Grandparents have long written checks to cover college and private school tuition for their grandchildren. And why not? It's a way to transfer thousands of dollars -- private school tuition alone averages $17,000 a year for 12th graders nationally -- to younger generations for a worthwhile purpose, while avoiding gift and estate taxes. Now, a recent Internal Revenue Service ruling lends support to individuals who'd like to transfer even more tax-free by prepaying years' worth of tuition. "We're seeing more individuals as well as schools who want to do this," says Susan Frunzi, a partner at New York law firm Schulte Roth & Zabel. "College and private school tuition is so expensive. Prepayments are a big help even to upper middle class families."
Strictly speaking, the IRS "private letter" ruling applies only to the taxpayer who requested it -- in this case, a grandparent prepaying several years' tuition for six grandchildren. But advisers say that if others follow the ruling's guidelines, which echo a similar private letter ruling from 1999, they're likely to receive the same favorable tax treatment.
You don't have to be a grandparent or even a relative to prepay a child's tuition. Be aware, though, that you risk forfeiting money if a student drops out or transfers to another school. This is the reason prepayments make the most sense for older people who have a need to transfer money out of their estates quickly, says Janine Racanelli, managing director at JPMorgan Private Bank (JPM).
You can give away up to $1 million during your lifetime tax-free. On top of that, you can transfer up to $12,000 a year tax-free to as many people as you like. On every dollar you give away after that, though, the federal government imposes a gift tax of up to 46%. When it comes to gifts to grandchildren, anything above $2 million is also subject to a "generation-skipping" tax, which is generally up to 46%.
But tuition payments don't count. Based on the IRS ruling, a grandparent can prepay as much tuition as he or she wants to and still give each grandchild $12,000 a year tax-free. Some caveats: You will have to pay the school directly, and if you foot the bill for expenses aside from tuition -- such as room and board -- you will have to use up some of your $1 million lifetime or $12,000 annual gift tax exemptions.
By prepaying many years' tuition, grandparents can also transfer substantial sums from their balance sheets, thereby reducing their taxable estates. Currently, the federal government levies a tax on estates worth more than $2 million. (Some states, including New York and New Jersey, impose their own taxes on smaller estates.)
Under the IRS private letter ruling, the benefactor agreed to pay tuition for future years at today's rate and to cover increases as they arise -- or the parents would become liable. In addition, the ruling requires that the money be "nonrefundable" to escape taxes, says Blanche Lark Christerson, a managing director at Deutsche Bank Private Wealth Management.
In practice, many private schools have forwarded unused tuition prepayments to another school when a student has transferred, says Sarah Daignault, executive director of the National Business Officers Assn., an organization that serves financial officers at private schools. You can always ask a school to agree to such terms in a contract or letter of agreement. Brooks School, a private boarding and day school for students in grades 9 through 12 in North Andover, Mass., currently has tuition prepayment agreements with two families. Both provide for any unused money to be transferred, in the event that the students switch to other schools, says business manager Jim Pugh.
But the IRS ruling doesn't make clear whether the agency would look favorably on such an arrangement. "The risk is that if you die, the IRS may say you never gave up control over the money if you retained the right to redirect it to another school," says Christerson. "In that case, the money would return to your estate." To find out for sure, you would have to request an IRS private letter ruling of your own.
By Anne Tergesen