529 Accounts and Fiduciary Duties

Take-Away: The tax law is silent if the owner of a 529 account has any fiduciary duty to the designated beneficiary of the 529 account. The creation and funding of a 529 account is treated much like a revocable gift because the account owner can retrieve the assets held in the 529 account at any time and without the beneficiary’s consent. Can the beneficiary designation of a 529 account be changed in bad faith? Maybe. The use of a trust to own and control a 529 account can limit the use, or abuse, of a 529 account, which might become important if the proposed SECURE Act expands the use of 529 funds.

Background: A few months ago, a case was reported out of Iowa, Alberhasky v. Alberhasky, where the father, Rod changed the beneficiary designation on a $65,000 529 account established for his son Max, to another 529 account established for another son, Grayson. A refresher of the facts of that case follow.

Facts: Two sons ‘took sides’ in their parents’ divorce. Max supported his mother Angela and lived with her. Grayson supported his father Rod and lived with him. The 529 accounts had been created and funded by Rod’s now-deceased mother’s trust, over which Rod (the settlor’s son) was the acting trustee. In addition, Rod’s mother previously had transferred family limited partnership/LLC interests to her two grandsons under Uniform Transfer to Minors Accounts (UTMA) with their father, Rod, as the named UTMA custodian.  The divorce court removed Rod as trustee of Max’s UTMA assets. Ultimately, the UTMA assets were transferred to Max.

Lawsuit: Max sued Rod for breach of fiduciary duties. Max’s allegations were that Rod had acted as trustee of various assets and funds that belonged to Max under the UTMA, and that Rod acted as “trustee of the 529 College Savings Plan” that had been created and funded by his late grandmother’s trust. Max sought (i) an accounting of Max’s UTMA assets; (ii) voiding Rod’s transaction that had changed the beneficiary designation of Max’s 529 account to his brother Grayson; and (iii) damages for Rod’s breach of fiduciary duties. Max’s claim with regard to his UTMA assets was that Rod had liquidated Max’s shares in the family limited partnership/LLC in bad-faith.

Brother Joins the Fray: Max’s brother, Grayson, was permitted to intervene in Max’s litigation because Grayson “had a direct financial interest in the outcome of the proceedings.” [Observation: Rod and Angela divorce. Max and Grayson each take one parent’s side in that divorce. Rod, in anger, removes Max from his 529 account and names his now favorite son, Grayson, as Max’s 529 account beneficiary. (Grayson had his own identical 529 account that his grandmother’s trust had established for him, too.) Max then sues his father for removing him as beneficiary of the 529 account that his grandmother’s trust had established and forcing him out of the family limited partnership/LLC. Max’s brother, Grayson, then intervenes in his brother’s lawsuit against his father. Only in America does all of this pass as The Alberhasky Family will probably appear next season on the Fox Network.]

Trial Court: The trial judge dismissed Max’s petition against his father. As to the UTMA account that judge found that the Iowa Trust Code did not apply to the UTMAs, and the UTMA account had been closed with the distribution of its assets to Max  four years earlier. With regard to Max’s 529 account the judge found that Max had no standing to challenge how the 529 account was controlled by its owner, who was Rod, the acting trustee. More to the point, the judge found that the 529 account was not subject to the Iowa Trust Code as there was a separate statute that specifically governs 529 accounts (Iowa’s separate version is somewhat like Michigan’s separate statutory scheme.)

Appellate Court: The Iowa Appeals Court reversed the trial judge’s decision as premature. Max’s petition was sent back to the trial court to permit Max’s petition to proceed with pretrial discovery. With regard to Rod’s actions while acting as trustee, the Appeals Court noted-

UTMA: Yes, UTMA custodial arrangements are excluded from Iowa’s Trust Code, just like in Michigan. The Michigan Trust Code provides: Trust does not include …custodial arrangement under the Michigan uniform transfers to minors act, 1998 PA 433, MCL 5543.521 to 554.552…[MCL 700.1107(n).] However, Rod was put on notice as to the nature of Max’s claim. Moreover, Max should be allowed to amend his petition to allege Rod’s violation of the standards of conduct of a custodian of a UTMA asset. In short, Max should have pled a violation of a custodian’s UTMA duties rather than a violation of fiduciary duties under the separate Iowa Trust Code, but Max should be permitted to amend his petition to refer to breach of an agent’s duties under the UTMA.

529 Account: Any asset can be held as an investment asset in a trust under the Iowa Trust Code: “Any kind of property may be transferred and conveyed by the owner to a trustee to be held by the trustee for the use or benefit of others.” As to the existence of the separate statute that authorizes and governs 529 accounts, that statute does not expressly place 529 accounts beyond the reach of the Iowa Trust Code.

“While section 12D.3 [governing 529 accounts] enables an individual account owner to change the beneficiary designation, such freedom does not automatically supplant fiduciary duties imposed on a trustee in managing a trust-owned 529 plan…The applicability of chapter 633A [authorizing 529 accounts] depends upon whether Allie [the grandmother] created a trust for Max by investing in the 529 plan as Max alleged in his petition. Whether Allie created a trust for Max’s benefit and under what terms are questions of fact…. Assuming -as we must- the trust based on Max’s factual allegations, the funds in the 529 plan were held in trust for Max. And if Rod, acting as trustee, depleted those funds out of animus toward Max, that action could constitute a breach of fiduciary duty entitling Max to relief.”

Conclusion: The outcome of the Alberhasky family litigation may ultimately turn on the fact that the 529 account was held in trust, established by the beneficiary’s grandmother, rather than an individual who is technically identified as the 529 account owner. As previously noted, the owner of a 529 savings account has no fiduciary duties to the beneficiary of the 529 account. Thus, the 529 account owner could change the beneficiary or withdraw the funds himself or herself and the beneficiary would have no grounds for complaint, even if the 529 account owner’s actions clearly violated the account donor’s intent. Yet a trust-owned 529 account could be the only mechanism to ensure that the donor’s wishes are carried out with regard to the use of the 529 account and the application of its funds. If a trustee is the technical 529 account owner, the trustee is bound by the terms of the trust and thus has a fiduciary duty to the trust beneficiaries. Susan T. Bart, The Best of Both Worlds: Using a Trust to Make Your 529 Savings Accounts Rock, 34 ACTEC J. 106 (2008).

If the SECURE Act passes with its expansion of permissible uses of 529 accounts, more thought should be given to using a trust “wrapper” to hold title as the technical owner of a 529 account to assure the account donor that their intent in creating the 529 account is carried out, e.g. the 529 account is only used to pay the beneficiary’s college education expenses, and not to repay a sibling’s school debt or to pay for a sibling’s home-school expenses.