Anyone who has set up a Section 529 plan to help pay for the education of a family member should be aware of the plight of Timothy Karlen, as described in a recent Tax Court case.

Timothy Karlen was experiencing financial difficulties. On Sept. 4, 2008, he took distributions from his children’s Section 529 accounts to obtain additional cash to pay household and other living expenses. On the application form, he indicated that the distributions were nonqualified withdrawals, not withdrawals for rollover.

The Section 529 plan mailed three checks, each dated Sept. 9, 2008. After receiving them, Karlen decided to confer with his wife, who disagreed with the decision to withdraw the funds from their children’s accounts. As a result, Karlen informed the Section 529 plan that he no longer wished to take the requested distributions.

However, a plan representative informed Karlen that he could not void the transactions. Karlen endorsed the three checks and returned them to the plan. By Sept. 19, 2008, the three checks had been received and redeposited.

The Karlens did not include the distributions in income, and the IRS determined a deficiency. The couple sought relief in the Tax Court.

Karlen argued that, because he did not cash or deposit the checks with his bank, he never received the distributions. The Tax Court disagreed.

The Karlens used the cash method of accounting. Under the cash method, an item is includable in gross income in the year in which it is actually or constructively received. Under the doctrine of constructive receipt, a check generally constitutes income when received, even though not cashed or deposited. Accordingly, the Tax Court held that the distributions were includable in income.

Karlen also claimed that the distributions were rolled over and were therefore not taxable. Because no distribution was transferred either to a different plan for the benefit of the original beneficiary or to the credit of a different beneficiary who is a member of the original beneficiary”s family, there was no rollover. Thus, the distributions were taxable.

Finally, the court noted that a 10 percent additional tax is imposed on an includable distribution not used for educational expenses. Since the Karlens never “used” the distributions, the court concluded that penalty did not apply.

Despite this small victory, it cost the Karlens more than $1,300 in tax just to end up in the same position where they started. (Timothy John Karlen and Jennifer Karlen v. Commissioner, TC Summary Opinion 2011-129, Nov. 10, 2011)