Education-finance and tax-law experts last week challenged Gov. James J. Blanchard’s optimistic interpretation of an Internal Revenue Service ruling on the tax status of Michigan’s tuition-prepayment plan.
At a Congressional hearing March 15, the Michigan Governor disclosed that under a long-awaited I.R.S. ruling, parents would not be required to pay federal taxes on income from the plan.
The program allows parents to guarantee their children four years’ tuition at a state college or university by investing in a state trust fund.
The I.R.S. determination “will allow our program and similar programs to move forward,’' Mr. Blanchard said.
But experts interviewed last week predicted that other aspects of the ruling would discourage parents from participating in Michigan’s plan or others like it.
They pointed, in particular, to the agency’s determination that the state will be liable for federal taxation for the income the trust fund generates. That could drive up costs for parents, they said.
And, the critics pointed out, students themselves will be liable for federal taxes on the investment income when they withdraw the funds.
“I don’t agree with Governor Blanchard’s view that it’s a victory,’' said Leo J. Raskind, a University of Minnesota law professor who specializes in tax issues.
“The ruling is more a deterrent than an encouragement, notwithstanding what Blanchard said,’' added Arthur Hauptman, a consultant for the American Council on Education. “It may be favorable, but it’s far from the most favorable ruling they could have gotten.’'
In any case, said Aims C. McGuinness Jr., assistant executive director of the Education Commission of the States, there is not likely to be a “bandwagon’’ for such plans in state legislatures.
Lawmakers have extensively debated the merits of tuition plans over the past two years, he said, and are well aware of their risks.
Those interviewed emphasized that their comments were based on secondhand accounts of the ruling. The I.R.S., citing privacy regulations, did not release a statement on the matter and would not confirm that a ruling had been issued.
Governor Blanchard’s announcement was based on unwritten communications with agency officials. He was expected to receive a written copy of the ruling late last week.
The Michigan ruling follows two setbacks for tuition-savings plans elsewhere in recent weeks.
In Maryland, the Senate finance committee killed Gov. William Donald Schaefer’s proposal to add a 1 percent, state-funded bonus to parents’ savings for their children’s tuition. Opponents argued that the plan would benefit only families that could already afford to save for college.
And in Pittsburgh, Duquesne University’s board of directors voted to suspend for a year that private college’s pioneering tuition-prepayment plan because of changing conditions in the bond market.
Michigan in December 1986 became the first state to enact a “tuition futures’’ proposal. Since that time, some 30 states have adopted or seriously considered similar plans, and one state program--Wyoming’s--has gone into effect.
Tax Benefit ‘a Bonus’
The Michigan law stipulated that its plan would only be implemented if the I.R.S. determined that the income from parents’ investments would be exempt from federal taxation.
Because the agency ruled favorably on that issue, parents can begin signing contracts with the Michigan Education Trust as early as May, according to Robert Kolt, a spokesman for the state treasurer.
The plan was attractive to parents even before the tax ruling, Mr. Kolt added. The state has received more than 35,000 inquiries about the plan in the past year, he said.
“What will sell is the guarantee of tuition with no risk,’' he said. “If it has favorable tax consequences, fine. That’s a bonus.’'
‘Significant Implications’
But the tax and finance experts interviewed argued that the I.R.S. ruling would make the plan more costly, and ultimately less attractive.
“The ruling has got to be discouraging,’' said Richard Anderson, director of the Forum for College Financing, a federally funded research group based in New York.
Even with the favorable determination on parents’ tax liability, he contended, the decision “has significant tax implications’’ for them.
Mr. Raskind of the University of Minnesota echoed that opinion, arguing that the provision requiring the state to pay taxes on income generated by the trust fund will drive up the cost to parents.
The state will either pass on to parents the cost of the taxes, he suggested, or else invest the funds in lower-yielding tax-exempt bonds.
The ruling on the state’s liability was “surprising,’' he added, since the I.R.S. has traditionally exempted state entities from federal taxation.
“States sell alcohol without paying federal taxes on the profits,’' he noted. “Education should have a higher value than liquor.’'
In his Congressional testimony this month, Governor Blanchard called for legislation to remove states’ tax liability for such plans.
Mr. Anderson noted that few experts were surprised, however, that students will be liable for taxes on the proceeds from their parents’ investments when they withdraw the funds.
“The I.R.S. has three concerns: loss of revenue, loss of revenue, and loss of revenue,’' he said. “If it didn’t tax those funds, it would be allowing a significant increase in value to parents to go untaxed.’'
Nevertheless, Mr. Anderson added, the provision could prompt parents to put pressure on legislators to enact other types of savings plans that may be even less promising.
“My concern is that we will put stop-gap plans in place that are not well-founded,’' he said.
