Prepaid tuition is a `good thing'

A recent Internal Revenue Service ruling is an estate planning opportunity for school patrons and a development opportunity for private schools. The ruling involves Code Section 2503(e) which allows a grandparent to pay a grandchild's tuition without the tuition payment constituting a taxable "gift" for purposes of the federal estate or gift tax.

Transfer tax background

Generally, high net worth individuals are limited to what they can give away without incurring gift or estate tax. Code Section 2503(b) permits all people to give away $10,000 a year to anyone else. Also, Code Section 2503(e) permits any person to pay additional amounts as tuition to an educational organization and to make medical payments on another's behalf without having such additional amounts be treated as taxable gifts. Gifts in excess of the limitations prescribed in Code Section 2503 can result in substantial gift or estate tax costs. After an individual exhausts his or her unified credit amount (an amount scheduled to grow from $675,000 to $1 million by the year 2006), the gift and estate tax rates rapidly reach an imposing 55 percent rate.

High net worth individuals have oftentimes exhausted their unified credit and are looking for ways to pass wealth to their children or grandchildren without incurring additional gift or estate tax. In other words, they are trying to reduce their net worth to avoid their wealth passing to the warm-hearted IRS. The recent IRS ruling presents just such an opportunity.

The IRS ruling

In the ruling, a grandmother entered into a written agreement with a private school providing classes for pre-school through 12th grade. Under the terms of her agreement with the school, grandmother prepaid tuition for her grandchildren.

The prepaid tuition was nonrefundable. In the event a grandchild ceased to attend the school, then the school would retain the funds.

After entering into the agreement with the private school and prepaying the tuition, grandmother died. Presumably, an estate tax return was filed and the prepaid tuition was not included in valuing grandmother's gross estate. The IRS held that Code Section 2503(e) applied to the prepaid tuition. In other words, under the arrangement entered into between grandmother and the private school, the prepaid tuition payments were not taxable gifts and the amounts paid to the school were not includable in grandmother's estate.

Estate planning opportunity

The IRS ruling represents a substantial estate planning opportunity for wealthy individuals who might not survive their descendants' school years. If grandmother's death is imminent or likely, grandmother can prepay her grandchildren's tuition and avoid substantial estate taxes. Essentially, she ensures that more of her wealth will benefit her descendants.

Development opportunity

Most private schools consider prepaid tuition a "good thing." First, those individuals who need estate planning and can afford to prepay tuition are the affluent individuals and families in the community that the schools want to attract as patrons. Second, if grandmother prepays tuition for her grandchildren and the tuition is forfeitable, the school can count on the grandchildren's attendance. In other words, mother and father will have a big incentive to leave their children enrolled in the school because the tuition is already paid. Third, in planning budgets and economic forecasts, prepaid tuition eliminates some of the guesswork.

Accordingly, boards of private schools need to adopt policies that will accommodate prepaid tuition arrangements. Then, development officers for the schools should identify those patrons who might benefit from prepaid tuition and educate them on the IRS ruling.

Conclusion

Under the right circumstances, prepaid tuition is a win-win scenario for wealthy patrons, their families and their educational institutions. Private schools should adopt policies, which will accommodate the estate planning opportunities afforded their patrons by the recent IRS ruling.

Steven P. Cole is an attorney with McAfee and Taft.

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