Direct Gifts Part 1 – Tuition

Take-Away: The direct gift of tuition is not classified as a gift. Accordingly, the payment of an individual’s tuition is neither treated as a taxable gift nor does it utilize the donor’s annual exclusion gift opportunity.

Background: This is the time of year when parents and grandparents start to think about fall and the coming school year, with difficult decisions made with regard to enrolling their child or grandchild in a private school that charges a tuition. Generally speaking, the payment of the child’s tuition is not a taxable gift.

IRC 2503(e): The Tax Code creates an exception to what is a gift for the direct payment of an individual’s education tuition. [IRC 2503(e); IRC 170(b)(1)(A)(ii).] It is a pretty straightforward exception, but it can present interesting questions with regard to its scope.

Direct Payment: Critical to exploiting this opportunity is that the payment for the child’s tuition must be directly made by the donor. The donor cannot give the money to the child with the child paying the tuition.The donor can, however, give the check payable to the education institution to the child with the direction that the child deliver that check to the institution.

Tax Treatment: Since the direct payment of the tuition obligation is not a gift, an unlimited amount can be transferred without any gift tax consequences.

Example: Greg pays Princeton University $63,000 for his granddaughter Gloria’s tuition for the 2021-2022 school year. The $63,000 is not a gift. Greg can also give to Gloria another $15,000 as an annual exclusion gift to help Gloria pay for her room and board at Princeton.

GST: The tuition payment gift exception also applies to the generation skipping transfer tax (GST). [IRC 2642(C)(3)(B).] Thus, the direct payment of tuition on behalf of a grandchild is also free from any GST tax, nor does it consume the donor’s GST tax exemption amount.

Schools: The exclusion applies to tuition payments to a reglious school or to a school in a foreign country. The school does not have be be post-secondary. The exclusion applies even if the school that charges the tuition is on the No Child Left Behind ‘watch-list.’ In general, the school must offer a regular curriculum and faculty and have a regular body of students.

Nursery or Preschool: Not so clear is the tuition charged by a nursery or preschool. A children’s day care center can satisfy the definition of an educational organization. [Regulation 1.170A-9(b)(1).] However,  formal instruction must be the primary function of that organization. The IRS has formally held that a children’s day care center satisfied the definition of educational organization when (i) there was regular enrollment; (ii) there were planned educational activities and instruction; (iii) from a staff of teachers and assistants. Yet in another case the day care center did not meet the definition of educational activities as its primary purpose- “its function was more custodial in nature.” [Revenue Ruling 78-446.]

Other Schools: The IRS has even permitted other organizations to satisfy the educational organization definition, e.g. a martial arts school [Revenue Ruling 78-309] and a school that provided yoga instruction and promoted the practice of yoga for an 8-week instructional program, but not for the other activities provided by the yoga ‘school.’ [Revenue Ruling 79-130.]

Boarding Schools: One area that the IRS has not yet answered is with regard to a flat-fee boarding school charge, where there is no breakdown in the flat-fee between the tuition portion and the room and board portion.

Not Tuition: What is not covered in tuition are the expenses for tutors, summer camp, payments to a nanny or an au pair,  or dorm and book and fee expenses.

Prepaid Tuition: The IRS has even recognized the prepayment of tuition on behalf of children and grandchildren as qualifying for the IRC 2503(e) exception to a gift. In one situation, a grandmother prepaid 5 years of tuition for her two grandchildren in the amount of $181,401, none of which was treated as a gift. The IRS held that the payment of tuition directly to the school was not a gift so long as it was not subject to a refund, i.e. the payment could be forfeited. [Technical Advice memo 199941013 (July 7, 1999.]

In another case, the prepayment of tuition on behalf of 6 grandchildren to their private school was permitted so long as the prepayment was neither refundable nor did it guarantee enrollment for the grandchildren. In this situation, the grandparent also had agreed that if the tuition was later increased, the grandparent agreed to pay the shortfall for that school year. [Private Letter Ruling 200602002 (January 13, 2006.]

Practical Observation: With the current concerns about an impending reduction in an individual’s applicable exemption amount and the thought of exploiting that large gift tax exemption while it exists, a direct payment, or prepayment, of a child or grandchild’s tuition obligation makes a lot of sense. Even if a trust has been previously created for a child, with the expectation that the trust will be used to pay for that child-beneficiary’s education, it may make more sense to directly pay the child’s tuition relying on IRC 2503(e) and not deplete the trust’s corpus in the payment of the child-beneficiary’s tuition expenses, thus permitting the trust to continue to grow as a wealth accumulation vehicle. The same might even be said even if a IRC 529 educational fund has been previously established for the child, thus limiting the use of the 529 account to pay non-tuition educational expenses while directly paying the tuition obligation.

Conclusion: The direct payment, or prepayment, of a child’s tuition obligation is a great way to reduce the size of the donor’s taxable estate and not incur any gift tax, or ‘waste’ the donor’s annual exclusion gift opportunity, or the donor’s applicable exemption amount. Prepaying the tuition obligation can remove substantial amounts from the donor’s taxable estate at one time, while permitting the donor to use his or her applicable exclusion amount in other wealth-shifting strategies.