With college tuition approaching $30,000 a year at some institutions, and private school tuition at all levels on the rise, tax-free tuition gifts to children and grandchildren can save hundreds of thousands in gift and generation skipping taxes. And these gifts can be made now to pay for descendants’ education free of gift taxes—even if the donor is no longer alive when the descendant goes to school.
Internal Code Section 2503(e) (2)(A) excludes from gift tax any amount paid on behalf of an individual as tuition at an educational organization described in Section 170(b)(1)(A)(ii). Such gifts are not, under Section 2611(b)(1), subject to generation-skipping transfer tax (GST tax). And the donee doesn’t even have to attend the school full-time.
What is not included in this gift-tax-free zone? The tuition exception does not cover room and board, books and supplies, or any other expenses, related as they may be to the donee’s education.
There are some caveats. For one, the tuition must be paid directly to the service provider, that is to say, to the school. Reimbursements to the donee for his expenses will be taxed.
Also, the educational organization must be described in Section 170(b)(1)(A)(ii). That includes any organization 1) whose primary function is the presentation of formal instruction, 2) that normally maintains a regular faculty and curriculum and 3) that has a regularly enrolled student body. A tax-exempt educational organization should have a determination letter from the Internal Revenue Service stating that it is described in Section 170(b)(1)(A)(ii). But for purposes of the exclusion, such a determination letter is not required so long as the organization is described in such Section.
An “educational organization” therefore is not limited to college; it includes any type and level of school. Tuition for nursery school, private elementary school and high school may qualify, as well as tuition at trade schools. In fact, based on the definition of “educational organization,” tuition for such extracurricular education, such as karate or ballet school, also should be covered where the primary purpose of the organization is formal instruction.1
How do we use this exclusion to make a large gift today to pay for the donees’ tuition in the future—perhaps even after the client’s death?
Education Trust
This goal will not be accomplished by trusts that restrict distributions to paying beneficiaries’ tuition. Proof: Reg. Section 25.2503-6(c), Example 2, considers a situation where the donor A, transfers $100,000 to a trust, the terms of which require the trustee to use the funds to pay tuition expenses for A’s grandchildren. The example concludes that A’s transfer to the trust is a completed gift for gift tax purposes, and is not a direct transfer to an educational organization; therefore, it does not qualify for the unlimited exclusion under Section 2503(e).
It’s safe to say, then, that such a trust is not an effective method of using the tuition exclusion. Gifts to such a trust either would be taxable gifts or annual exclusion gifts, and the GST exemption may need to be allocated thereto.
Gift of Prepaid Tuition
In Technical Advice Memorandum 199941013, issued July 9, 1999, a set of grandparents made payments to a private school providing classes from preschool through grade 12 to cover the tuition of their two grandchildren who already were attending the school. At the time the payments were made, the grandparents entered into written agreements with the school stipulating that their funds were to be applied in payment of tuition for the grandchildren for a specified number of years, and were not refundable. If, for example, the grandchildren ceased to attend the school, the school would retain the funds. In addition, the grandparents and the grandchildren’s father agreed that the school would be paid additional funds necessary to cover any increase in tuition.
The IRS concluded that the payments were made directly to an educational organization to be used exclusively for the payment of specified tuition costs for designated individuals. Accordingly, the payments constituted an “amount paid on behalf of an individual as tuition to an educational organization...for the education or training of such individual” for purposes of Section 2503(e)(2). The gift tax exclusion applied.
So we can conclude that clients can enter into agreements with any school (preschool, elementary, college or any other level) that their children, grandchildren or more remote descendants are attending or someday may attend. The clients can prepay their descendants’ tuition at such schools, with the understanding that if the descendants withdraw from or never attend such schools, the funds will remain with the schools.
So, for example, assume a client, Harold, is 72 years old and has six grandchildren. Three are in grade school, two are about to start high school and one was just accepted at his parents’ alma mater, Ivy University, for which the tuition currently is $30,000 per year. The grandchildren’s parents intend to send them to a private high school, Gilded High, at which the tuition currently is $15,000 per year.
The client could enter into an agreement with Ivy University to prepay the eldest grandchild’s tuition at a cost of $120,000, with an agreement by the client and the grandchild’s parents to cover any future tuition increases with additional funds. The client also could enter into an agreement with Gilded High to prepay four years’ tuition for the other five grandchildren, for a total cost of $300,000.
The result of all these agreements: The client has transferred a total of $420,000 to his grandchildren free of gift, estate and GST taxes, with the knowledge that such funds will be used to provide for their education even after he is gone.
In contrast, it would require a total of $1,446,667 to transfer $420,000 to the grandchildren at death, after estate and GST taxes (assuming 50 percent marginal rates).
Put another way: The prepaid tuition gifts would save $1,026,667 of transfer taxes.
It may be possible to negotiate better terms with the schools than those described in the technical advice memorandum. For example, the obligation of the donor or others to cover any subsequent tuition increases could be negotiated, especially as the school will earn interest on the funds before they are used to cover tuition costs. For the same reason, one may be able to negotiate a reduced tuition cost.
While a separate arrangement could be made for each grandchild, because more than one grandchild will attend Gilded High, perhaps an agreement could be reached that covers all five grandchildren so that tuition funds that are “unused” by one grandchild can be used to cover tuition of another.
Finally, the schools might agree to turn over at least part of any “unused” funds to another school attended by the grandchildren to be used solely for their tuition. However, this latter arrangement clearly would fall outside the scope of the TAM, so it would be wise to obtain a private letter ruling from the Internal Revenue Service on the strategy.
529 Plans
How does the prepaid tuition option compare to Section 529 plans, that other tax-efficient way to fund descendants’ education?
First, gifts to 529 plans require the use of annual exclusion gifts, while the prepaid tuition gifts can be made in addition to annual exclusion gifts.
Second, if a client front loads five years’ worth of annual exclusion gifts in the 529 plans, he must survive for five years in order to exclude the full amounts from his estate. The prepaid tuition gifts have no such survival requirement; once paid, the amounts are excluded from his gross estate.
Third, 529 plans may be used to cover costs only of higher (college and graduate) education, while the tuition exclusion can be used to pay nursery school, elementary school and high school tuition as well.
But 529 plans funds may be used toward room and board, supplies, and other costs of higher education besides tuition.
My conclusion: Using 529 plans in conjunction with prepaid tuition gifts may be the ideal way to fund higher education.
Endnote 1. See Rev. Rul. 67-447, 1967-2 C.B. 121 (ballet school), Rev. Rul. 78-309, 1978-2 C.B. 123 (martial arts school) and Rev. Rul. 79-130, 1979-1 C.B. 332 (yoga school). But see Rev. Rul. 79-167, 1979-1 C.B. 335 (art, cooking, dance, photography, swimming, languages, gymnastics and mechanics classes offered by a community center were considered interrelated parts of the organization’s social, cultural, and recreational programs rather than the planned curriculum of a school).