RSM Resources

Think you’ve exhausted ways to shield your estate from the "deathtax"? Be sure to consider prepaying a loved one’s tuition. With thisstrategy, you can move large amounts of money out of your estate,saving on taxes — and making a substantial contribution to yourfamily’s future.

If you pay tuition directly to a qualifyingeducational institution, you don’t have to report the payments to theIRS and the payments are not subject to gift taxes. This holds true forprivate-school (including elementary and secondary) and college tuition.

Thefollowing example illustrates the power of prepaying tuition. Agrandparent paid almost $200,000 to a private school that teacheschildren from kindergarten through 12th grade. The payment provided 10years of tuition for two grandchildren. In a private-letter ruling, theIRS determined that the payment should be exempt from gift taxes,because the tuition was nonrefundable. When the grandparent died soonafter paying the tuition, the estate saved approximately $100,000 ontaxes. Instead of leaving a significant windfall for the IRS, thegrandparent used prepaid tuition to keep money in the family whilegiving loved ones an excellent education.

This private-letterruling does not have a binding effect on everybody’s situation.However, the ruling gives some assurance to advisors and taxpayers thatthe IRS would follow similar reasoning in other cases.

More conventionally speaking
Thegift tax annual exclusion also provides an opportunity to provide fortuition while optimizing tax obligations. For 2006, the gift tax annualexclusion is $12,000. That means you can give an individual gifts orcash totaling $12,000 during the year — for tuition or other purposes —without having to file a gift-tax return. Aggregate gifts, in excess of$12,000 in a calendar year, to someone triggers a reporting requirementand possibly taxes if the donor has exhausted their $1 million lifetimegift-tax exemption. It’s important to remember that, for family memberscurrently in school, a tuition payment made directly to the school(versus made to the student to sign over to the school) does not countagainst the $12,000 annual exclusion limit.

Amounts paiddirectly to a person or organization providing medical services alsoqualify for exclusion from the gift tax. This includes costs fordiagnosis, treatment or prevention of diseases, as well as medicalinsurance premiums. This exclusion counts only for out-of-pocketexpenses; those reimbursed by insurers do not qualify.

Pay it up front, carefully
Planningto spend money on a family member’s education? For the wealthy, elderlyor ill, it can be financially advantageous to pay the tuition now forestate-planning purposes, says Susan T. Bart, a partner withChicago-based law firm Sidley Austin, LLP.

However, severalmore conventional, education funding strategies may offer moreflexibility compared with making prepayments to a specific school. Manytax advisors might be inclined to exhaust other options before pursuinga prepay strategy.

"I would want to make sure that anyone usingthis exclusion to the gift tax would be already maxing out the morecommon exemptions," Bart says. "People should really first look at theCoverdell education savings accounts, education tax credits, andsection 529 qualified tuition programs. I would think that theinflexibility involved with prepaying tuition in a lump sum would makeit something only the wealthy or those in failing health wouldconsider."

Know the risks, do your homework
Bartcautions those considering tuition prepayment to consider seriousrisks. For example, know that a family member is committed to attendinga specific school before prepaying any tuition. The gift tax exclusionwill not apply unless the payment is nonrefundable, even if your lovedone chooses not to attend, is unable to attend that particularinstitution or dies.

A final word of advice: Encourage yourloved ones to attend your alma mater or another educational institutionto which you have close ties. In the event you prepay tuition for afamily member who ultimately does not attend the school, you may feelbetter regarding any nonrefundable tuition as a philanthropic donation.