Prepaid Tuition—A New Estate and Gift Tax Strategy

Taxpayers are always looking for new estate and gift tax strategies, especially if they are easy to implement. Over the years, many taxpayers have taken advantage of the educational and medical exclusions, under which payments made by a donor directly to a provider of educational or medical services for a donee's educational or medical expenses are specifically excluded from gift tax and removed from the donor's estate under Sec. 2503(e). The payments are also excluded from generation-skipping transfer tax under Sec. 2612(c).

For educational expenses, the provider must be a qualified organization under Sec. 170(b)(1)(A)(ii). To qualify, it must be an educational organization that normally maintains a regular faculty and curriculum, and normally has a regularly enrolled body of students in attendance at the place educational activities are carried out.

In Letter Ruling (TAM) 9941013, the IRS ruled that nonrefundable advance payments made to a private school on behalf of a donor's grandchildren qualified for the Sec. 2503(e) exclusion. The private school submitted invoices for tuition for the donor's two grandchildren for multiple future years. The donor and the private school then entered into a written agreement, under which the advance payments would be applied only to future tuition. The payments were not refundable; if a grandchild ceased to attend the private school, it would retain the funds. Under the agreement, the school would bill any increase in future tuition costs to the donor.

Given the above agreement, the Service held that the payments were made directly to an educational organization 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 Sec. 2503(e)(2) purposes. The advance payments were also not deemed to be a support obligation; thus, there were no income tax ramifications to the parents.

This appears to be a simple, yet effective planning strategy for wealthy individuals to reduce their estates without gift tax implications. This can also be used in addition to any Sec. 529 Educational Plan or annual gifting strategies.

From Roger W. Lusby, III, CPA, CMA, AEP, Frazier & Deeter, LLC, Atlanta, GA