Take-Away: Health and Education Exclusion Trusts (HEETs) are an effective way to pay for tuition and medical expenses while avoiding the generation skipping transfer tax (GSTT.) However, the recent proposed 2024 Budget revenue provisions attempt to curb a perceived abuse

Background: A Health and Education Exclusion Trust (or HEET) is a dynasty-type of trust that is intended to directly pay medical and tuition expenses of persons who are two or more generations younger than the trust’s settlor. A HEET builds on the federal gift tax provision that excludes as a taxable gift direct payments of a beneficiary’s school tuition or medical care expenses. [IRC 2503(e).]  Often a grandparent creates and funds the HEET for the benefit of his/her grandchildren and more remote descendants.

GST Exclusion: A HEET further builds on IRC 2611(b)(1) that provides that distributions from an irrevocable trust directly for a trust beneficiary’s school tuition or medical care or medical insurance are not generation skipping tax (GST) transfers, no matter what generation the beneficiary is in. Accordingly, a HEET enables an individual to make a lifetime or testamentary gift to fund an irrevocable trust (the HEET) without incurring the generation skipping transfer tax (GSTT). As its name implies, the funds held in the HEET can only pay for medical or educational needs of a settlor’s grandchild and the grandchild’s descendants.

Charitable Beneficiary HEET Requirement: One ‘catch’ to the use of a HEET is that at least one beneficiary must be a charitable organization. Restated, a key feature of a HEET is to ensure that the HEET itself is not considered a skip person. If all of the trust beneficiaries are skip persons, then the transfers to the HEET would be considered direct skip taxable transfers., subject to the GST tax. This otherwise taxable transfer is avoided by providing that at least one of the beneficiaries is not a skip person. Naming the charity as a potential beneficiary of the HEET prevents the HEET from being classified as a conventional generation skipping tax transfer (GSTT) trust that is subject to the GST tax on distributions and terminations.

Meaningful Amount: The charitable beneficiary (or beneficiaries) can be selected by the settlor or left to the discretion of the HEET trustee. In order to ensure that the charity has a valid interest in the HEET and the HEET is not considered to be a skip person, the charity must have a present, nondiscretionary right to receive income or principal from the HEET. It must, per the IRS, be a “meaningful amount.”

Fixed Amount: Charitable beneficiaries can only receive funds from the HEET as qualified transfers under existing IRS rules, i.e. the direct payment by the trustee. The amount that the charity receives annually depends on the terms of the individual HEET instrument. Conventional wisdom has been that the amount of income that is distributed annually to the charitable beneficiary must be between 6% and 10% to escape IRS scrutiny.

No Charitable Deduction: There is no immediate income or gift-tax charitable deduction available when a settlor establishes a lifetime HEET. If, however, the HEET is structured as a grantor trust, the distributions to the charity will be deductible by the settlor-grantor. As with all grantor trusts, since the settlor-grantor pays the tax on the HEET’s income, a grantor taxed HEET also benefits its beneficiaries, since the growth of the HEET’s principal is not diminished by any income taxes.

Aggressive HEET Planning: Creative planning of HEETs over the years included adding as the HEET charity a social welfare organization as a permissible beneficiary with an interest in the HEET that was sufficiently vague so to avoid being treated as the charity’s ‘separate share.’ Social welfare organizations are technically described in IRC 501(c)(4); however, they are not publicly supported charities under IRC 501(c)(3) that seem to be more highly regulated by the government.

Why Include a Charity: The purpose of intentionally including the social welfare organization as a potential beneficiary-distributee of the HEET was that, as a non-skip person under the GST rules, the social welfare organization would continue have an interest in the HEET (regardless of who the other individual HEET beneficiaries are). [IRC 2612(a)(1)(A).] The result, so the thinking goes, is that the HEET will avoid the imposition of a GST tax on the taxable termination that would otherwise occur as beneficial interests in the HEET pass from one generation of individual beneficiaries to the next generation of individual beneficiaries.

2024 Budget Proposal: The recent Greenbook (page 128) with its multiple tax proposals intended to finance the proposed 2024 budget, includes a short but clear provision that would prevent the use of a social welfare organization under IRC 501(c)(4) as a HEET beneficiary. Specifically, the Greenbook provides that “additional tax-exempt organizations would be ignored for purposes of the GST tax, i.e. 501(c)(4)-(9) or 501(c)(11)-(29.)”

Observation: It is not clear to me why naming a social welfare organization is somehow an abuse that needs to be curbed by the proposed change to the Tax Code. The Greenbook does not say why there is an abuse and why it needs to be curtailed. What is clear, though, is that going back to 2013, the IRS was targeting HEETs as a form of tax abuse that it wanted to outlaw.

Conclusion: If this proposal under the Greenbook becomes law it does not mean that HEETs are no longer viable as estate planning tools. Rather, it is just that the HEET’s charitable beneficiary should be limited solely to a 501(c)(3) tax exempt organization and that its interest in the HEET should continue to be substantial.