Education

Here are my thoughts for what it’s worth.  Let’s take an example in which my daughter is a sophomore in college in 2020.  She doesn’t work and has very little savings (less than $1k).  Assume we use 529 distributions to pay $40k for 100% of her college (tuition, room and board, books, etc).  The question is whether she is our dependent.  Below are the reasons I believe the answer should be “yes” regardless of whether the distribution is paid to her, directly to the college or me (as the account owner).

1. In a very real sense, she is entirely dependent on me (within the non-tax meaning of the word).  If I don’t provide the funds for her to go to college (either by paying for it myself or directing the 529 admin to make distributions) she would not be able to attend college.  Her “dependency” is not based on whether the distribution is made to her or whether it’s made to me.  In all events, she is dependent on me (again, within the non-tax meaning of that word) to cause the 529 account to make a distribution.
2. The gift tax consequences of a contribution should not be dispositive.  First, I’ve seen nothing to lead me to believe Congress meant to change the income tax consequences of a contribution by treating the contribution as a completed gift for gift tax purposes.  Second, it’s hard to square the idea that the beneficiary of the 529 account is the “income tax owner” of the account at the time of contribution when (A) the income tax consequences of any earnings won’t be known until a payee of a distribution is designated by the account owner and (B) the account owner can change the designated beneficiary at any time (including by naming himself beneficiary) and (C) the account owner can distribute the money to himself at any time.  
3. There are many circumstances in income tax law in which the state law owner of property isn’t the income tax owner of the property because another person bears the economic upside and downside of the property or another person has such control of the property that such person should be treated as the income tax owner even though he/she doesn’t have legal ownership (examples include deep in-the-money options and revocable trusts).  In the case of a 529 account, it seems the account owner has BOTH legal title and control and can capture all of the upside (by naming himself beneficiary or distributing funds to himself). Thus, it doesn’t seem appropriate to look at gift tax consequences for determining income tax consequences (e.g., dependency). 
4. Treas. Reg. section 1.152 likely wasn’t intended to cover the income (or excluded income) from a section 529 account distribution.  Even if this regulation has some bearing on the current dependency issue, however, it would seem the regulation only applies to treat the earnings (1099-Q Box 2) as excluded income (and therefore beneficiary self-support) and the portion of the distribution that is tax basis (1099-Q Box 3) would not seem governed by the regulation because tax basis isn’t excluded from income (because return of tax basis isn't income in the first place).  
5. If I didn’t have a 529 account and I deposited $40k into my daughter’s bank account to pay her college invoices, that would seem to be parent support even though the money arguably becomes her money until she actually pays the invoices.  If I instead direct the 529 account to make a distribution to my daughter and she then pays the invoices, is the substance any different?
6. Assume I paid the $40k invoices out of my own funds and then made a distribution from the 529 account on December 31, should the dependency question really hinge on whether I make the distribution to myself or I make the distribution to my daughter and my daughter then gives the money back to me?
7. Consider the 2020 tax year in which non-dependents might be entitled to a Recovery Rebate Credit (because he/she didn’t get a stimulus check because he/she was a dependent in 2019).  The Recovery Rebate Credit is $1,200 and potentially another $600 (or more) if currently proposed legislation is signed by Trump.  In my example, should my daughter really get the Recovery Rebate Credit?  Although I might the lose the AOTC and the credit for other dependents, this Recovery Rebate Credit is more than the sum of (A) the refundable portion of the AOTC and (B) the non-refundable credit for other dependents.  Since we can't use all of our nonrefundable credits, we would be better off if she wasn’t a dependent (but that seems like the wrong answer).

In conclusion, I'm struggling to think of a single fact set in which a person was treated as the income tax owner of property where someone else (1) had legal ownership of the property; (2) had total control over the property; and (3) could capture all of the economic upside of the property (and suffered the economic downside of the property).  Thus, it makes more sense to me to treat the account owner as providing support to the student regardless of how the cash distributions flow.