Education Credit

[Christian]

The summer has been blissfully uneventful until now. A client has a daughter who has been in university for three years. I computed the American Opportunity Credit for him as I have done for the prior two years. He just received a notice disallowing the entire credit until he can show proof that he and wife paid the tuition and related expenses to the university. The university sent him the required Form 1098-T with box 1 clearly showing what amount was paid. He has cancelled checks for part of his daughter's expenses but much of her tuition was paid directly from a 529 plan which he paid into for her over a number of years. I am wondering if a letter from the university verifying that the couple paid them the amount indicated in box 1 of the form would suffice. Any info would be appreciated. He has checks for an amount much greater than the $4000 allowed for computing the credit and I am wondering if this would do the trick as well.

[Yardley CPA]

How were the 529's set up?  There are different options on who can receive the disbursements from the plan.  I believe they can be set up so that the distributions can go to:

• Account Owner
• Beneficiary
• Directly to the School

In some instances, the owner can pay the school and other expenses and then reimburse themselves.

In any event, a letter from the school (assuming they are willing to provide this), cancelled checks and 529 statements should all help in proving the payment was made.

Good luck and please keep us posted on how this goes.

[SaraEA]

Last summer we got at least a half-dozen of these letters, all for clients who had 529 distributions (some made too much to even get an ed credit).  You can't double dip--expenses used for the education credit must be deducted from the "qualifying ed expenses" used to account for the 529 distribution.  Of course, the 529 allows expenses for room and board that can't be used for the credit, so hopefully the remaining amount of the distribution can be accounted for with those.  You need to show that the qualifying expenses used for the credit were paid, and that the distribution from the 529 was used for other qualifying expenses.

One of my clients took out exactly the amount of education expenses from the 529, to the penny.  Deducting the $4k used for the credit resulted in an excess distribution.   Fortunately no penalty applied because the $4k was used for the credit.

[Tax Prep by Deb]

I had a client who got that letter last year.  She did not have any 529 plan.  By the time I got the letter she had one day to respond, so I had her call to get an extension so she could pull her records and the IRS Agent pulled up her account to and could see no reason for the letter and told her everything was fine.  Never heard anything else since.  So it's worth a try to call and ask?

[Catherine]

You can also take the 529 plan money as taxable income - sometimes paying the income tax and then getting the credit works out enough better to make it worthwhile.  If that was done, you'll also have to show the taxable income on Line 21 from the 529 plan distribution.

[Christian]

Thanks to all for your replies. The client produced his Form 1099-Q from his 529 plan. The funds were a direct transfer from the plan to the university. The university had reported the tuition CHARGES on line 2 of the Form 1098-T (my mistake) hence the IRS did not know if that amount had been paid by the client. We are sending them a copy of his Form 1099-Q and a cover letter. They may come back and ask proof that the funds were paid for tuition which since the tuition charges were greater than the amount paid by the plan I would not expect but knowing the Service I am preparing for that possibility. I will need to make sure any Forms 1098-T I get in future show the amounts in box 1 or this will likely happen again. Whether a college will cooperate with such a request is another question.

[RitaB]

On ‎8‎/‎30‎/‎2017 at 2:56 PM, Christian said:

The summer has been blissfully uneventful until now. A client has a daughter who has been in university for three years. I computed the American Opportunity Credit for him as I have done for the prior two years.

 

47 minutes ago, Christian said:

We are sending them a copy of his Form 1099-Q and a cover letter.

 

On ‎8‎/‎30‎/‎2017 at 8:34 PM, SaraEA said:

You can't double dip--expenses used for the education credit must be deducted from the "qualifying ed expenses" used to account for the 529 distribution. 

 

Christian, forgive me if I'm being presumptuous, but did you get the part about not double-dipping?  If earnings in the 529 plan escape taxation, they can't be used for any other education credit or deduction.  You did indicate that the tuition BILLED was more than the 529 distributions, but that could be because there are charges for 2017 in Box 2.  (See if Box 7 is checked.)  Ultimately, they want to know what got PAID during 2016, and whether or not it got paid with after tax funds.  (I think we're talking about 2016, if not, adjust accordingly.)

[Catherine]

1 hour ago, RitaB said:

Ultimately, they want to know what got PAID during 2016,

Printouts from the Bursar's Office can be a huge help here - I demand them from all my clients with education expenses.  (And they're getting better about actually getting them for me, too.)

[Christian]

Thanks Catherine I may  have to ask the client to obtain that from the college.

[Christian]

I think I got this resolved. It seems to me the university by reporting the tuition amount as billed in box 2 of the client's 1098-T instead of showing it in box 1 indicating it as paid caused this problem. In any event the client had enough money in basis in his 529 distribution which was paid toward tuition to qualify him for the credit. However, knowing the Service they may yet ask for more info. To be brutally honest this whole matter smells of a fishing expedition on the part of the Service but time will tell. 

[SaraEA]

Christian, just about all schools report the amount billed instead of the amount paid.  When the Hope credit started in 1998, the schools complained that they couldn't get their systems ready in time to show amount paid.  Two or three years ago they were given a one-year deadline to begin reporting in Box 1, but they whined some more and got another extension.  Beginning in 2017, they finally have to comply. If it takes our institutions of higher learning almost 20 YEARS to figure out how to do a simple programming change, I have to question whether they are capable of teaching their students anything.  At any rate, our lives should be made easier starting this tax season with Box 1 filled out.

You still need transcripts in the event of 529 distributions though.  Earnings on plan distributions are tax-free if used for qualifying education expenses, but not the same expenses used for the education credits.  However, payments for room and board count as allowable expenses for plan distributions (but not for the credit).  Books are allowable expenses for both but won't be listed on the T.   Let me try an example.  Client withdraws $10k from a 529 plan.  Tuition is $5k, r&b is $4k, and books are $1k.  The ed credit uses $4k of the tuition payment.  That leaves only $6k to apply to the distribution and thus a $4k excess distribution.  The earnings on that $4k is taxable but the penalty is waived because otherwise qualifying distributions were used for the ed credit.  You calculate the earnings on the $4k by first calculating the ratio of earnings included in the distribution (Box 2 divided by box 1 on the 1099Q).  Apply the resulting percentage to the excess distribution to determine how much of it is earnings and must be reported as taxable income.  The IRS may still demand proof, which you will get by supplying the school's financial transcripts (which show r&B, which is not on the T), book receipts, and your calculations.  Good luck with those receipts.  Today's plastic generation does not know what a paper receipt is, so educate your clients who will have a college freshman in the fall to demand them.

I am sorry to go into so much detail, but your statement " In any event the client had enough money in basis in his 529 distribution which was paid toward tuition to qualify him for the credit" suggested you didn't get that you can't apply just the basis to get a tax break.  Each distribution contains both basis and earnings and you have to pro-rate the amounts applied toward each break.  This is not a witch hunt but has been a focus of the IRS for a couple of years.  Last year we had a half dozen or more such letters, including for clients who made too much to take the credit.

 

[RitaB]

1 hour ago, Christian said:

In any event the client had enough money in basis in his 529 distribution which was paid toward tuition to qualify him for the credit.

I agree with Sara.  She said it all, but since I've been working on this forever, I'm posting it anyway. 

If you're going to exclude the earnings in the 529 distribution from income, you have to use the entire distribution toward this purpose.  Let's say your earnings are 20% of the account and you withdraw $5,000.  To exclude the $1,000 of earnings from income, you have to apply $5,000 of your education expenses to the $5,000 distribution.  You can't withdraw $5,000 from the 529, exclude the $1,000 of earnings from income, and use the $4,000 of basis to pay expenses for AOC purposes.  You'd need $9,000 of expenses to both exclude the $1,000 of earnings in the distribution AND get the maximum AOC in this scenario.

Whew, I hope that makes sense to somebody besides me.  My head hurts.

[RitaB]

On ‎9‎/‎1‎/‎2017 at 1:58 PM, RitaB said:

Christian, forgive me if I'm being presumptuous, but did you get the part about not double-dipping?  If earnings in the 529 plan escape taxation, they the distribution can't be used for any other education credit or deduction.  You did indicate that the tuition BILLED was more than the 529 distributions, but that could be because there are charges for 2017 in Box 2.  (See if Box 7 is checked.)  Ultimately, they want to know what got PAID during 2016, and whether or not it got paid with after tax funds.  (I think we're talking about 2016, if not, adjust accordingly.)

If I had a nickel for every time I messed up a post, I'd have a sock full of nickels to hit people pitching 529 plans.  Just kidding.  Maybe.

[Abby Normal]

When you use 529 funds to claim an education credit, a prorated amount of the earnings can be taxable. But in my experience, the room and board costs are usually more than enough to make the earnings not taxable.

[Catherine]

2 hours ago, RitaB said:

I'd have a sock full of nickels

You don't need nickels to Rita-hug them, though!

[Gail in Virginia]

2 hours ago, RitaB said:

If I had a nickel for every time I messed up a post, I'd have a sock full of nickels to hit people pitching 529 plans.  Just kidding.  Maybe.

 

17 minutes ago, Catherine said:

You don't need nickels to Rita-hug them, though!

But the sock full of nickels can get them ready for the Rita hug, if used correctly!

 

[Christian]

We will see how it plays out. I sent the Service copies of over $9,000 in personal checks made payable to the university. Since this was out of his pocket and is not identified as to what it paid for it may resolve it altogether. Otherwise we will just have to get the university to cough up some additional info. Between tuition and room and board the client coughed up some twenty two grand in all. So if we need to argue about it we can. This may be my last ed credit .  In point of fact he entire 529 distribution (earnings and basis) were used to pay tuition which amount was greater than the entire distribution. 

[Christian]

On a day like today I feel like taking out my trusty .38 and relieving myself of all my client's future tax woes .

[RitaB]

Education credits / deductions are the WOAT.  (Worst of all time.)  Hang in there!

(Well, WOAT until ACA.)

[SaraEA]

But Christian, so the entire distribution was used to pay for tuition.  If you took an education credit, you have to deduct that $4k from the tuition paid for by the 529.  So if tuition was $22k and $4k was used for the credit, you better have at least $18k to account for the distribution.  You can use the remaining tuition, room and board and books for the 529 amount.  Cancelled checks are useless.  They could have been paid to the university for health insurance, gym fees, dorm damage, and other things not allowed for either tax break.  You have to have to financial statement from the school and break out the allowable expenses.  When the due diligence requirements for the credit took effect this past tax season, we have required these statements from every client.  It's amazing how many we discovered weren't eligible for the full credit and/or tax-free treatment of 529 distributions.  No wonder the IRS is cracking down.

[Catherine]

Also how many "we paid the tuition" payments were actually made by Grampy and/or Grammy.  Those don't count for education credits.  But Grampy and Grammy sure deserved thank-you notes and *really* nice Christmas presents!

[Christian]

Alas. To quote the immortal bard "One more time into the breach dear friends" or something to that effect .  The tuition was $13,900 and the 529 distribution was $12,100 all applied to the tuition. Subtracting $4,000 form $12,100 leaves $8,100 . Since the credit is based on $4,000 surely he qualifies for it would you not think? For future reference I will require more info from clients should this recur. I do mostly older folks and my experience with this particular credit was likely not what it needed to be although I read the relevant material but as sometimes happens I must have missed something. I have already contacted my client and advised him to have the university business office supply him with a breakdown or statement showing that the 529 distribution was fully applied to his tuition. Lord ! What I now need is a vacation in Tennessee where I can recover from this matter. 

[Catherine]

If you want to take the credit, you will *have* to claim some of that 529 distribution as taxable income.  But you'll have to try it both ways; frequently taking taxable income plus a credit works better for the client than using non-taxable money and not taking the credit.  There are already plenty of good guidelines in this thread for you to use, so I won't duplicate them.  See SaraEA's posts.

[Christian]

Assuming you do not tax $5,000 or so earnings in the account he still has some $7,000 dollars or so of fully taxed basis applied to the tuition. Why would this not qualify for a credit based on $4,000. I see no difference between that money and money he might have paid out of post taxed wages or pension income for that matter. If the credit is based only on after tax money surely his basis will qualify ? Of course, no one ever said our beloved tax was simple.

[Catherine]

Ah, yes, you also need to split out between basis and growth.  

No, it's not simple - and be sure to charge for your analysis time.  However, if you can get the client $2,500 in tax credits that lowers his overall tax hit by (guess the amount; I've seen $300 extra income tax to get that $2,500 credit, plus a couple hundred extra for your time) - tell the client he spent $500 to get $2,500; $2,000 more IN his pocket.  They like that.