Education costs reaching unprecedented highs, paying tuition fees for grandchildren and other people can save you a lot of money in donations and inheritance taxes even if the donor is not alive when the tuition money is actually used.
In general, tax laws exempt from tuition tax tuition fees paid by grandparents or other persons, provided certain conditions are met. First, the only tuition fees that are not subject to donation taxes are tuition fees. Accommodation and meals, books and other educational expenses are not exempted.
Secondly, tuition fees must be paid directly to an educational organization "which normally maintains a regular faculty and program and normally has a regularly enrolled student body or student attending the location where its educational activities take place. take place regularly ". Note that there is no need for tuition to be paid to a college or university. In fact, tuition fees for kindergartens, private elementary schools and private high schools may also be eligible. It is also possible that tuition fee payments for part-time courses, such as dance, drama, music, visual arts, etc., are also eligible for the exemption from the tuition fee. donations.
So, how is this a good deal? In the first place, these tuition payments are not treated as taxable gifts. You do not have to worry about excluding them from the annual donation tax. In fact, you can pay the tuition fees of your grandchildren or other people and give them the annual amount of the exclusion ($ 12,000 for 2006) as a birthday present or other.
Second, if your estate is big enough to worry about federal estate taxes (currently over $ 2 million, $ 4 million for a couple), the amount of tuition payments will be excluded from your estate to your death. In other words, your tuition payments will not be subject to a gift tax at the time of payment, nor to an estate tax upon your death. In addition, they will not be subject to any Generation Skip Tax (GST) upon your death.
It's a good deal in itself, but here's an added bonus. On July 9, 1999, the Internal Revenue Service issued Technical Advice Memorandum No. 199941013 stating that the pre-payment of tuition fees was also exempt from gift tax under subsection 2503 (3) (2). ) of the Tax Code. In this particular case, several grandparents had made payments to a private school to cover the tuition fees of their two grandchildren from kindergarten to grade 12. An agreement had been reached between the school and the grandparents, stating that tuition payments would not be refundable even if the grandchildren did not attend school each of these years. The total amount of payments made by grandparents is more than $ 181,000 over a two-year period.
Recently, the Internal Revenue Service issued a decision by private letter in support of the above-mentioned technical advice memorandum. In this case, the IRS informed a taxpayer that advance payments of many years of tuition for his grandchildren would not be considered a gift.
Although technical notice memoranda and decisions regarding private letters only apply to taxpayers who request it, they are a good indication of the IRS's position on specific tax issues. Here it seems pretty clear that advance payment of several years of tuition will not be treated as a taxable gift by the IRS.
Now, let's put all this in perspective. In the TAM mentioned above, the grandparents paid approximately $ 181,000 in tuition fees over a two-year period. Payments were not considered taxable donations and, as the money had been withdrawn from their estate, he was not subject to inheritance tax upon their death. If the grandparents kept the money until they died and then gave it to their grandchildren, they would have first undergone an audit and then would have been subject to a federal estate tax. and, possibly, a tax on previous generations – all before it can be used by grandchildren.
If the grandparents had a fairly large estate, greater than $ 4 million, the inheritance tax paid on those $ 181,000 would be about $ 83,260 (based on a marginal rate of $ 85,000). 46% tax). In this case, the pre-payment of tuition fees resulted in an inheritance tax saving of approximately $ 83,260. In addition, grandparents were not required to use their annual gift tax exclusion to earn inheritance tax savings.
Nevertheless, you must be aware of some disadvantages. First and foremost, you need to have a domain large enough to worry about inheritance taxes. Secondly, you should probably be afraid to die before your grandchildren finish their studies. Otherwise, you could simply pay the tuition fees as they become due.
Finally, when you pay your grandchildren's tuition in advance, you will not be able to get the money back if your grandchildren drop out of school or decide to attend another school. Some schools may allow the money to be transferred to another school, but this must be agreed in advance. Even in this case, there is no guarantee that the IRS will accept this type of arrangement.
One last point, tuition tax payments that are excluded from the gift tax under section 2503 (e) (2) of IRC are not the same as payments made under plan 529. First, donations to 529 plans are subject to the annual donation tax exclusion. Prepaid educational gifts are added to annual exclusion gifts.
Second, 529 plan donations are excluded from the donor's estate only if the donor survives each year for which the prepayment was made. Donations of tuition fees paid in advance are excluded from the donor's estate as soon as the advance payment is made.
Thirdly, 529 schemes concern only higher education (colleges and beyond), while postage gifts are paid at all levels of education, including kindergartens, primary schools and high schools.
Fourth, 529 plans apply to all education-related costs, including lodging and meals, books and supplies, as well as tuition fees. Prepaid educational gifts only apply to tuition fees.
This does not mean, however, that tuition donations paid in advance can not be used in conjunction with 529 plans.
For wealthy grandparents who are inclined to contribute to the educational costs of their grandchildren, a donation for prepaid tuition fees under section 2503 (3) (2) of the IRC regulation should definitely be considered.