With education costs soaring to all time highs, making tuition payments for grandchildren and others can save plenty of cash in gift and estate taxes down the road – even though the donor isn’t alive when the tuition money is clearly used.
By means of some background, the tax laws exempt tuition payments by grandparents or others from any gift taxes, provided certain requirements are met. First, the only real educational costs that are gift-tax free are tuition costs. The expense of room and board, books, and other educational expenses aren’t exempt.
Second, the tuition costs must be paid right to an academic organization that “normally maintains a regular faculty and curriculum and normally includes a regularly enrolled body of pupils or students in attendance at where its educational activities are regularly carried on.” Notice that there is no requirement that the tuition costs be paid to a college or university. In fact, tuition payments for nursery school, private elementary school, and private senior high school may also qualify. It’s possible, too, that tuition payments for part-time courses, such as for instance dance, theater, music, cullinary arts, and the like may also qualify for the gift tax exemption.
So, how is this such much? In the very first place, these tuition payments aren’t treated as taxable gifts, which means you don’t have to be worried about having them come under the annual gift tax exclusion. In fact, you can make tuition payments for your grandchildren or others and still give each of them the annual exclusion amount ($12,000 for 2006) as a birthday gift or whatever.
Second, if your estate is large enough to take into account federal estate taxes (currently in excess of $2 million, $4 million for a couple), then the quantity of the tuition payments will undoubtedly be excluded from your estate upon your death. Put simply, your tuition payments won’t be susceptible to something special tax when the payments are made, nor will they be susceptible to an estate tax upon your death. Furthermore, they’ll not be susceptible to any generation-skipping taxes (GST) upon your death tuition for maths
That’s pretty good deal alone, but here’s an extra bonus. On July 9, 1999, the Internal Revenue Service issued Technical Advice Memorandum 199941013 stating that prepayment of tuition costs was also exempt from gift taxes under IRC Section 2503(3)(2). In that particular case, a couple of grandparents had made payments to a private school to cover tuitiion costs for his or her two grandchildren from pre-school through grade 12. There clearly was an agreement between the institution and the grandparents indicating that the tuition payments would not be refundable even though the grandchildren failed to go to the institution each of the years. The sum total payments produced by the grandparents amounted to over $181,000 over a two-year period.
Recently, the Internal Revenue Service issued a private letter ruling that supports the Technical Advice Memorandum cited above. In that case, the IRS told a taxpayer that prepayments of several years of tuition costs for his grandchildren would not be described as a gift.
While Technical Advice Memorandums and private letter rulings only affect the taxpayer’s who request them, they’re a good indication of the IRS’ position on specific tax matters. Here, it appears fairly clear that prepayment of multiple years of tuition costs won’t be treated as a taxable gift by the IRS.
Now, let’s kind of put all this into perspective. In the TAM discussed above, the grandparents pre-paid roughly $181,000 of tuition costs over a two-year period. The payments weren’t treated as taxable gifts and, since the cash was taken off their estate, it wasn’t susceptible to estate taxes upon their death. If the grandparents kept the cash until they died and then gave it for their grandchildren under their will, it would have been through probate first, then could have been susceptible to a federal estate tax and then, possibly, a generation-skipping tax – all before maybe it’s used by the grandchildren.
If the grandparents had a reasonably large estate, say larger than $4 million, then the estate taxes paid on that $181,000 would be roughly $83,260 (based upon a limited tax rate of 46%). In that case, prepaying the tuition costs resulted in an estate tax savings of roughly $83,260. Plus, the grandparents didn’t have to use up their annual gift-tax exclusion to get the estate tax savings.