrawal for Rollover' as his reason for taking the distributions."
The court noted that:
[Taxpayers] are `bound by the consequences of * * * [their] transaction as structured, even if hindsight reveals a more favorable tax treatment.'8 … Although we may be sympathetic to the circumstances surrounding Taxpayer's decision to request the distributions, we may not restructure the transaction as a rollover simply to produce a favorable result to Taxpayers. Because no distribution was transferred either to a different QTP for the benefit of the original beneficiary or to the credit of a different beneficiary who is a member of the original beneficiary's family, there was no rollover …
The court did find, however, in what appears to be a case of first impression, that Taxpayer was not liable for the §529(c)(6)9 10% penalty tax on distributions not "used" for educational purposes. In this case, the court observed, Taxpayer never "used" the distributions at all. Instead, when he received the distribution checks in the mail he immediately returned them for redeposit into his childrens' education investment accounts. Thus:
Congress granted tax-exempt status to education investment accounts `To encourage families and students to save for future education expenses.' … To impose a 10-percent additional tax upon petitioners given the unique facts in this case `would be like throwing salt into a wound.' … Although the distributions received are includable in petitioners' gross income, "doubt exists in our mind as to whether the * * * [additional tax] was designed to cover the situation involved herein." … We are mindful that `A particular construction must not produce inequality and injustice if another and more reasonable interpretation is possible.' … Because petitioners never used the distributions and instead immediately returned the distribution checks to the NC 529 Plan to save for their childrens' future educational expenses, `we think it judicious to resolve this issue in favor of' petitioners given their unique situation… . Consequently, we hold that the 10-percent additional tax does not apply. [Citations omitted.]
Comment. We note that there are no ameliorative provisions under §529(c) similar to those under §408(d) (regarding the effect of failing to make a rollover of a retirement plan distribution within 60-days of receipt). Under §408(d)(3)(I), the Secretary may waive the 60-day requirement where the failure to waive such requirement would be "against equity or good conscience," including casualty, disaster, or other events beyond the reasonable control of the individual subject to such requirement.
Rev. Proc. 2003-1610 provides that, in determining whether to grant a waiver of the 60-day rollover requirement pursuant to §408(d)(3)(I), the IRS will consider all relevant facts and circumstances, including: (1) errors committed by a financial institution; (2) inability to complete a rollover due to death, disability, hospitalization, incarceration, restrictions imposed by a foreign country or postal error, (3) the use of the amount distributed (for example, in the case of payment by check, whether the check was cashed); and (4) the time elapsed since the distribution occurred. (Emphasis supplied.)
The decision in Karlen appears to have reached a similar result - at least with respect to the penalty portion of the tax - as might have been reached under §408(d)(3)(I) had it been applicable to QTP distributions.11
This commentary also will appear in the March 2012 issue of the Tax Management Estates, Gifts and Trusts Journal. For more information, in the Tax Management Portfolios, see Streng, 800 T.M., Estate Planning, and in Tax Practice Series, see ¶6330, Gift Tax Exclusions, Deductions and Computation, and ¶6350, Estate Planning.
1 T.C. Summ. Opin. 2011-129 (11/10/11).
3 §529(c)(3)(A). Generally, this will mean that the taxpayer will get credit for his or her basis in the distributed amounts, and will only be taxed on the income, determined in a manner similar to the "exclusion ratio" applicable to annuity payments under §72. The court also noted that the taxpayer in Karlen should receive a basis increase for the amounts redeposited in the account that were subject to income tax as the result of the court's decision.
7 Citing §451(a); Regs. §1.451-1(a).
8 Citing Est. of Bean v. Comr., 268 F.3d 553, 557 (8th Cir. 2001), and Grojean v. Comr., 248 F.3d 572, 576 (7th Cir. 2001), aff'g T.C. Memo 2000-355.
9 Cross-referencing §530(d)(4).
10 2003-4 I.R.B. 359.
11 See also §72(t)(2) on exceptions to the 10-percent penalty tax on early distributions from qualified retirement plans.
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