Par. 2. An undesignated centerheading and Secs. 1.529-0 through 1.529-6 are added to read as follows:
(a) In general. To be a QSTP, a program must satisfy the requirements described in paragraphs (a) through (i) of this section. A QSTP is a program established and maintained by a State or an agency or instrumentality of a State under which a person--
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(1) May purchase tuition credits or certificates on behalf of a designated beneficiary that entitle the beneficiary to the waiver or payment of qualified higher education expenses of the beneficiary; or
(2) May make contributions to an account that is established for the purpose of meeting the qualified higher education expenses of the designated beneficiary of the account.
(b) Established and maintained by a State or agency or instrumentality of a State--(1) Established. A program is established by a State or an agency or instrumentality of a State if the program is initiated by State statute or regulation, or by an act of a State official or agency with the authority to act on behalf of the State.
(2) Maintained. A program is maintained by a State or an agency or instrumentality of a State if--
(i) The State or agency or instrumentality sets all of the terms and conditions of the program, including but not limited to who may contribute to the program, who may be a designated beneficiary of the program, what benefits the program may provide, when penalties will apply to refunds and what those penalties will be; and
(ii) The State or agency or instrumentality is actively involved on an ongoing basis in the administration of the program, including supervising all decisions relating to the investment of assets contributed to the program.
(3) Actively involved. Factors that are relevant in determining whether a State, agency or instrumentality is actively involved include, but are not limited to: whether the State provides services or benefits (such as tax, student aid or other financial benefits) to account owners or designated beneficiaries that are not provided to persons who are not account owners or designated beneficiaries; whether the State or agency or instrumentality establishes detailed operating rules for administering the program; whether officials of the State or agency or instrumentality play a substantial role in the operation of the program, including selecting, supervising, monitoring, auditing, and terminating any private contractors that provide services under the program; whether the State or agency or instrumentality holds the private contractors that provide services under the program to the same standards and requirements that apply when private contractors handle funds that belong to the State or provide services to the State; whether the State provides funding for the program; and, whether the State or agency or instrumentality acts as trustee or holds program assets directly or for the benefit of the account owners or designated beneficiaries. If the State or an agency or instrumentality thereof exercises the same authority over the funds invested in the program as it does over the investments in or pool of funds of a State employees' defined benefit pension plan, then the State or agency or instrumentality will be considered actively involved on an ongoing basis in the administration of the program.
(c) Permissible uses of contributions. Contributions to a QSTP can be placed into either a prepaid educational arrangement or contract described in section 529(b)(1)(A)(i) or an educational savings account described in section 529(b)(1)(A)(ii), or both, but cannot be placed into any other type of account.
(1) A prepaid educational services arrangement or contract is an account through which tuition credits or certificates or other rights are acquired that entitle the designated beneficiary of the account to the waiver or payment of qualified higher education expenses.
(2) An educational savings account is an account that is established exclusively for the purpose of meeting the qualified higher education expenses of a designated beneficiary.
(d) Cash contributions. A program shall not be treated as a QSTP unless it provides that contributions may be made only in cash and not in property. A QSTP may accept payment, however, in cash, or by check, money order, credit card, or similar methods.
(e) Penalties on refunds--(1) General rule. A program shall not be treated as a QSTP unless it imposes a more than de minimis penalty on the earnings portion of any distribution from the program that is not--
(i) Used exclusively for qualified higher education expenses of the designated beneficiary;
(ii) Made on account of the death or disability of the designated beneficiary;
(iii) Made on account of the receipt of a scholarship (or allowance or payment described in section 135(d)(1) (B) or (C)) by the designated beneficiary to the extent the amount of the distribution does not exceed the amount of the scholarship, allowance, or payment; or
(iv) A rollover distribution.
(2) More than de minimis penalty--(i) In general. A penalty is more than de minimis if it is consistent with a program intended to assist individuals in saving exclusively for qualified higher education expenses. Except as provided in paragraph (e)(2)(ii) of this section, whether any particular penalty is more than de minimis depends on the facts and circumstances of the particular program, including the extent to which the penalty offsets the federal income tax benefit from having deferred income tax liability on the earnings portion of any distribution.
(ii) Safe harbor. A penalty imposed on the earnings portion of a distribution is more than de minimis if it is equal to or greater than 10 percent of the earnings.
(3) Separate distributions. For purposes of applying the penalty, any single distribution described in paragraph (e)(1) of this section will be treated as a separate distribution and not part of a single aggregated annual distribution by the program, notwithstanding the rules under Sec. 1.529-3 and Sec. 1.529-4.
(4) Procedures for verifying use of distributions and imposing and collecting penalties--(i) In general. To be treated as imposing a more than de minimis penalty as required in paragraph (e)(1) of this section, a program must implement practices and procedures to identify whether a distribution is subject to a penalty and collect any penalty that is due.
(ii) Safe harbor. A program that falls within the safe harbor described in paragraphs (e)(4)(ii) (A) through (E) of this section will be treated as implementing practices and procedures to identify whether a more than de minimis penalty must be imposed as required in paragraph (e)(1) of this section.
(A) Distributions treated as payments of qualified higher education expenses. The program treats distributions as being used to pay for qualified higher education expenses only if--
(1) The distribution is made directly to an eligible educational institution;
(2) The distribution is made in the form of a check payable to both the designated beneficiary and the eligible educational institution;
(3) The distribution is made after the designated beneficiary submits substantiation to show that the distribution is a reimbursement for qualified higher education expenses that the designated beneficiary has already paid and the program has a process for reviewing the validity of the substantiation prior to the distribution; or
(4) The designated beneficiary certifies prior to the distribution that the distribution will be expended for his or her qualified higher education expenses within a reasonable time after the distribution; the program requires the designated beneficiary to provide substantiation of payment of qualified higher education expenses within 30 days after making the distribution and has a process for reviewing the
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substantiation; and the program retains an account balance that is large enough to collect any penalty owed on the distribution if valid substantiation is not produced.
(B) Treatment of all other distributions. The program collects a penalty on all distributions not treated as made to pay qualified higher education expenses except where--
(1) Prior to the distribution the program receives written third party confirmation that the designated beneficiary has died or become disabled or has received a scholarship (or allowance or payment described in section 135(d)(1) (B) or (C)) in an amount equal to the distribution; or
(2) Prior to the distribution the program receives a certification from the account owner that the distribution is being made because the designated beneficiary has died or become disabled or has received a scholarship (or allowance or payment described in section 135(d)(1) (B) or (C)) received by the designated beneficiary (and the distribution is equal to the amount of the scholarship, allowance, or payment) and the program withholds and reserves a portion of the distribution as a penalty. Any penalty withheld by the program may be refunded after the program receives third party confirmation that the designated beneficiary has died or become disabled or has received a scholarship or allowance (or payment described in section 135(d)(1) (B) or (C)).
(C) Refunds of penalties. The program will refund a penalty collected on a distribution only after the designated beneficiary substantiates that he or she had qualified higher education expenses greater than or equal to the distribution, and the program has reviewed the substantiation.
(D) Documentation of amounts refunded and not used for qualified higher education expenses. The program requires the distributee, defined in Sec. 1.529-1(c), to provide a signed statement identifying the amount of any refunds received from eligible educational institutions at the end of each year in which distributions for qualified higher education expenses were made and of the next year.
(E) Procedures to collect penalty. The program collects required penalties by retaining a sufficient balance in the account to pay the amount of penalty, withholding an amount equal to the penalty from a distribution, or collecting the penalty on a State income tax return.
(f) Separate accounting. A program shall not be treated as a QSTP unless it provides separate accounting for each designated beneficiary. Separate accounting requires that contributions for the benefit of a designated beneficiary and any earnings attributable thereto must be allocated to the appropriate account. If a program does not ordinarily provide each account owner an annual account statement showing the total account balance, the investment in the account, earnings, and distributions from the account, the program must give this information to the account owner or designated beneficiary upon request. In the case of a prepaid educational arrangement or contract described in section 529(b)(1)(A)(i) the total account balance may be shown as credits or units of benefits instead of fair market value.
(g) No investment direction. A program shall not be treated as a QSTP unless it provides that any account owner in, or contributor to, or designated beneficiary under, such program may not directly or indirectly direct the investment of any contribution to the program or directly or indirectly direct the investment of any earnings attributable to contributions. A program does not violate this requirement if a person who establishes an account with the program is permitted to select among different investment strategies designed exclusively by the program, only at the time the initial contribution is made establishing the account. A program will not violate the requirement of this paragraph (g) if it permits a person who establishes an account to select between a prepaid educational services account and an educational savings account. A program also will not violate the requirement of this paragraph (g) merely because it permits its board members, its employees, or the board members or employees of a contractor it hires to perform administrative services to purchase tuition credits or certificates or make contributions as described in paragraph (c) of this section.
(h) No pledging of interest as security. A program shall not be treated as a QSTP unless the terms of the program or a state statute or regulation that governs the program prohibit any interest in the program or any portion thereof from being used as security for a loan. This restriction includes, but is not limited to, a prohibition on the use of any interest in the program as security for a loan used to purchase such interest in the program.
(i) Prohibition on excess contributions--(1) In general. A program shall not be treated as a QSTP unless it provides adequate safeguards to prevent contributions for the benefit of a designated beneficiary in excess of those necessary to provide for the qualified higher education expenses of the designated beneficiary.
(2) Safe harbor. A program satisfies this requirement if it will bar any additional contributions to an account as soon as the account reaches a specified account balance limit applicable to all accounts of designated beneficiaries with the same expected year of enrollment. The total contributions may not exceed the amount determined by actuarial estimates that is necessary to pay tuition, required fees, and room and board expenses of the designated beneficiary for five years of undergraduate enrollment at the highest cost institution allowed by the program.