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For many years, the New Jersey Division of Taxation has generally applied the Internal Revenue Code to the treatment of New Jersey estates, including the general rule of Section 529 of the Code, which states in part that, with two exceptions, no amount is includible in a decedent’s gross estate “by reason of an interest in a qualified tuition program.” Most practitioners have interpreted this to mean that qualified tuition programs (more commonly referred to as “529 accounts”) are not included in a decedent’s gross estate for New Jersey estate or inheritance tax purposes; however, it turns out that this understanding may not be true, especially with respect to the latter.

Background

Since their inception, 529 accounts have been used by families as vehicles to save tax-free money for education expenses. Although often owned by a parent or grandparent for the benefit of a child or grandchild who might later require use of the funds toward the cost of education, in certain instances the account owner and beneficiary may be of a non-lineal relationship. For example, it is not uncommon for the owner of a 529 account to be the aunt, uncle or even step-grandparent of a named beneficiary; however none of these relationships is considered by the State of New Jersey as lineal for New Jersey transfer inheritance tax purposes (or “Class A” as labeled by New Jersey) which relationships pass free of transfer inheritance tax. Rather, they are labeled as “Class D” relationships which are subject to the tax.

The significant flexibility offered by 529 accounts makes them an even more desirable mechanism for education savings. For example, contributions can be made by third parties who are not the owner or beneficiary. Moreover, ownership of an account can generally be transferred by an existing owner either during life or upon death, and beneficiary designations can also be amended with certain limitations. Therefore, it is not uncommon for a 529 account to be opened with the owner and beneficiary being of a Class A relationship; but later ownership transfers and/or changes in beneficiary resulting in a Class C or D relationship between owner and beneficiary.

NJ Inheritance and Estate Tax

Notwithstanding the prevailing wisdom that Section 529 accounts are not included in a decedent’s taxable estate, the Division has begun taking the position that at least in certain cases they are included in the taxable estate for estate tax purposes, and in all cases they are included for inheritance tax purposes unless the relationship between owner and beneficiary is Class A.

Although no formal guidance has yet been issued by the Division, practitioners are reporting being advised by the Division that where the decedent is the owner of the 529 account, the decedent retained control over the account until death, and thus it is includible as part of the decedent’s estate for inheritance tax purposes where the named beneficiary is a Class C or D beneficiary in relation to the decedent.

The Division has also advised practitioners that with respect to estate tax, for the estates of decedents dying on or before Dec. 31, 2016, when an estate tax return is prepared utilizing the simplified “Column A” method, the account is included as part of the decedent’s taxable estate. In contrast, and in a confusing attempt to be consistent with Section 529, when a “Column B” estate tax return is prepared (which requires the preparation of a 2001 Form 706, United States Estate (and Generation-Skipping Transfer) Tax Return (“2001 Form 706″)), the 529 account need not be included in the decedent’s estate and thus may be excluded from the contents of the estate tax return entirely. Because the Division is still preparing its new estate tax return for 2017, which is expected to eliminate Column A and Column B options, it is unclear if and when a 529 account may be included for New Jersey estate tax purposes in 2017.

In addition, certain financial institutions are reporting that a New Jersey estate and inheritance tax waiver must be obtained for all 529 accounts, including those on which the named beneficiary is a Class A beneficiary in relation to the owner. In such a situation where the beneficiary is Class A, a waiver may apparently be obtained either by: (a) completing Form L-8, assuming the circumstances for a Form L-8 are otherwise appropriate (for example, the taxable estate must be less than $675,000 for the estates of decedents dying in 2016 or earlier, or $2 million for the estates of decedents dying in 2017); or (b) if use of the Form L-8 is not appropriate and a New Jersey estate tax return is required, requesting Form 0-1 on the appropriate waiver request schedule attached to the return (even if the 529 account is not required to be disclosed elsewhere on the return, such as when utilizing a Column B filing method for the estate of a decedent who died on or before Dec. 31, 2016). Although not required, it is recommended that if requesting Form 0-1 on a waiver request schedule for an account not otherwise required to be disclosed on the return, the practitioner still disclose the existence of the account on the appropriate schedule for bank accounts on the estate tax return, but with a $0 value for estate tax purposes.

Potential Complications

The Division’s position with respect to 529 accounts has raised certain academic issues which as of the writing of this article have yet to be clarified. For one, while contributions to the 529 account might be a completed gift of the donor pursuant to Section 529, the Division apparently considers these contributions in specific circumstances as part of the 529 account owner’s taxable estate, arguably even if certain contributions made by the owner have already been included in the calculation of the inheritance tax (or for estates of decedents dying on or before Dec. 31, 2016, estate tax owed), by reason that certain adjusted taxable gifts must be included for purposes of calculating the tax liability, thus potentially resulting in double taxation. Furthermore, if the contribution to a 529 account is an adjusted taxable gift made by a third-party donor and not the owner, it seems unjust, but apparent, that the contribution would still be included in the 529 account owner’s taxable estate, despite that it could separately result in further estate or inheritance tax ramifications in the estate of said third-party donor by way of the treatment of such gifts in calculating the tax liability.

Example

Imagine an adult brother and sister. The brother is divorced and the owner of the 529 account for the benefit of his son. Suddenly, the brother passes away, designating his sister as the new owner of the 529 account for the benefit of his child. Because the relationship between father and son is Class A there is no New Jersey inheritance tax owed upon the brother’s death. However, imagine if one year later the sister dies. Now, because the relationship between aunt and nephew is Class D, the Division could assess a tax of 15 to 16 percent over the amount held in the 529 account, including all contributions made by the brother and other relatives and friends. Applying the issues outlined above, things become even more complicated if the sister had, within three years of her demise, made an adjusted taxable gift of her own to the 529 account, as not only might the entire balance of the account be included in her estate for New Jersey inheritance tax purposes (because she retained control over the account until her death), but the valuation of the account would include her adjusted taxable gift which amount arguably might be required to be included separately (again, because it is a transfer within three years of death) which could potentially result in double taxation.

Because this treatment of 529 accounts appears to be a relatively new position of the Division, all of the ramifications have not yet been identified. Therefore, until formal guidance is issued by the Division, it is recommended that practitioners advise resident clients that 529 accounts for the benefit of Class C or D beneficiaries will likely trigger New Jersey inheritance tax, and for a decedent dying in 2017 with a gross estate over $2 million, potentially New Jersey estate tax as well, depending on the Division’s treatment of 529 accounts for 2017 taxable estates, which remains to be seen.•

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For many years, the New Jersey Division of Taxation has generally applied the Internal Revenue Code to the treatment of New Jersey estates, including the general rule of Section 529 of the Code, which states in part that, with two exceptions, no amount is includible in a decedent’s gross estate “by reason of an interest in a qualified tuition program.” Most practitioners have interpreted this to mean that qualified tuition programs (more commonly referred to as “529 accounts”) are not included in a decedent’s gross estate for New Jersey estate or inheritance tax purposes; however, it turns out that this understanding may not be true, especially with respect to the latter.

Background

Since their inception, 529 accounts have been used by families as vehicles to save tax-free money for education expenses. Although often owned by a parent or grandparent for the benefit of a child or grandchild who might later require use of the funds toward the cost of education, in certain instances the account owner and beneficiary may be of a non-lineal relationship. For example, it is not uncommon for the owner of a 529 account to be the aunt, uncle or even step-grandparent of a named beneficiary; however none of these relationships is considered by the State of New Jersey as lineal for New Jersey transfer inheritance tax purposes (or “Class A” as labeled by New Jersey) which relationships pass free of transfer inheritance tax. Rather, they are labeled as “Class D” relationships which are subject to the tax.

The significant flexibility offered by 529 accounts makes them an even more desirable mechanism for education savings. For example, contributions can be made by third parties who are not the owner or beneficiary. Moreover, ownership of an account can generally be transferred by an existing owner either during life or upon death, and beneficiary designations can also be amended with certain limitations. Therefore, it is not uncommon for a 529 account to be opened with the owner and beneficiary being of a Class A relationship; but later ownership transfers and/or changes in beneficiary resulting in a Class C or D relationship between owner and beneficiary.

NJ Inheritance and Estate Tax

Notwithstanding the prevailing wisdom that Section 529 accounts are not included in a decedent’s taxable estate, the Division has begun taking the position that at least in certain cases they are included in the taxable estate for estate tax purposes, and in all cases they are included for inheritance tax purposes unless the relationship between owner and beneficiary is Class A.

Although no formal guidance has yet been issued by the Division, practitioners are reporting being advised by the Division that where the decedent is the owner of the 529 account, the decedent retained control over the account until death, and thus it is includible as part of the decedent’s estate for inheritance tax purposes where the named beneficiary is a Class C or D beneficiary in relation to the decedent.

The Division has also advised practitioners that with respect to estate tax, for the estates of decedents dying on or before Dec. 31, 2016, when an estate tax return is prepared utilizing the simplified “Column A” method, the account is included as part of the decedent’s taxable estate. In contrast, and in a confusing attempt to be consistent with Section 529, when a “Column B” estate tax return is prepared (which requires the preparation of a 2001 Form 706, United States Estate (and Generation-Skipping Transfer) Tax Return (“2001 Form 706″)), the 529 account need not be included in the decedent’s estate and thus may be excluded from the contents of the estate tax return entirely. Because the Division is still preparing its new estate tax return for 2017, which is expected to eliminate Column A and Column B options, it is unclear if and when a 529 account may be included for New Jersey estate tax purposes in 2017.

In addition, certain financial institutions are reporting that a New Jersey estate and inheritance tax waiver must be obtained for all 529 accounts, including those on which the named beneficiary is a Class A beneficiary in relation to the owner. In such a situation where the beneficiary is Class A, a waiver may apparently be obtained either by: (a) completing Form L-8, assuming the circumstances for a Form L-8 are otherwise appropriate (for example, the taxable estate must be less than $675,000 for the estates of decedents dying in 2016 or earlier, or $2 million for the estates of decedents dying in 2017); or (b) if use of the Form L-8 is not appropriate and a New Jersey estate tax return is required, requesting Form 0-1 on the appropriate waiver request schedule attached to the return (even if the 529 account is not required to be disclosed elsewhere on the return, such as when utilizing a Column B filing method for the estate of a decedent who died on or before Dec. 31, 2016). Although not required, it is recommended that if requesting Form 0-1 on a waiver request schedule for an account not otherwise required to be disclosed on the return, the practitioner still disclose the existence of the account on the appropriate schedule for bank accounts on the estate tax return, but with a $0 value for estate tax purposes.

Potential Complications

The Division’s position with respect to 529 accounts has raised certain academic issues which as of the writing of this article have yet to be clarified. For one, while contributions to the 529 account might be a completed gift of the donor pursuant to Section 529, the Division apparently considers these contributions in specific circumstances as part of the 529 account owner’s taxable estate, arguably even if certain contributions made by the owner have already been included in the calculation of the inheritance tax (or for estates of decedents dying on or before Dec. 31, 2016, estate tax owed), by reason that certain adjusted taxable gifts must be included for purposes of calculating the tax liability, thus potentially resulting in double taxation. Furthermore, if the contribution to a 529 account is an adjusted taxable gift made by a third-party donor and not the owner, it seems unjust, but apparent, that the contribution would still be included in the 529 account owner’s taxable estate, despite that it could separately result in further estate or inheritance tax ramifications in the estate of said third-party donor by way of the treatment of such gifts in calculating the tax liability.

Example

Imagine an adult brother and sister. The brother is divorced and the owner of the 529 account for the benefit of his son. Suddenly, the brother passes away, designating his sister as the new owner of the 529 account for the benefit of his child. Because the relationship between father and son is Class A there is no New Jersey inheritance tax owed upon the brother’s death. However, imagine if one year later the sister dies. Now, because the relationship between aunt and nephew is Class D, the Division could assess a tax of 15 to 16 percent over the amount held in the 529 account, including all contributions made by the brother and other relatives and friends. Applying the issues outlined above, things become even more complicated if the sister had, within three years of her demise, made an adjusted taxable gift of her own to the 529 account, as not only might the entire balance of the account be included in her estate for New Jersey inheritance tax purposes (because she retained control over the account until her death), but the valuation of the account would include her adjusted taxable gift which amount arguably might be required to be included separately (again, because it is a transfer within three years of death) which could potentially result in double taxation.

Because this treatment of 529 accounts appears to be a relatively new position of the Division, all of the ramifications have not yet been identified. Therefore, until formal guidance is issued by the Division, it is recommended that practitioners advise resident clients that 529 accounts for the benefit of Class C or D beneficiaries will likely trigger New Jersey inheritance tax, and for a decedent dying in 2017 with a gross estate over $2 million, potentially New Jersey estate tax as well, depending on the Division’s treatment of 529 accounts for 2017 taxable estates, which remains to be seen.•

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