Federal tax advantages for qualified state tuition programs.

• Author: Herskovitz, Donald L.

The Small Business Job Protection Act of 1996 (SBJPA), enacted Aug. 20, 1996, substantially enhances the attractiveness of college prepaid tuition programs. Previously, 12 states had established some form of a prepaid tuition program for their residents. Until the SBJPA, the IRS had refused to allow a Federal tax exemption for the investment income build-up in the trust established to pay for the plan, causing many states to postpone adopting such programs. In addition, uncertainties as to the application of the original issue discount (OID) contingent payment regulations to the plans raised the possibility that plan purchasers or beneficiaries might be taxed on income prior to any actual distribution of tuition payments.

The new law allows states to create a tax-exempt qualified state tuition program (QSTP) and provides other important tax advantages for investing in QSTPs. These tax benefits should boost the availability and popularity of QSTPs. Many states must modify their existing programs to comply with the new law, but others are likely to establish new QSTPs. Tax advisers will be called on to provide tax, estate or financial planning advice to clients regarding their states, QSTPs.

Background

In Michigan v. United States, 40 F3d 817 (1994), the Sixth Circuit held that the Michigan Education Trust (Trust), an entity created by the State of Michigan to operate a prepaid tuition payment program, was an integral part of the state and, thus, the investment income realized by the Trust was not currently subject to Federal income tax. The Trust was established to receive advance payments of college tuition, invest the money, and ultimately make disbursements under a program that allowed beneficiaries to attend any of the states public colleges or universities without further tuition costs for a year or more (depending on the terms of the contract). However, IRS personnel generally believed this case to be wrongly decided, and refused to issue letter rulings allowing such an exemption for other state prepaid tuition plans. In addition, Service personnel indicated in conferences on these rulings that possibly the then recently proposed contingent payment OID regulations might apply to the plans. If so, purchasers or beneficiaries would have to include income from the prepaid tuition plan program prior to any payment from the program.

On June 11, 1996, the Treasury Department issued final regulations specifically providing that the OID...