Taxation of Prepaid Tuition Plans and the 1997 Tax Provisions - Middle Class Panacea or Placebo? Continuing Problems and Variations on a Theme

This article addresses the continuing tax issues and policies attendant to one form of financing the costs of higher education -- prepaid tuition plans. These plans generally allow one to purchase tuition in advance for future use. One attraction of such a plan is that the purchaser can lock in tuition at present rates, thus protecting against inflation and other tuition hikes. Moreover, favorable tax treatment exists as the build up of benefits is generally tax-free to the purchaser, which provides a significant advantage over other savings programs. Although prepaid tuition plans have been in existence for a number of years,8 they have become particularly noteworthy in light of three recent developments, which will be addressed in this article. The first development involves the taxability of the plan\u27s investment income in light of the recent case, State of Mich. V. United States involving the Michigan Education Trust, and holding the trust exempt from tax on its annual investment income. Although the Sixth Circuit\u27s divided opinion drew strong criticism, Congress essentially codified the result in new Internal Revenue Code Section 529, as enacted in the Small Business Tax Act of 1996. The second issue involves the question of whether the prepaid tuition contracts are contingent debt obligations, and as such, subject to the original issue discount rules. In recently promulgated regulations, the Treasury ruled that prepaid tuition plans are not debt subject to the original issue discount rules. The final development very much reflects the prevailing political and policy winds flowing from the first two developments. This last development concerns President Clinton\u27s recently-enacted education initiatives, which include a higher-education tax credit and an educational savings account